If the boss is selling, should you?

Monday, 18th September 2017 09:13 - by David Harbage

Last week housebuilder Linden Homes – which is part of the FTSE250 index construction group Galliford Try - announced that it built 7% more homes in the year to 30 June 2017 (to 3,296) and achieved a 6% uplift in the average selling price of its private completions (77% of the total) to £354,000. Moreover, the company expressed confidence that the second half of 2017 had begun strongly – despite the political instability caused by the June election and the apparent weak consumer confidence indicators. This was just the latest in a series of trading results – and typical of outlook comment - from a number of the listed house builders over the past two weeks, including Barratt Developments, Berkeley Group, Bovis , McCarthy & Stone and Redrow.

While each update was positive in showing robust demand, higher number of completions, stronger balance sheets and forward order books, high profile director selling captured the media headlines. It is inevitable when big stakeholders like Steve Morgan and Tony Pidgeley – the chairmen of Redrow and Berkeley Group, respectively – reduce their exposures, cries of “What do they know that we don’t?” or suggestions that “This must be the top of the market” result. Mr Steve Morgan and his charitable trust reduced their exposure to Redrow stock to the tune of £152.8m. In similar vein, the wife of Berkeley Group’s CEO Robert Perrins sold £17.8m and Tony Pidgeley sold £26.8m worth of Berkeley Group shares. Hence the question posed by this blog.

The broking community is supportive of house builders, by reference to their price targets and consensus recommendations. For the record, current views suggest: Barratt Developments - 7 brokers say Buy, 6 Hold and 3 proffer Sell recommendations, Bellway features 12 Buys, 2 Holds and 1 Sell, Berkeley Group 8 Buys, 4 Holds and 3 Sells, Bovis 5 Buys, 5 Holds and 2 Sells, Countryside Properties 3 Buys and 1 Hold, TJ Gleeson 1 Buy, Inland Homes 1 Buy, McCarthy & Stone 5 Buys, 1 Hold and 2 Sells, Persimmon 3 Buys, 12 Holds and 2 Sells, Redrow 8 Buys, 2 Holds and 1 Sell, Taylor Wimpey 9 Buys, 5 Holds and 1 Sell, and finally Telford Homes with 3 Buys and 1 Hold.

However, when brokers are typically overwhelmingly positive on a sector, this means that any change in opinion is likely to be negative – and when a ‘bear’ (who could perhaps be termed a lone-wolf?) issues a warning – as Bank of America did on Tuesday on the sector - that trading conditions are as good as they can get (and can only deteriorate), short term traders may take that as a signal to book their profits and make for the exit. One could speculate that making such a call represents a ‘hiding to nothing’ after the strong performance in the equity of house builders over the past year. Although a more rationale assessment might begin with the premise that profit expectations have risen further than share prices.

Housebuilders’ shares have weakened over the past week, but astute longer term investors will not be frightened into disposing of their stock but rather should consider if anything fundamental has changed or if the valuation of their holding(s) has become uncomfortably stretched. First of all, let’s consider the high profile sales made by these business-founding ‘insiders’ (who should know best about what is occurring within their businesses). Steve Morgan still retains a 33% stake after the disposal, worth £660m, and Tony Pidgeley possesses 3.5% in his FTSE100 index company (currently valued at £167m). Not insignificant, and of course likely to be boosted by further tranches of share options in future years. These individuals possess considerable wealth and while it is heavily biased to their own company’s stock, it makes sense that they ‘don’t have all their eggs in the one basket’. Senior management’s lightening of their positions is likely to say as much about progressing diversification as flagging over-valuation. 

Sentiment towards house builders also took a knock on Thursday when the Bank of England’s Monetary Policy Committee indicated that interest rates might have to rise ‘over coming months’ to curb the threat of rising inflation. Earlier in the week the Office of National Statistics had advised that inflation reached 2.9% in August – higher than the BoE prediction and well in excess of the official 2% longer term target. Although voting 7-2 for no change, in the all-time low level of 0.25% Bank rate, the prospect of a rate hike pushed sterling up - to reach its highest level against the US dollar since the EU referendum in June 2016. Whether mortgage rates rise to the point of dissuading new home buyers remains to be seen, but few expect a Bank or base rate in excess of 4% within five years. Indeed, consensus forecast is for no change in rates until the domestic economy consistently delivers GDP growth of 2% or more – something which is unlikely to occur until clarity surrounding Brexit emerges.

Investors should always monitor their shareholdings on a regular basis (to reduce the prospect of a negative surprise), and this should be based on a hard-headed medium term assessment rather than on emotional (fear-greed), shorter term consideration. Accordingly, an individual should take a look at fundamentals rather than consider where a share price has historically traded (be it days or years). In addition, one should read widely (certainly beyond the company’s own reports) to take into account as many opinions as possible – but, importantly, make and ‘own’ the final decision oneself, perhaps aided by making a note of the rationale for disposal or retention, to either retain or exit.

The prime data that this writer sets store by - as a driver and determinant of equity prices - is earnings forecasts, essentially looking to see how the trend in consensual profit numbers for next year is moving. In the first half of 2017 the housebuilders have, without exception, announced pleasing operational and financial progress - looking at headline numbers and profitability (margins et al) – and indicated a strong prognosis for the second half of this year. Closely monitoring the builders mentioned earlier in this article, the broking community has raised 2018 earnings (best seen when expressed as earnings per share or EPS) expectations for each of these listed companies – with the exception of retirement homes builder McCarthy & Stone - when comparing forecasts published by the big investment research houses on the 15th September, with those produced on the 1st September.

However, the analysis in the most recent research will have been guided by the latest positive trading updates and investors must take a view on whether the supportive factors like high levels of employment (job security), low interest rates (cost of servicing a mortgage), supply-demand imbalance (population growth, planning constraints) and exceptional ones (like the HMG’s Help to Buy scheme) continue in future. The other prime aspect to consider is, based on those fundamentals, what outcome – in terms of sustainable profitability, and magnitude of earnings growth or decline thereafter - is currently already ‘in the price’. One has to decide the extent to which the builders’ profits are currently highly, fairly or lowly valued by the stock market, and the most recently disclosed figures (completions, profitability) are underpinned or are at risk of falling when considering the next 3 to 5 year period.    

Based on today’s earnings per share estimates for their next accounting year, these are the share prices, EPS, and the price-to-earnings multiple (PE ratio) of the above mentioned listed companies:

Barratt Developments – price 583p, EPS to June 2018 is 63.8p, PE is therefore 9.1 times.

Bellway – price 2994p, EPS to July 2018 is 388.8p, PE is 7.7 times.

Berkeley Group – price 3496p, EPS to April 2019 is 330.5p, PE is 10.6 times. Bovis – price 1037p, EPS to December 2018 is 87.8p, PE is 11.8 times. Countryside Properties – price 328p, EPS to September 2018 is 34.4p, PE is 9.5 times.

Crest Nicholson – price 532p, EPS to October 2018 is 75.1p, PE is 7.1 times. 

TJ Gleeson – price is 627p, EPS to June 2018 is 51.8p, PE is 12.1 times.

Inland Homes – price is 54p, EPS to June 2018 is 7.4p, PE is 7.3 times.

McCarthy & Stone – price 149p, EPS to August 2018 is 17.1p, PE is 8.7 times. Persimmon – price 2437p, EPS to December 2018 is 253.4p, PE is 9.6 times. Redrow – price is 548p, EPS to June 2018 is 76.6p, PE is 7.2 times.

Taylor Wimpey – price is 187p, EPS to December 2018 is 20.9p, PE is 8.9 times.

Telford Homes – price 369p, EPS to March 2019 is 55.9p, PE is 6.6 times.         

Beyond profits, the other fundamental factor that the prospective investor will want to consider is the listed businesses’ asset worth – bearing in mind the ease and expense attached to replenishing the builder’s land bank – as the business model of ‘buy land, build & sell house’ profitably is expedited. Some firms operate off a short term, quick turn model – notably Barratt Developments who will normally own land to cover three and a half years’ work, plus a further one year’s completions worth of controlled land. Other companies will have much longer ‘banks’ of land (both strategic and that with consent), most obviously Berkeley Group, who operate primarily in the Greater London area and currently possess twelve years’ worth of land, based on current rates of consumption. Incidentally, this upmarket company tends to operate more complicated brown land which, often being contaminated urban sites, take longer to clean up and gain planning permission.

In addition to the length of the land bank, one can assess the listed house builders by reference to their net tangible assets (viewed by reference to NAV per share); for example Barratt Developments reported net asset value of 340p per share as at 30 June 2017, which was 9.3% higher than a year previously. The builders typically seek to defer payment on land purchases (in Barratt’s case such land creditors amount to approximately 37% of the worth of their owned land bank, but in Berkeley’s case land creditors are just 7%) and this is taken into account when arriving at the NAV. By contrast, the longer life asset which is Berkeley Group saw its net asset value increase by 18.4% to 1556p per share in its last accounting year ended 30 April 2017. Besides this, one has to look and see if the land is valued at cost (which may significantly discount its true worth) or is subject to revision at its current value. Beyond that, the land can either already have planning permission or it could be ‘strategic’, whereby the builder has acquired it (much more cheaply, without consent) with a view to getting the land through the permission process itself. In addition, the worth of cash or net debt, together with the cost of servicing any debt (if only drawn short term to facilitate operational purposes) should be considered by investors.

Currently, as compared to the historical evidence of the past twenty years, listed house builders’ shares are valued highly by reference to net asset value (an assessment termed price:book) – with share prices are often twice the firm’s NAV - but lowly valued, based on anticipated profits. If house prices continue to rise – or put more pertinently: if revenue derived from land continues to rise (consider apartments or developments for the private rental sector) – then one can be relatively relaxed about current share price valuations being a long way ahead of net asset value. By contrast, if prices or achieved revenues fall (by say ten per cent) then this will have a significant impact on builders’ EPS and NAV. The sector is correctly viewed as cyclical but, as compared to the financial crisis that prevailed ten years ago, there are three very different and positive industry features today: the listed builders have low or no levels of debt, are finding no difficulty in acquiring land on attractive terms (to meet their own accountants’ high hurdle rates of return, while small builders cannot procure finance to compete) and HMG are offering or underpinning exceptionally attractive terms to home buyers.    

The bottom line is that share prices in the sector have, overall, fallen by 6.1% in the first two weeks of September. More specifically, we have seen Redrow stock fall by 10.3%, McCarthy & Stone retreat 9.4%, Persimmon -7.0%, Barratt Developments -6.1%, Bellway -5.8%, Taylor Wimpey -5.6%, Berkeley Group -5.5%, Countryside Properties 5.5%, Telford Homes -3.9%, Bovis -1.3%, Crest Nicholson -0.9% while, by contrast, TJ Gleeson shares rose 0.9% and Inland Homes rose 1.4%. Investors have to decide whether such falls represent buying opportunities (as the value on offer has typically improved) or whether the outlook has taken a turn for the worse, and is set to deteriorate further. Please take the time to independently assess the situation and make your own mind up – be it in respect of the house builders or any other industry sector, for that matter. Be especially careful if it is your intention to exit a business with a view to buying back into the stock (at a lower price) at a later date. If a company share has fallen for reasons more associated with sentiment than robust rationale, it is likely to bounce back rapidly once traders or the insecure have ceased selling.