| Buffett, the Downturn Slayer? |
| Written by Jonathan Smoke | |
| 07.16.2007 | |
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Discuss this article on the forums. (0 posts) The public builder news late Friday was all about the Wall Street rumor that Warren Buffett was considering a stake in Hovnanian. Could this be true? Or as the article in the Chicago Tribune quoted: “‘It's just another junk rumor on a Friday,’ said Greg Palmer, head of equity trading at Pacific Crest Securities Inc. in Portland, Ore. ‘But if you put a big name to it, then away you go.’”
Let’s review Buffett’s Investment Approach, according to the Wikipedia entry on Warren Buffett:“The following are some questions to determine what business to buy, based on the book Buffettology by Mary Buffett:
• Is the company in an industry of good economics, i.e., not an industry competing on price points. Does the company have a consumer monopoly or brand name that commands loyalty? Can any company with an abundance of resources compete successfully with the company? • Are the Owner Earnings on an upward trend with good and consistent margins? • Is the debt-to-equity ratio low or is the earnings-to-debt ratio high, i.e. can the company repay debt even in years when earnings are lower than average? • Does the company have high and consistent Returns on Invested Capital (his version differs from the popular definition)? • Does the company retain earnings for growth? • The business should not have high maintenance cost of operations, low capital expenditure or investment cash outflow. This is not the same as investing to expand capacity. • Does the company reinvest earnings in good business opportunities? Does management have a good track record of profiting from these investments? • Is the company free to adjust prices for inflation? Buffett's next concern would be when to buy. He does not hurry to invest in businesses with indiscernible value. He will wait for market corrections or downturns to buy solid businesses at reasonable prices, since stock-market downturns present buying opportunities. He is known for being conservative when speculation is rampant in the market and being aggressive when others are fearing for their capital. This contrarian strategy is what led Buffett's company through the Internet boom and bust without significant damage, although critics have also noted that it may have led Berkshire to miss out on potential opportunities during the same period. Then he asks at what price is the business a bargain, and his answer typically is when it provides a higher rate of compounded return relative to other available investment opportunities. Buffett has coined the term ‘economic moat,’ preferring to acquire companies that possess sustainable competitive advantages over their competitors.”  I’d say that few homebuilders, if any, would pass Buffett’s complete set of criteria. There are several criteria that fail: the industry is heavily fragmented—about as far away as you can get from a monopoly but arguably trending in the consolidation direction; no company has a strong brand compared to other industries; earnings have been good but clearly not this year; pricing power in the current market and for the foreseeable future will be weak; and finally, there isn’t exactly a defensible moat around any company as there are weak barriers to entry.On the positive side, it clearly is a current contrarian bet based on current market sentiment. Furthermore, if land investments are managed as shrewdly as Buffett manages company investments, a well run builder could achieve relatively strong compounded returns over the medium and long-term as the industry’s fundamentals are very strong for the longer term. Will it happen? I doubt it, but if Mr. Buffett considers a stake in Hovnanian or any other public builder, we’ve got the perfect intelligence subscription for him to stay on top of what’s happening in each market across the country. 
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