Risk Week: The Homebuilers Fiasco

I read a revealing piece in last weekend's Wall Street Journal, discussing what went wrong with homebuilders' plans to break free of their historic roller coaster attachment to the boom/bust of the housing cycle.

As with a related business, mortgage lending, the answer is absurdly simple. Homebuilders departed from their newly-avowed business model which had allowed them to prosper nationally in the modern age.

My own portfolio selections, gains, and losses, it turns out, remained, relative to the current environment, remarkably free of trouble. I got out well before the carnage. As I wrote in this post, just last March,

"Over the time period stretching from mid-2003 to mid-2006, my selection process had selected companies in these sectors which returned a total of 4.8%. By July of last year, however, the process had rinsed mortgage lending and homebuilding out of the portfolio."

Further reading of the Journal article reveals that these guys simply couldn't accept slowing growth. So, they did what financial executives nearly always do in a slowing market- they cut standards and stoked higher-risk growth. Hand in hand with the mortgage banking industry, the homebuilding executives thought that that, as so many before them, could repeal the laws of Schumpeterian dynamics, and continue to grow their revenues and unit volume forever. Soon, these companies began to resume practices they swore off some years ago, including buying large amounts of land, instead of optioning it, as they claimed they had, prudently, now learned to do.

And now, big surprise, the homebuilders- KB Homes, Lennar, Beazer, etc., are paying the price. As the Yahoo-chart nearby shows, these homebuilders all peaked in mid-2005, and have continued sliding every since. Even so, a few are still above the S&P's return for the entire period, if not consistently.

But that minor amount of outperformance is probably not going to remain for very long, given the current environment.

When you study this chart closely, the magnitude of the homebuilders' losses in shareholder value are stunning. From a high of as much as 400%, they have mostly plummeted to 100% or less, in just two years.

That's the price of departing from a disciplined business model, refusing to accept the natural occurrence of the rise and fall of demand in any sector, and managing a firm as if growth will continue unabated for years.

It never works that way. Never has. Never will.