Potential Opportunity in an Ugly Industry

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News flash: Bad news can be a long-term investor's best friend. Remember that, it might save your portfolio some day. A healthy dose of negativity can send asset prices from high to low in no time flat. To take this dynamic one step further: Several years of bad news can make investors forget that a sector ever made money at all.

We all know that sectors, like the broader economy, move in cycles. They have their winning streaks as well as their down days. And while those ups and downs might occur more violently in some industries, the broad truth for most every part of financial markets is that for every yin there also exists a yang. So while I plan on making a case that I imagine will make many readers scratch their heads, please know I chose today's subject for that exact reason. Picking up assets on the cheap can be one sure-fire way to beat the market over time

Hunting alone
The oft-quoted Warren Buffett instructs us to "be fearful when others are greedy and greedy when others are fearful." With the benefit of hindsight, we can all understand why some of the greatest investments of all time made perfect sense. Unfortunately, investors have to make their decisions in the present using imperfect information. The key to success comes from finding those opportunities where investors want nothing to do with your opinion. Such opportunities allow investors to find only the most favorable options for which they'll pay rock-bottom prices.

Buffett's made a career out of seizing opportunities others regarded as senseless. To use one of my favorite examples, he began acquiring shares in Washington Post Co. in 1973 at prices in the neighborhood of $6.50. Those same shares trade today for $424.60, netting the Oracle a cool 6,500% unrealized gain (he still holds the shares). While investors shouldn't typically expect such astronomical gains, this certainly, and powerfully, illustrates the value in investing where others don't tread.

The seven-letter word you love to hate (h-o-u-s-i-n-g)
I recently read an interview with respected value-oriented fund manager Arnold Van Den Berg, whose Century Management has returned a market-beating 13.36% annually for the last 36 years, net of fees. Some of his investment ideas really piqued my interest, striking me as particularly counterintuitive. When asked about housing, he actually made a compelling case for investing in housing stocks in the not-too-distant future. One quote especially got my attention:

Historically, homebuilder stocks have recovered well BEFORE the industry has recovered. Once the general consensus feels that housing has recovered, the opportunity to profit from what is typically a large discrepancy between the market value and the intrinsic value is significantly diminished. The highest probability of success appears to occur when purchasing stocks at a discount to intrinsic value, which is almost always early, averaging down through the bottom of the cycle, and having the patience and discipline to wait for the cycle to turn.

Van Den Berg said his firm expects the housing market to require three or four more years to return to some state of normalcy. Going by the quote above, it seems like now might be the right time to start looking into these stocks. I did a little digging to try to find the most beaten-down homebuilders and this is what I came up with:

Company

Price Change Q2 2006 - Present

Price / Earnings Before Extra Items

Return on Equity (LTM)

D.R. Horton (NYS: DHI) (64.3%)112.71.8%
Toll Brothers (NYS: TOL) (40.7%)56.02.4%
Lennar (NYS: LEN) (70.1%)33.24.6%
PulteGroup (NYS: PHM) (81.1%)NM(42.4%)
MDC Holdings (NYS: MDC) (63.5%)NM(6.32%)
Brookfield Residential Properties (NYS: BRP) (80.7%)NM(9.5%)
KB Home (NYS: KBH) (86.1%)NM(31.5%)

Source: Capital IQ, a Standard & Poor's Company. NM = not meaningful.

As you can see, the bursting of the housing bubble took the air completely out of these companies' sails. However, these companies generate some pretty decent returns when demand actually exists (as will happen again eventually). At present, these companies are either just eking out profits or failing to produce earnings outright, which should keep them unpopular in investors' eyes.

I don't pretend to know when the housing market will improve. However, I know it will eventually. While those better-informed than I seem to think the market has a few more years of pain to endure, the time to start thinking and preparing yourself to act should be rapidly approaching. Investors who prepare themselves for those initial upticks stand to gain the most. Worse yet, those who wait for finite signs of improvement may already have missed the boat. I'm certainly not recommending buying these shares today, or even tomorrow. However, as an investor keenly aware of the potential rewards, I thought I'd take some time to make the case ahead of time.

Don't say you weren't warned.

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At the time this article was published Fool contributor Andrew Tonner holds no position in any of the companies mentioned in this article.Motley Fool newsletter serviceshave recommended buying shares of MDC Holdings. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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