Everybody hates housebuilders – and why wouldn’t they? After all, houses in the UK are horribly over-priced and George Osborne promised us that they would fall the very second we voted for Brexit. We voted for Brexit. So that, quite clearly, is that.
If you haven’t already done so, you should sell your shares in housebuilders. Or maybe don’t – because at these prices they might just be cheap. So says Gary Channon, manager of the Phoenix funds and of the Aurora Investment Trust.
I interviewed Gary earlier this year (you can watch the video here) and much of our conversation was about the housebuilders – several of which he owns in his portfolios. That didn’t look good in the immediate aftermath of the referendum (the housebuilders fell by 25% on the first day and another 20% on the second).
But not only has Channon not sold, he has been buying – both Bellway and Barratt – because he feels he has a “key insight that is incredibly simple and enormously powerful”. There is “a big disconnect between the accounting profits of a housebuilder and the cash generation when house prices are moving”.
Let’s say it takes a builder three years to turn around a piece of land (buy it, build on it, sell it). It costs him £110,000 to build the thing, and £50,000 for the land, he sells it for £200,000 – profit: £40,000. If house prices fall, his profit falls too: at £180,000 he is only making £20,000. A modest fall in house prices (10%) has a disproportionate effect on profits (50%).
But the key here is that it doesn’t last long. Falling house prices mean falling land prices, and that will work through by year four. So if in year four the land price has fallen to, say £34,000, profit per house will be £36,000, even if house prices don’t move at all – and the builder’s margins will be as they were before house prices fell.
So the case for buying now is simple: if house prices don’t fall, the falls in the housebuilder shares will look like a massive overreaction. If they do, accounting earnings will fall and share prices will reflect that. But as we approach year three a jump in accounting profits will be in the pipeline and “at some point that will be reflected in prices”.
Channon doesn’t mind waiting for that point – particularly given that he sees the UK housing market as “undersupplied” (I’m not as convinced as he is on this, by the way) and that the big housebuilders currently have no debt (Barratt has net cash of £300m).
MoneyWeek readers can get access to Channon’s investment style via the Aurora Investment Trust. However, you will only want to do this if you reckon that whatever happens to prices, sales volumes will stay high in the UK (profit per house is irrelevant if you are selling 50% fewer). Bellway and Barratt each make up over 10% of the portfolio, and the shares are currently trading on a 6% premium to their net asset value.