Anecdotal evidence is suggesting that a housing recovery might be starting to sprout.
The trouble with housing is that it’s difficult to be certain — it can go in fits and starts, and it’s difficult to determine if it’s for real. Some people are concerned that this is a phantom recovery, as the housing purchases we’re seeing are cash-driven purchases by speculators looking to buy and flip, or to buy and rent.
Another concern is that this particular trend is creating another bubble in the multi-family residential market. California has its own concerns, but there has been a drop in bank-owned foreclosure purchases.
As an investor, it’s can be a dicey game trying to call a bottom. Instead, using options can be a useful way to play a potential bottom and still yield big upside if you’re right, while limiting downside if you’re wrong.
Let’s look at D.R. Horton (NYSE:DHI). As a homebuilder, you’d think it would be hurting, yet the company has seen a decent operating profit each of the past three years, with $333 million in profit coming in FY2012, and $132 million in Q1 of FY2013. You can’t be too careful, though, because D.R. Horton takes write-offs and losses on inventory, so its cash flow position isn’t fantastic. Nevertheless, it’s not going bankrupt, so it’s worth looking at from an options perspective.
I think housing is the kind of thing you need to use LEAPs for, as you are more likely to see a big change in the overall situation over a year or two, not in a month or two. In this case, I would consider buying at-the-money calls, because when we get that clarity, these stocks will move quickly.
As I write, DHI trades at $22.86. The January 2014 $22 Calls are going for $3.50, meaning you will make money if the stock is at or above $25.50 by next January. That being said, I prefer the January 2015 $22 Calls, which are going for $4.85. It’s a slight increase in cost, but it buys you an entire year, and I suspect it will take two years for us to get real clarity.
Like D.R. Horton, Lennar (NYSE:LEN) also can have large inventory write-offs, but both companies have something else in common, which is the ability to carry forward some large tax losses. You have to look at operating income as a result, since the income tax issue increases the company’s net profit. Indeed, Lennar saw a $322 million operating profit last year as well, but it also has a lot more debt than D.R. Horton. I’m not too concerned, though, because that debt is pretty cheap at between 4% and 5%.
In this case, I’d go with the calls again. LEN presently trades at $40.55. The January 2014 $40 Calls are going for $5.70, so they are also being priced at about 16% of the underlying, just like D.R. Horton. Looking another year out, the January 2015 $40 Calls are going for $8.40. Notice that, in this case, the premium is 21% of the underlying, and a bit more for D.R. Horton, so that might be worth looking at on a relative basis.
Of course, if you think the housing recovery is all hype, go ahead and buy puts. Both stocks are offering the puts at a price of about 20% of the underlying for their respective at-the-money options. It might make for a good hedge if you own a home in an area that is still seeing price declines.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at email@example.com and follow his tweets @ichabodscranium.