The housing sector has been disrupted recently by mixed economic reports. Homebuilder sentiment was released this week, showing optimism, but a little less so than expected. Interest rates have been flat or in decline as stocks have been selling off.

However, mortgage applications are continuing to fall. Home-centers have done well, but recent analyst downgrades have spooked many investors. The bottom line is the housing sector may not really know where it is heading.

Within the group, there are a few homebuilders who have been selling off at resistance. Shorts have been targeting stocks like Hovnanian Enterprises, Inc. (HOV), Lennar Corporation (LEN) and PulteGroup, Inc. (PHM) while they look a little overvalued.

We don’t disagree, however, the homebuilders themselves have been prone to short-squeezes over the last couple of years, which makes a bearish trade challenging. On the other hand, a long position is hard to justify until a stronger, bullish reversal-signal appears.

It seems to us that economic reports are pointing to a housing sector that is flattening out at best, which could create some interesting bearish trades. It may make more sense to look on the periphery of the sector rather than one of the homebuilders themselves for a trading opportunity.

As long as the housing market is choppy, we think investors are going to be shy about unprofitable companies or those with greater levels of uncertainty. Within the housing sector, there are a few of these firms that may be attractive for a short.

We like Norcraft Companies Inc (NCFT) for a potential downside move. NCFT is one of the world’s largest cabinet makers and sells direct, through dealers and within home centers. Norcraft appeared on the radar because it concentrates on Ebitda earnings in its investor presentations. Earnings before interest, taxes, depreciation and amortization (Ebitda) can be used legitimately but can also be used to distract investors from the fact that the company has bottom line losses — not profits. Many notorious dot-coms of the late 1990s manipulated Ebitda well.

Norcraft is obviously not a dot-com but still wants investors to look at Ebitda earnings rather than actual net income because NCFT looks pretty good at the operational level but not so much on the actual bottom line. Norcraft is only recently public, and part of the initial public offering in 2013 included a Tax Receivable Agreement (TRA) with the pre-IPO owners. Basically, a TRA means that the pre-IPO owners are entitled to the majority (usually around 85%) of the potential tax savings that the company will realize when it switched from an LLC to a public C-Corp.

Those tax savings are distributed to the pre-IPO owners and reduce the positive Ebitda to negative net income. Obviously, this deal was disclosed to investors before the IPO. So, it should be priced into NCFT stock — theoretically anyway. However, the public markets don’t always work like that. TRA’s are complicated and very hard to understand, which makes it very difficult to establish a consensus value.

So what? If Norcraft is operationally profitable and has cash flow, what difference does the TRA make for expectations for the stock? This question is a good one and it comes back to a simple issue in the market. Investors discount complexity and uncertainty when the market gets choppy. The actual outflows from the TRA are based on future projections. So, we don’t really know what they will look like in the future. They may or may not be distributed as anticipated. Investors in NCFT are faced with having to make estimates about changes to the tax benefit, changes in how the pre-IPO investors will sell their stock (which could affect the payout) and new guidelines or rules from the IRS in addition to the usual revenue and earnings forecasts.

From a technical perspective, we think traders are starting to lose a little momentum on NCFT. Norcraft missed expectations for top-line revenue during the last quarter and, although earnings were better than expected, it seems unlikely that all investors understand why they were better and whether it had anything to do with operational efficiency and growth.

As you can see in the next chart, although NCFT stock has been forming higher-highs in November, the Moving Average Convergence Divergence (MACD) has been forming lower lows, which has completed a bearish divergence. Volume has been in decline since earnings were reported in November as well. We think there is some significant support at $17, which may lead to a bounce. However, a break of $17 and Norcraft stock could fall another 18% and hit $14 per share before finding a bottom.

Norcraft Companies (NCFT): Chart courtesy of eSignal (volume on right y-axis, price on left y-axis).

NCFT is an interesting company because there aren’t very many IPOs that are launched with a TRA like this. We have seen a few, such as Belden Inc. (BDC), Genworth Financial Inc (GNW) and The Blackstone Group L.P. (BX), and the results are a little mixed. To be clear, it’s not that NCFT is a bad company. The TRA is valuable because the firms that became Norcraft had such large net operating losses that could be used to offset taxes as a public entity. It’s a credit to the management team that Norcraft has been able to turn operations around.

Our argument is that information is not evenly understood in the marketplace despite the claims of the Efficient Market Hypothesis (EMH). TRAs are complex and rare, and investors have historically underestimated the real value that the post-IPO company continues to transfer to its pre-IPO owners. If the market is bullish, homes are being purchased and remodeled and interest rates remain low — no problem. However, if those circumstances change (which is our forecast), then investors tend to move from stocks they struggle to value and look for a companies that make a profit they can understand.

John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.

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