Financial Jungle

This MSN Money article by Jack Hough of SmartMoney is a must read if you’re a renter. I love this article for a number of reasons; it’s provocative, but more importantly, it’s like seeing myself in the mirror, since we share so many similar opinions together!

It’s not easy being a renter. Letting the world knows you’re a renter is like walking around town with a prominent “L” on your forehead. It’s just human nature. Renters are stereotyped as financially irresponsible people, however that’s simply a myopic view. There are just as many irresponsible buyers who live beyond their means by borrowing high-ratio mortgages. I don’t see homeownership as a necessity. Rather, it’s a culture, and sometimes, it’s even a status symbol like owning a BMW. No offense to Beamer owners.

Jack Hough starts his article with a confession that he rents despite having enough to buy a house. The reason? Stocks returned 7% inflation-adjusted over the previous century, while …

the average real return for houses over long periods might surprise you: It’s virtually zero.

Surely, that has to be a mistake! In the midst of one of the most glorious housing booms in Vancouver, homeowners roll their eyes when all the evidence point to double-digits return. Let’s not forget that over this short period (yes, 5 years is short), anything goes, but they don’t call it average for nothing. Sometimes prices overshoot, but eventually they’ll revert to the mean.

Over the long haul, home prices rise in tandem with rents. When prices race ahead of rents, the equilibrium is disrupted temporary until either (a) prices fall or (b) prices plateau in order for rents to catch up. In the case of Vancouver, rents haven’t gone up as much, so price appreciation comes mostly from valuation expansion. To steal an analogy from the stock market, a stock can trend higher via P/E expansion even with earnings remain flat, but P/E expansions aren’t sustainable. Only fundamental improvements like earnings growth can push the share price higher over the long term. To give you some perspective, we sold our home in Nov 2006. The earning yield (which I inflated to satisfy any nit picky readers) was 3.9%. It was 5.2% when we bought 3 year earlier, and 7% when our former neighbors bought theirs.

Make no mistake about it. Renting and investing the difference in the stock market isn’t for the faint at heart. If you don’t have the stomach to face recurring setbacks in your portfolios, the little butterflies in you will hinder the execution. This post aren’t to encourage readers to sell their homes, but to point out that diverse point-of-views exist and they’re just as rational.

In his article, Jack Hough tackled a few common objections to this approach:

“You can’t live in your stocks” or “Renters throw money down the drain.”
No, but with a combination of diversified income trusts (read my income trust series) and dividend yielding stocks, it’s possible to derive close to a 3.9% yield to cover most of my rents. Moreover, yields from dividend-paying stocks and growth-oriented income trusts will outpace inflation, while rents will move in tandem with inflation.

“What about the pride of homeownership?”
Pride of homeownership is overrated to me, though I admit it’s a matter of preference. Similar to Jack, I relish the pride of owning successful businesses. When I have the urge, I munch at my favourite Korean food court to admire the Telus building across the street. On a good bicep day, Scotia Bank is also only a stone’s throw away from my office.

Another one that I heard, “income trusts and dividend-paying stocks aren’t diversified”
That’s true to a degree, but it’s still considerably more diversified than a home. The leaky condos fiasco in the late 90’s serves as a reminder to complacent homeowners that a single misstep can send anyone to bankruptcy. Contrast that to REITs where with a few mouse clicks, your portfolio is instantly diversified across the nation and different real estate segments including residential, office, retail, hotel, industrial, storage and nursing homes.

Alright. Maybe I can fit a little sequel to the income trust series.

I’m not sure if anyone noticed, but there is a distinct divergence between prosperous and crummy trusts in the aftermath of the income trust tax ruling. The prosperous ones continued to flourish, while the crummy ones never quite recovered to their roaring days.

You heard of the old saying:

A rising tide lift all boats

As long as everyone was happy about receiving their 10+% yield, no one was questioning the sustainability of the underlying foundations that supported these yields. Alas, all good things must come to an end. The tide came and went. The Halloween upheaval exposed so many little elusive holes beneath some of the rottenest boats. The tax ruling announcement turned investors’ stomachs, and sure enough, most trusts retreated 15-20% the next morning.

As painful as it may be, I think Ottawa’s decision to plug the tax leakage was a blessing in disguise as it forced out the excess speculation in the trust market. Even the most relentless critics must admit; investors today (including myself) are more attentive to the quality of trusts. This is good! It serves as a wake-up call. Fussy unitholders put their trusts in a spotlight and make management more accountable to their actions. Wouldn’t you rather suffer a healthy 20% haircut today, than having your 10% yield tab shut tight during your golden years?

What do I mean by prosperous and crummy trusts? To illustrate, let’s contrast 2 strikingly different trusts: Canadian Oil Sand and Vault Energy Trust .

Now scrutinize Vault Energy 2006 cash flow statement and balance sheet. Folks, this is a textbook income trust that forensic accountant, Al Rosen, would love to hate!

• The $45.61 mil cash flow from operations is too cute when standing next to the $88 mil from capital expenditures and cash distribution.
• Switching over to their balance sheet, total assets are falling, total liabilities are rising, thus book value is falling.
• Outstanding shares are rising, which further dilutes the existing shares.

Still think all trusts are created equal?

Either I lack the bargain hunting talent, or SLR lenses age well like good bottles of wine.

Recently, I’ve been hunting for a used Canon EF-S 17-55mm F2.8 IS over at CraigsList.org. This lens is everything that I’m drooling for, abet a little weak on tele-zoom. However, this lens can shoulder most of my shooting demands, which include wide angle zoom, image stabilization, wide aperture, top notch resolution, minimal distortions, and silent auto-focus. Isn’t she a beauty? If you think point-and-shoot cameras are just swell, wait till you harness the power of fast auto-focus, instant power-on, noise-free ISO settings, and most notably, low-light performance. Once you are enchanted with a Digital SLR (DSLR) camera, you’ll howl over your old vacation photos with regrets.

Trouble is sellers treat this Canon lens as if it’s an appreciating asset like stocks! At eBay, you can bypass the auction process by directly purchasing products with the “BuyItNow” logo. For instance, TriState is offering this lens for $938Cdn. If you don’t mind the grunt work, you can often snatch this lens up for $900Cdn + $100 in shipping and taxes. In short, a brand new Canon 17-55mm for $1,000.

What are they asking for over at Craigslist?

• $1,100 - warrenty expired
• $1,300 - two weeks old
• $1,200 - 10 months old
• $1,150 - age isn’t specified, but include a lens hood
• $1,250 - age isn’t specified

I’m astounded by the asking prices. Shouldn’t there be an automatic depreciation of 10% once the lens is driven off the lot? Suffice to say, I’ll go tell my wife that I’m going back to eBay to claim my brand new Canon lens.

That’s my story, and I’m sticking to it.

One great reward about being a blogger is the new insights you gain from researching and presenting articles. It’s one thing to skim over the Internet for the lowdown of income trusts, but quite another to articulate them to an audience. So much to learn still despite spending a couple of evenings on O&G trusts. Well, this post wraps up my part on the income trusts series initiated by Thicken My Wallet. I hope you’re enjoying it so far.

Saving the worst for last, oil and gas trusts are probably the most provocative group of all.

O&G trusts are holding structures that own the right to royalties on the production of natural reserves. These trusts do not engage in explorations. Instead, they negotiate and buy royalties from exploration companies. These exploration companies will generally stay behind to manage the production, but the trusts and their unitholders own the right to the stream of profits from the reserves. The one key difference between investing in O&G trusts and most other investments is that at the end of the day, your equity vanishes! Poof! Your objective is to squeeze every drop of your money back from the reserves, and hopefully a little more to compensate you for the risk-taking.

On the surface, O&G trusts have few bright spots:

• No exploration risks
• Reserves are well known
• Productions are well known
• Operation costs are well known

Alas, these trusts also come with a number of caveats; one being the limited lifespan of these reserves, many of which will not survive more than 10 years. In order to nourish the cash distributions to unitholders, the trusts must continuously replenish depleting reserves through new acquisitions. Huh? New acquisitions? Where are the down payments coming from? Through share issuances and debt financing of course. This part bugs me the most. This arrangement is reminiscent of the Ponzi scheme, where money from new investors is scrounged to maintain distributions to existing unitholders. The tale doesn’t end here, because the new reserves, as their predecessors, also have a limited lifespan. Saving investors from the agony of waning income, the trusts must dig themselves into deeper holes by tallying up even more investors and even more money to fund even more new reserves.

This illustrates the fundamental flaws of this trust model. No rational investor will want to share her profits when she’s the one risking her money on the line. If she’s the rightful owner of the new oil wells, she deserves all the cash flow produced from it.

Our anxieties shouldn’t end here. In addition to the dwindling reserves, investors must be conscious of future oil and gas prices. For instance, the price of crude oil today is $75 which is near its historical high. If the production cost per barrel of oil is $45, one may project a margin of $30 per barrel until all the reserves are depleted, but this is not a sure thing. A mere $10 drop per barrel would evaporate 33% of the profits. Even a cursory understanding of the intricacies behind oil and gas trusts explains why cash flows from O&G trusts can be erratic over time when compared to bonds. Oil trusts achieve high levels of operating leverage as their production costs are largely fixed no matter what the crude oil price is. Profits are a function of the prevailing crude oil price. As oil price diverges from costs, profits expand. Conversely, as oil price gravitates toward costs, profits erode. The lowest cost producers have the best competitive advantage against price volatility.

Finally, O&G trusts are very interest rate sensitive, as with all income trusts. This is a given.

With these caveats in mind, I’ve compiled the following criteria to help jump start your search if you’re extremely bullish on energy prices.

• Long-life reserves - Keep the distributions coming longer.
• Low(est) cost producer - Profits from the lowest cost producers are the least sensitive to energy prices. Likewise, a small dip in oil prices can wipe out all of profits from the least efficient producers.
• Clean balance sheet - The less debt on the balance sheet (low Debt/Equity ratio), the less sensitive it is to interest rate fluctuations.
• Low payout ratio - This is especially true for O&G trusts that engage in Pac-Man acquisition sprees.

Example: Canadian Oil Sand

If I were to invest in an oil trust, it’d probably be Canadian Oil Sand. It owns a 37% interest in the Syncrude project, a pure play in an oil sand that has stunning reserve life of 40+ years. I believe the slow depletion rate is confirmed by the miniscule 3% in of Return of Capital. The trust also sports a healthy 0.36 Debt/Equity ratio and 55% payout ratio, notwithstanding a weak 4.9% yield. Based on some preliminary readings on their web site and StockChase.com, they have just completed the third and final stage of their Syncrude 21 expansion. With capital spending behind them, analysts expect distributions to rise this and next year subject to oil price remaining at a high level.

According to Syncrude, their operating cost per barrel is $26.46 in 2006. That’s pretty cheap! Perhaps I’m missing something, but there is an enormous margin between the operating cost and the market price of $75 per barrel. The dual of low debt obligation and efficient production should yield some breathing room from external crisis such as deteriorating oil price and soaring interest rates.

Other Oil and Gas Trusts

• PenGrowth Energy
• EnerPlus Resource
• Bonavista Energy
• Crescent Point Energy
• Harvest Energy

Additional Resources

• In case you’re interested, a video of the oil sand production process is available here: “How We Make Oil at Syncrude”
• Hot idea fuelled energy trusts - A nice history on energy trusts.
• To keep abreast on the current energy prices, visit Bloomberg.

Pipeline trusts are terrific additions to any diversified portfolio; their cash flows are generous, predictable and sustainable. When you buy a pipeline trust, you’re buying a combination of long-lasting energy infrastructure cash-cow machines used to transport and store oil and gas. Many pipeline trusts are involved in some of the largest and longest-lasting oil projects in North America, thus enabling them to secure long-term contracts to transport oil from productions to refineries.

What are some of the key characteristics of pipeline trusts?

1. Strong competitive advantages from high barriers to new competitions due to hefty capital costs, government regulations and brands.
2. Pipelines have longevity and low maintenance.
3. Revenues are largely fixed while capital expenditures are minimal. (Translation: reliable cash flows)
4. Not much growth potential. Buying at the right price is crucial, because you don’t want to be stuck with a low yielding and slow growing investment.
5. Unlike oil and gas production trusts, pipeline trusts’ transportation revenues are generally decoupled from commodity prices.
6. Since pipeline trusts must compete with other income-based securities, share prices are sensitive to the prevailing interest rates.

What to look for in a pipeline trust?

• Squeaky-clean balance sheets - We want to turn away trusts burdened with massive debts on their balance sheets. Trusts with conservative capital structures desensitize themselves from rising interest rates, and give them little wiggle room to expand. The key ratio to look for is the Debt-to-Equity ratio. Here are several examples: Inter Pipeline (0.56), Pembina Pipeline (0.75) and Fort Chicago Energy Partners (1.99 - ouch!)
• Positive cash flow - As with all income trusts, ensure the pipeline business generates enough money to maintain existing infrastructures and to pay us cash distributions. Normally, I’d glance over the cash flow statement from MSN Finance, but there underlies a problem; capital expenditures lump both maintenance and expansions together. Since a few of the major pipeline trusts, likeInter Pipeline and Pembina Pipeline) are currently in expansion mode, I have to discern maintenance from other growth initiatives. Otherwise, MSN Finance will confuse me into thinking that these trusts are bolstering the distributions with new shares and debts — a very yucky situation. There are no short-cuts. Investors must download and soak up the annual reports to separate out the maintenance expenses.
• Payout ratios - This goes hand-in-hand with the positive cash flow criterion above. The lower the payout ratio, the safer the distributions. Do not blindly accept the payout ratios from third-party sources, such as MSN Finance, due to discrepancies in how distributable cash flows are calculated. It’s best to crunch the payout ratio yourself. An example is coming.
• High S&P Stability Rating - A trust with a high S&P stability rating has a better chance of sustaining the distribution. Most of the high quality individual trusts have an SR-2 rating, whereas “portfolios of funds” tend to have the SR-1 rating. Some of the SR-2 rated trusts include CML Healthcare, Pembina Pipeline, RioCan and Yellow Pages. It’s too bad that S&P doesn’t rate all the available trusts. However if a trust is listed and it’s below SR-2, don’t bother investing.

Example: Inter Pipeline

There are several popular pipeline trusts at your disposal, but I’ll pick Inter Pipeline since Money Gardener has been nagging me a couple of times. When you buy Inter Pipeline, you become part-owner of the following enduring assets:

• 5,900 kilometres long of petroleum pipelines (Four conventional oil pipelines, and two oil sand pipelines).
• 3.6 million barrels of storage in western Canada.
• The above assets pipe 822,000 barrels per day of oil sands bitumen, conventional crude oil and gas plant condensate, with a market share of 18% in western Canadian conventional volumes and 50% of oil sands volumes. These represent 44% of earnings.
• 3 major natural gas liquids extraction facilities in southern Alberta on the TransCanada system. These facilities are processing 4.2 billion cubic feet/day of natural gas and producing 142,100 barrels/day of natural gas liquids for now, but have the capacity to process 6.2 bcf/d of natural gas, and 195,000 b/d of natural gas liquids. (Don’t ask me what these numbers mean. ) These represent 41% of earnings.
• More impressively, their natural gas extraction facilities are responsible for processing 40% of Alberta’s natural gas export.
• 9 bulk liquid storage terminals in UK, Germany and Ireland. These represent 15% of earnings.

You can find Inter Pipeline’s distribution history here. As of this writing, the trust is trading at $9.51 with an 8.85% yield. The distribution is 85% taxable with remaining as tax-deferred capital gains (return of capital). Do keep in mine that although unitholders have been indulged with a bountiful yield, in exchange, they settled with an uninspiring 3.2% distribution growth rate.

Inter Pipeline has a positive cash flow. According to the cash flow statement, operational cash flow in 2006 is $201 mil. At first glance, this cash flow doesn’t cover the $160 mil cash distributions to unitholders and the $65 mil in capital expenditures, but wait. As I alluded to earlier, part of the capital expenditures is assigned to growth. According to page 40 of their 2006 annual report, only $5.6 mil was “sustaining capital expenditures”. The effective payout ratio after sustaining capital expenditures is around a healthy 82% ($160 / [$201-$5.6]).

Unfortunately, S&P doesn’t have a rating on Inter Pipeline.

Valuation wise, the best two times to buy Inter Pipeline were in 1999 when investors were flocking to growth oriented technology stocks, and in Nov 2006 when Finance Minister, Mr. Flarity, detonated the Halloween bomb on taxing income trusts. Moving forward, I don’t see any more corrections in the horizon unless Bank of Canada hints further hikes are lurking beyond Sep 2007. The units have settled in the range of $9.00 and $9.80 and trending upward. The trust is suited for RRSP, because the tax on distributions can be deferred inside in registered accounts.

Disclosure: I don’t hold Inter Pipeline nor any other pipeline trusts. As always, I’m an amateur investor. Do not buy or sell securities based solely on the information provided on this site.

Examples of other pipeline trusts:

• Inter Pipeline
• Pembina Pipeline
• Fort Chicago
• AltaGas Income
• Gaz Metro
• Keyera Facilities

I’m collaborating with Thicken My Wallet and Million Dollar Journey to compose a series of posts on income trusts investing. Thicken My Wallet is leading the series with a bird-eye’s view on the financials such as payout ratios, cash-flows, capital expenditures and financing. I recommend you visit his introductory post, and then follow his links to the different categorizations of income trusts by Million Dollar Journey and me.

The traditional sense of business trusts is slow-growing mature businesses in the manufacturing, service or general industrial sectors. They typically produce stable cash-flow and distributions to trust-holders, which is why yield-starving investors are finding the distributions from business trusts irresistibly tempting. However, critics are warning that a majority of business trusts are sprinkling only small amounts of genuine income from operations, while a significant amount (over a third) of the distributions are simply return of equity.

Return of equity is the original capital returned to investors. For instance, suppose you invest $10 in my business. When I take $1 out of the pool and give it back to you, that’s a return of capital. You get your dollar back, but your investment is now worth only $9. Obviously, this magic show can only sustain until there’re no more rabbits in the hat. It’s crucial for investors to scrutinize the distributions beyond the yield percentage. Often, a trust yielding 6% has fortified growth profile and solvency, but another is upholding its 15% yield using cash from new share issuances. Some people call this scheme Ponzi, where the business tallies up cash from new investors to maintain the distribution.

Here at Financial Jungle, we shun away from return of capitals, and favour only exceptional business trusts that produce sufficient cash-flow to fund all of maintenance expenses, income distributions and growth. One such fabulous trust is North West Company fund (NWF.un), which constantly brings me tears of joy whenever I admire its filthy rich cash flow statement. Here are some criteria I’m looking for:

• Cash from Operating Activities - This is a summation of all the cash generated from the business’ operations. Although an up trend is a must, investors must ascertain the quality of the operational cash-flow to rule out any anomalies within. For examples, is the trust producing a humongous cash-flow by deferring tax obligations and/or not replenishing working capital? Investing Skeptically lead me to this article by the ferocious Al Rosen. In his words,
  
  

  We tell our institutional money-managing clients that all cash flow mistakes result from the arbitrary timing or classification of management actions or inactions.

  I believe one method of rectifing the disparity of timing is to measure the trend over multiple fiscal years instead of snapshotting one year. Looking at North West Company fund, the operational cash flow looks reasonably clean: income is rising, depreciation is stable, and working capital evens out over time.

• Cash from Investing Activities - The crucial factor is capital expenditures. Capital expenditures are investments made by the trust to maintain or grow the operations through purchases of physical assets such as property, industrial buildings or equipment. Trusts with capital expenditures greater than depreciation indicates that they’re replacing depleted assets as well as increasing capacity to stimulate operation growth.
  
  

  North West Company fund depreciated their assets by $120 mil over the previous 5 years. During this time, they reinvested $130 mil back to the business.

• Cash from Financing Activities - Total Cash Dividends Paid is arguably the most cherished figure by income investors; this is the actual cash distributed to trust holders. Any high-caliber business trust will fund this distribution internally with surpluses from operation after replacing depreciation.
  
  

  For instance, North West Company fund has $81.49 mil from operational cash-flow in 2006. Depreciation is $26.17 mil. That results in a surplus of $55.32 mil, which is more than enough to satisfy the $38.7 mil distribution. In fact, the trust has enough cash left over to expand its stores (capital expenditures > depreciation), buy back some shares (retirement of stock by $1.53 mil ), and repay some debts (retirement of debt by $5.57 mil).

Needless to say, I’m giving North West Company’s cash-flow statement a clean bill of health. I’d love to know what you think of this post, and learn your unique angles on business trusts investing. What other criteria do you fancy in business trusts?

Examples of business trusts

• Restaurants - A&W Royalties (8.7%), Boston Pizza (9.2%) and The Keg (8.8%)
• Transportation - Transforce Income (11.0%) and Contrans Income (11.0%)
• Retails - North West Company (5.6%) and Sleep Country (5.9%)
• Health Care - CML Healthcare (6.5%)
• Specialities - Versacold Income (8.2%), SFK Pulp Fund (11.8%)
• Media and Telecommunication - Yellow Pages Income (7.6%) and Bell Aliant (8.8%)

1. Stiff the waiter with a penny for poor service?
   Never. I always tip 15%. Tips are part of salaries in my book. I feel that restaurant owners factor in gratitude in their salary offers. According to this ad, this catering company offers only $12.00/hr in Vancouver, which is the least affordable city in Canada. The proper etiquette for handing poor services is to inform his manager, not to seize his pay cheques.
2. Pose naked for one million dollars?
   If I’m dead broke and look half as magnetic as Brad Pitt, then I might consider.
3. Want to know when you’ll die in order to plan your finances efficiently?
   You bet. Although I feel the chill of knowing my expiry date, that pales in comparison to experiencing maximum gratification from the fruits of my labour. I accomplish more with the ultimate deadline is looming.
4. Quit your current job if you win a million dollar?
   Yes. But I might launch a new career.

1. I’m watching our Canadian exchange rate in complete disbelief as the dollar advanced to 95.33 US cents on Friday. While my US positions (30% weighting) are getting whipped, I’m contemplating if I should snatch up some global dividend-paying US blue chips. The higher Canadian dollar buys you more US shares. At the same time, businesses with significant international revenues should benefit from the cheaper US dollar.
2. Value Discipline explains why a diverse market is healthier than one with homogeneous thinking. Passive, value and technical investors need each other for the market to flourish. Group hug everyone!
3. If you have kids, don’t miss out on these free monies from the government: spousal amount tax credit, tax-deduction on day care expenses, Universal Child Care benefit, and Canada Child Tax benefit. Reference MillionDollarJourney and Canadian Capitalist for more juicy details.
4. Walter Updegrave warns against mixing your investments with insurance products. Tax saving is the sales pitch, but the humungous fees will drag the portfolio. I’ve written a similar piece on universal life insurance.

I was quite skeptical when Horizon BetaPro released this leveraged ETF at the beginning of this year. It promises to double the TSX 60’s daily volatility before various fees. For instance, if the index is up 1%, the ETF rises 2%. Conversely, if the index is down 1%, the ETF dips 2% as well.

Despite Horizon’s emphasis on daily performance, I believe the ETF should emulate two-times the index’s long performance provided that (a) the short-term amplifications remain consistent, and (b) the volatility is tame.

On the surface, this strategy is more electrifying compared to the alternative of direct leveraging. Let’s assume you like to double your TSX 60 holding with borrowed money at 6% prime. If the index is up 10% over the next 12 months, then your return on investment is 14% (10% plus the 4% on the borrowed money after paying for interests). With BetaPro, your ROI is 20%. Sweet! Secondly, with borrowed money, you can lose more than your ante, if the index tanks by more than 50%. With BetaPro, you only lose what you invested.

However, here’s the problem: the arithmetic breaks apart in a volatile market. For instance, if your $100 index fund declines 20%, and recovers 30% the next day, the resulting balance is $104 ($100 x 80% x 130% = $104). Effectively, you’re up 4%. On the other hand, when your $100 in BetaPro declines 40% and recovers 60%, the resulting balance is $96 ($100 x 60% x 160%). You’re down 4%, not doubling the index’s return. There’s no free lunch!

Arguably, this could be the most vulnerable time to double your exposure to this index after nearly five-years of uninterrupted prosperity. Investors should thread carefully.

This ETF is only six-months old, but the short history looks promising so far. The MER is 1.15% on your invested capital, or 0.575% when you spread it across the exposure. Since I’m more of a buy-and-hold investor, I may consider this ETF as long as it has the potential to reach my investment goal in half the time. Having said that, I’ll patiently observe how the ETF behaves over a complete market cycle prior to jumping in with both feet.

Sources

• Inverse and Leverage ETFs - Larry MacDonald
• Horizon BetaPro Funds

One man’s garbage is another’s treasure. Sometimes it’s quite fruitful to snoop around other people’s dumpsters salvaging disgraced stocks.

Lo and behold, I may be gaping at the rottenest of all: Homebuilder stocks. The S&P Homebuilders index has been nailed and hammered over the past couple of years, and is already plummeting 20% six-months into 2007. Many Homebuilder stocks are teasing their historical low price/book ratios, but who can blame the market when you consider:

• The National Association of Realtors is reporting a nine-month worth of home inventory waiting to burn through. This is a 15-year high.
• The sub-prime fiasco is forcing lenders to tighten their mortgage lending practice, thus reducing housing demand.
• Homebuilders are lowering their prices and enticing buyers with perks in order to clear the excess inventory.
• Homebuilders are expiring and writing off their land options.

I know this may sound counter-intuitive, but bad news is good news for value investors, because the stocks have already absorbed much of these glooming expectations. (For full disclosure, I purchased a half position in DR Horton, which I’ll get to later.)

On Monday, Citigroup slapped nasty downgrades against many Homebuilder stocks:

Analyst Stephen Kim downgraded to “Hold” the shares of D.R. Horton Inc., Hovnanian Enterprises Inc., KB Home, Lennar Corp., Pulte Home Inc., Toll Brothers Inc. and Ryland Homes Inc.

What happened to the DR Horton stock? It dusted off a miniscule 1% over the next 2 sessions. Shareholders are so accustomed to pessimistic forecasts that they barely flinched after the downgrades. When the stock is already priced for disaster, the low expectations along with a higher dividend yield bolster the current price point.

Since homebuilding, by nature, is a cyclical sector, price-to-earning and price-to-sales are deceptive valuation matrices due to the fickle earnings and sales figures. A more reliable valuation matrix for cyclical stocks is the price-to-book ratio, assuming the company can hold its book value steady. Please visit MoneyCentral to appreciate how DR Horton vigorously maintained a modest equity growth even during these difficult times, and then compare what it’s trading now in relation to its historical price-to-book ratios.

Current P/B = 0.96

The question now isn’t if a recovery is looming, but when. Most of the industry experts are projecting a revival of the housing sector within the bottom half of 2008, so securing a HomeBuilder stock at this time may appear premature. However, the market tends to factor in future expectations into today’s price. Accordingly, the stock should rebound ahead of the sector. To quote Brett Arends from TheStreet.com:

[The current valuation] is a fraction of where the stocks usually trade. The last time we saw valuations this low was in late 1990, and that was in the depth of the last real-estate crash. And that time around, the shares quickly rallied — even though the housing market itself took years to get back in the swing.

There are two ways to participate in the Homebuilding sector. The diversified approach is to buy an ETF, such as XHB. The other approach, my preference, is to bypass the MER and snap up a stock directly, since Homebuilders tend to swing in lockstep with each other. DR Horton(DHI) is a reasonable choice because it is the largest US Homebuilder, and the company is buying you beer (3% dividends) while you wait for the inevitable vengeance.

DR Horton traded as high as $42 before tumbling down to $19.75. I haven’t decided when to double-down yet, but I suspect the next cyclical peak will likely surpass the previous high.

Disclaimer: I’m an amateur investor. This is not a recommendation to buy. I welcome any constructive feedback.