A tale of two industries, can it last?

Wednesday, 23rd September 2015 13:59 - by David Harbage

In the writer's blog of 3 September 2015, the increased uncertainty concerning the outlook for the world's economic prospects and global profits - highlighted by the VIX indicator - together with the prime ‘bear’ case for equity markets was flagged.

The article concluded with a rhetorical question: wondering if the current valuation of apparently robust businesses can prevail in a wider sell-off of stocks. In particular, if US equities fall (on a perceived overvaluation, compared to their longer term rating based on earnings multiple and asset backing), is it inevitable that thriving domestic businesses are similarly impacted?

Weakness in global commodity prices (take copper as an example, which has fallen 20% over the past four months) has typically been reflected and exacerbated (by operational and financial gearing) in the mineral extraction companies' share prices - like Rio Tinto falling from £29 to below £22 over that period. By contrast, the location-constrained price of UK land and houses has been resilient. This week has seen upmarket and London-focused Berkeley Group promoted into the FTSE100 (as the 83rd largest listed business), joining the stocks of volume national home builders Barratt Developments (no. 62), Persimmon (64th) and Taylor Wimpey (88th) in the index.

While short term traders might correctly consider that any stock offering big potential profits (on paper) cannot be immune from the wider market's retreat, longer term investors should re-assess retention by reconsidering the merits - and risks to - their individual industry and company-specific investments . Mindful that 'hopping off' out of a particular company share, or the wider market, will always leave the psychologically difficult consideration of when to re-enter (on the presumption that the individual deems equity investment suits their circumstances and objectives). And the very human risk of forgetting altogether.

So, taking a closer look at the UK home builders - which have bucked the overall market's performance - investors should remain vigilant to any deterioration in prospects for the industry. Amongst regular media dispatches on the subject, the following announcement from Mr Brandon Lewis, the housing minister, "that the government plan to see one million new homes built over this parliament" caught the writer's eye this week. In addition, the National Housing Federation’s statement that they had estimated 974,000 homes were required in the four years to 2014, but less than 458,000 were built according to data from 326 local councils. Elsewhere, in terms of pertinent news flow, HMRC advised that 106,480 homes changed hands in August (an 18 month high, but below the 149,000 transactions back in 2006), house prices nationally rose 5.2% over the year according to the Office of National Statistics and that 40% of homes were bought last year without recourse to a mortgage.

We also had news regarding the future pipeline. Changes in the planning process, initially by reference to the National Planning Policy Framework of 2012, appear to be taking effect. 158,000 detailed consents were awarded immediately prior to that in 2011, whereas 240,000 planning applications were granted in 2014. Further pressure has been put on councils this year - in particular to become more aggressive in releasing unused or occupied urban land. Supported by the Campaign to Protect Rural England, which estimates that there is enough such brownfield land to accommodate 1.8 million new homes.

Evidence of slowing economic growth and benign general inflation is keeping a lid on medium-longer term mortgage rates. Following the Federal Reserve Bank's recent decision to not hike interest rates in America, our central bank's chief economist Andy Haldane suggested on Friday that the Bank of England "may have to cut rates, to combat low inflation, rather than raise them". Bottom line, affordability by reference to mortgage costs does not appear to be a problem, with the consensus for a move in the overnight Bank rate slipping from May to September 2016. Affordability, by reference to gaining a deposit, is being helped by HMG's Help to Buy scheme and an increasing number of 95% loan-to-value offerings (and 120% where negative equity applies) have come to the market in September.

Yesterday's announcement by Telford Homes of a £23 million purchase of land in its east and north London heartland - with the potential to build four significant developments, which have the potential to add £500 million to the company's development pipeline - is encouraging evidence that land can be acquired at reasonable price, even in the capital which needs another 100,000 new homes to keep pace with population demand. The aforementioned Berkeley Group and AIM listed Inland Homes also specialise in such urban - rather than the more controversial 'nimby' green field - redevelopment.

Over the past month, most of the major national house builders have reported trading results (in-line with, or ahead of, City expectations) and commented on the critical future issues of replenishment of their land banks and the planning process - as well as shorter term issues of material costs and labour shortages. Whilst naturally wary of over promising and under delivering, consensual opinion from these industry leaders has been encouraging and suggests a more sustainable (by reference to costs, selling prices, profit margins) outlook.

Long term investors will have to consider if they agree with this view - or perhaps alternatively suggest that the builders are talking up their own book ("they would say that, wouldn't they?") Secondly, make a call on domestic house prices; while demographic drivers of population and smaller family units cannot be disputed, a global slowdown would necessarily adversely impact UK jobs and the housing market. If comfortable on those counts, then the investor must be prepared to 'sit out' any further market turbulence. And be content to pick up regular dividend income - which is set to be comfortably ahead of cash interest rates for the foreseeable future.

While asset backing (assessing the net worth of a company) is currently relatively low - at around half of equity worth - earnings and pay-out (in the form of dividends) ratios appear attractive. Putting a figure on this, Berkeley Group is currently forecast (on an average of 14 brokers) to produce profits of 245 pence and a dividend of 150.5 pence in its current year which ends on 30 April 2016. Based on its 3330 pence share price at the time of writing, this equates to a prospective earnings yield of 7.3% and a dividend income yield of 4.5%. The same analysts predict earnings of 378 pence in the following year for Berkeley (which equates to an 11.3% earnings yield), accompanied by a 155 pence dividend.

While the overall prognosis from the builders' latest missives on the outlook has been consistently positive, in valuation terms the companies’ equity naturally differs a little. The largest, most liquid (easily dealt and worthy of a significant investment to a big fund manager) tend to be more expensive than their smaller peers but, in terms of profit-based metrics, all the premium listed builders are priced at a discount to the overall UK stock market. This reflects the historic 'boom-bust' nature of the industry.

The AIM listed builders, are less homogeneous: Telford Homes, pre yesterday's acquisition, appears cheap on an admittedly more lumpy (less predictable, as they often operate on longer term sites) earnings basis - featuring an earnings yield of 10 times in the year to 31 March 2016, based on a forecast 40 pence, but with little asset backing. Inland Homes, which focuses on taking unwanted (often publicly owned) land into consent, has the same 10% earnings yield - which incidentally also represents a PE ratio of 10, based on forecast 6.9 pence earnings - but has higher asset backing. The outlook for both companies is, by reference to their particular activities and scale, less certain than their higher volume peers and both will do well to maintain profits at a rate of 10% of their current market capitalisation in their respective second forward year.

Investors have to decide how much risk is already - or not - priced into the shares of the house builders. Essentially, the magnitude of a profits fall if appetite for homes (often from overseas investors in the case of London property or, for prospective UK buyers, prompted by job loss or higher mortgage costs) were to diminish. Ultimately, the safety and the relative attraction of the dividend income will be the prime determinant for an institutional investor - and, amongst the current turbulence in the stock market, should be a key consideration for private individuals too.

In current market conditions, it is tempting to acquire the apparently oversold stock - such as the natural resource giants, be it in mining or the oil & gas segments of the industry. But this writer would prefer to await real evidence of a turnaround (for example in the supply-demand picture of the particular commodity or in the global economy) before owning such businesses, and would prefer those that are currently flourishing.

Written by David Harbage

22 September 2015

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The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.