Why Buffett likes homebuilders

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Berkshire/homebuilders

Our pal Eric Platt, writing in the Financial Times earlier this week:

Warren Buffett’s Berkshire Hathaway on Monday unveiled an $814mn investment in three US housebuilders, a bet on a sector that has benefited from dearth of supply. 

Berkshire disclosed it had purchased 6mn shares of DR Horton, worth about $726mn at the end of the second quarter, as well as 152,572 shares in Lennar and 11,112 shares of NVR.

The natural question to ask about Berkshire’s investment is whether it comes too late. The big US homebuilders have been on a stonking run since 2020. Here is what the five largest have done in 2023 alone: 

Buying the second quarter, Berkshire is coming in at the end of the party. And just yesterday, the national association of homebuilders survey showed the first decline in homebuilder confidence in seven months, as customer traffic fell. Meanwhile, mortgage rates keep flirting with new cycle highs, which will continue to pressure new home prices in the short term. 

The first thing we should say here is that no matter how badly wrong Berkshire and Buffett get the homebuilders, they can’t get them as wrong as Unhedged. We thought rising mortgage rates would crush the homebuilders, and bet against Pulte in the FT stockpicking contest. But the exact opposite happened: high rates froze the existing house market by giving homeowners a huge incentive not to move — their irreplaceable cheap mortgages. That left new homes as almost the only game in town for anyone who really needs to buy a home. Pulte has been one of the best- performing stocks in the S&P 500. Never pick stocks, even in a stupid stockpicking contest, on the basis of superficial research. 

But I don’t think Berkshire has got this one wrong, even if the rally driven by the sudden jump in mortgage rates is petering out. I think the homebuilder stocks can generate very solid long-term returns for three reasons:

• The stocks remain relatively cheap, even though the companies have reduced their leverage and as such the cyclicality of their earnings. 

• A significant US housing shortage that is not going away in a hurry.

• The big homebuilders’ economies of scale, relative to fragmented local competition, in both purchasing land and materials, and in financing inventory.

On the first point, four of the five top homebuilders trade at price/earnings ratios below 10 (the exception is NVR, which has a capital-light business that does not develop the underlying land and only takes risk on the homes themselves). And the stocks’ run-up has been driven mostly by rising earnings estimates.

The crucial point for investors is that despite the increase in demand for homebuilders’ services, the market is not being flooded with new homes. Here are new housing starts and permits:

More generally, fixed residential investment, which only recovered to pre-financial crisis levels in 2019, and then jumped in the coronavirus pandemic boom, is now falling hard:

Durable scale advantages; a market in semi-permanent deficit; management teams that learnt hard lessons in the financial crisis; and reasonable valuations. This looks like a group that can compound earnings at a decent rate through cycles and across decades. It looks like a Buffett bet, whatever the stocks do in the next year or two.

Japan, holy crow

If you thought the Atlanta Fed’s US growth estimate at 5 per cent sounded impressive, have a look at this:

Six per cent annual growth! In Japan!

Like that 5 per cent US growth number, though, Japan’s 6 per cent misleads. It reflects a very large bounce in net exports, rather than a more sustainable rise in consumption or investment. For a 6 per cent overall growth reading, spending looked curiously weak. Personal consumption fell 0.3 percentage points in the second quarter. Even the increase in net exports was chequered, driven in part by much weaker imports, suggesting soft consumption. This chart from Pantheon Macro breaks down GDP contributors nicely (note these numbers are not annualised, unlike the 6 per cent figure):

Weird quarter-to-quarter swings in GDP do happen, so what’s more interesting is what can be learnt from this report about inflation, the white whale Japan may be on the verge of catching. One morsel of good news: the GDP deflator, the price index used to convert nominal to real GDP, hit 3.4 per cent in the second quarter, the highest since 1981. 

But the best news came in wages. Even though nominal wage growth has looked decent for some time, negative real wage growth remains the biggest missing piece in Japan’s inflation story. But evidence is building, ever so slowly, that real wages have turned a corner. On a seasonally adjusted basis, real compensation per employee rose 0.6 per cent in the second quarter — the first quarterly increase since Japan’s inflation surge began two years ago. Meanwhile, nominal compensation per employee grew a punchy 2.6 per cent year over year.

This matches other encouraging wage data. Numbers published last week showed nominal wage growth at 2.3 per cent in June. Real wage growth is getting less negative, too, as the smoothed chart below shows:

The turnaround in real wage growth would get a boost if inflation falls, which many economists expect in the coming months.

Consistently impressive Japanese economic data is winning over sceptics. When we spoke with Marcel Thieliant, head of Asia-Pacific at Capital Economics, back in May, he sounded pessimistic about the durability of inflation, arguing that wage growth was not strong enough to change inflation dynamics. On Friday, he changed his call: 

With consumer confidence rebounding, the labour market holding up and the savings rate still a bit above its pre-pandemic average, we’re revising up our forecasts for consumption growth and no longer expect outright falls across the second half of the year . . . 

Amid early signs of a virtuous cycle between wages and prices, the absence of a major economic downturn raises the chances that the Bank of Japan will eventually lift its short-term policy rate.

Japan’s economy may not really be growing at 6 per cent, but exciting things are still happening. (Ethan Wu)

One good read

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