June 18th, 2007

Life Cycle Investing: Home Builders, Lennar (LEN)

Life Cycle Investing represents the convergence of many different investment philosophies. The approach distills the dynamics brought about by all market investors continually making buying and selling decisions using their particular approaches (weighted by the size of their transactions) into one number, price.

Up to now, I’ve demonstrated how Life Cycle Investing might operate on IPO’s (the birth and development phase of the life cycle), on companies in the growth phase and companies that appear to be in the declining phase. But the same dynamics also work on all the stocks in an industry group. One recent typical example might be the home builders. Here is a chart of the unweighted average of the 21 stocks comprising the industry for 1984-current:

The industries Life Cycle birth was in 1991 when the average Home Building stock broke through a long-term resistance trendline. The average stock price increased through 1994 when, as often happens when stocks breakout of a long consolidation pattern, stocks formed a secondary consolidation pattern that lasted 3 ½ years after which it broke out again. Another consolidation formed in 1998-2000 after which the average stock increased nearly 20-fold.

For the past 3 ½ years, the industry has been forming a pattern which eerily resembles a head-and-shoulder topping pattern. (I’ve been negative on the industry since my post of March 7, 2006, entitled “Selling Homebuilding Stocks Short?“). Does this represent the industry life cycle hitting maturity with the only prospect being a decline phase? Will it take some monumental industry or economic event causing the industry’s “rebirth” and beginning a new life cycle.

The following chart of Lennar Corp. is representative of how the industry life cycle played out at the individual stock level.

We can all recount the fundamental factors underlying these results: new wealth created by the 90’s stock market bubble; the real estate bubble caused by declining interest rates since 2000; declining $US leading to foreign investment in US real estate; shift in “hot money” from the stock market after 2000 into real estate.

And when you listen to the various “experts”, you hear all sorts of conflicting opinions on when real estate demand will stabilize, when the surplus housing stock will be absorbed, when home prices will recover, what the impact will be of expected rising interest rates (due to the fed’s attempt to make the $US dollar more competitive in the foreign exchange market), which home builders will be able to dispose of surplus land inventory and which are having financial difficulties, what impact will the decline of home building employment be on the rest of the economy, etc., etc.

The bottom line is that the individual investor in unable to distill all these issues to arrive at accurate projections of future profits in order to determine, at any given point in time, whether home builders’ stock prices are fair, over-valued or under-valued. It was easier and less risky to buy homebuilding stocks when they were in the growth phases of their life cycles and, now, merely avoid them until after there’s a clear indication that a new life cycle has begun.

Will the current topping pattern eventually be no more than a consolidation pattern similar to the one of 1998-2000? It will take a while to find out. And in the meantime, we see many stocks breaking into new all-time highs. With huge price increases available through life-cycle investing, one doesn’t have to get in just as the train leaves the station, one can catch it once it’s already started moving and its direction is clear.

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