2023-07-26 07:44:53 ET
Summary
- The US's largest homebuilder, D.R. Horton, has reported positive operating results alongside its land bank subsidiary, Forestar Group, amid a market of high mortgage rates and tight housing supply.
- Forestar Group, which was previously undervalued, has seen its shares rise significantly due to its role as a key supplier to the home building industry.
- Despite its high profit margins, Forestar Group stock is no longer seen as a compelling value due to its current share price, prompting some investors to sell their shares.
The nation’s largest homebuilder, D.R. Horton ( DHI ) recently reported operating results coincident with its land bank subsidiary, Forestar Group (FOR). By all measures, the economic circumstances of higher mortgage rates in a market of sustainingly tight housing supply, has created an environment where home builders might thrive. Long passed over, FOR has become today’s FOMO issue in a resurgent, rediscovered appetite for home builder stocks.
Homebuilder Share Price Performance YTD 07/24/2023:
Source: S&P Capital IQ
Land: They are not making any more of it
As a value focused investor, we twice in last year’s fourth quarter wrote about our optimistic outlook for Forestar. FOR shares were trading at a huge discount to book value, but the company was still delivering impressive profitability.
At the time, it seemed that though housing demand remained high, financial conditions had changed to adversely affect the options for both home builders and home buyers; credit had tightened and become more expensive for builders and soaring mortgage rates had priced many prospective buyers out of the market. Builders could not affordably inventory or finance lots and buyers could no longer swing the monthly mortgage payments.
Our argument was that a lot manufacturer, like Forestar Group, could be the magic ingredient that would grease the wheels of a stalling market. Look what happened.
The New World
On July 18 th , CNBC’s Diana Olick reported that the survey of homebuilder sentiment had risen for the seventh straight month to reach a reading of 56 (anything above 50 is considered positive sentiment). This data was fully in line with recent quarterly reports from almost every home builder outlook. Most delivered more homes than forecast and many upped guidance for future deliveries.
Specific to Forestar, D.R. Horton raised its fiscal year sales estimates to more than 83,000 homes from a previous estimate of 78,500. To make that delivery, they must buy about 5,000 more lots. FOR, a largely owned subsidiary of DHI, is D.R. Horton’s lot pipeline. FOR also aspires to be the finished lot pipeline for any other optimistic builder.
Manufacturing
In our prior examinations of Forestar Group’s business model, we really understood the essential simplicity of the product that they offer. Before you build a house, you must have a lot. Current credit markets and capital constraints make FOR a more valuable vender than they have ever been. DHI has the means, but FOR is the economic choice; for other builders without the means, FOR may be the only functional choice.
With FOR’s “manufacturing” approach to supplying the home building industry they now sit in the catbird’s seat. FOR has a huge lot inventory. They have liquidity and access to capital. This combines to address all of D.R. Horton’s demand and third-party builders as well.
Market Change
We have spent the better part of four decades as value investors in pursuit of discounted acquisitions. When we last covered FOR in the 4 th quarter of 2022, shares were changing hands at 25% discounts to book value. We are in a different world now.
In 2022, FOR enjoyed high profit margins and could be purchased at a 20%+ discount to its $25 book value. Today, FOR still has high, sustainable profit margins, but you have to pay $28.75 for shares (an 11% premium to book).
Forestar Group has transitioned from a value/growth play to a momentum stock. We bought shares for their deep value discount and pace of growth. That discount has more than evaporated and we have sold our shares.
Forestar Group is a great company. At these prices it is no longer a compelling value. We will continue to watch but will not buy until a significant discount returns.
Other discounts abound!
Patience Ultimately Rewards Value Investors
Last fall, in revealing our interest in the likes of FOR, the soundness of our reasoning may have come into question. Maybe our supposition of buying land for a 20% discount to its market value was a false premise in the gloom that surrounded the home building industry. Eight months later passive ETFs are tripping over themselves to buy shares at double digit premiums to book value. Go figure.
Discipline is the overriding governance for value investors. Take your measures. Take them again. Remain long for as long as your value/growth prospect exists. When the value/discount sublimes, take your measures again. When the discount evaporates, sell and pursue new opportunities.
For further details see:
Forestar Group: Linchpin Of The Resurgent Home Building Sector