How to Hedge Housing’s Next Move

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Consider for a moment what Ara Hovnanian, the CEO of major US homebuilder Hovnanian (NYSE: HOV) said recently about housing,

We are undoubtedly well on the recovery route. It's not a question of are we beginning it. I'd say it began at the beginning of this year and that's not just for Hovnanian, that's for the entire industry…that means we're all going to start building, which means we're going to be hiring, and that will boost employment and help strengthen the economy overall.

Now, contrast that with the ramifications of the statements made by House Speaker John Boehner as he talks about the progress of the fiscal cliff talks:

I would say we’re nowhere. Period.  We’ve put a serious offer on the table by putting revenues up there to try to get this question resolved. But the White House has responded with virtually nothing. They’ve actually asked for more revenue than they’ve been asking for the whole entire time.

He goes on to say that he was “flabbergasted” by the Democratic plan as delivered by Treasury Secretary Timothy Geithner and that he “looked at him and said, ‘You can’t be serious.’ I’ve just never seen anything like it. You know, we’ve got seven weeks between Election Day and the end of the year. And three of those weeks have been wasted with this nonsense.” 

It figures; just as it finally appears that we’re about to get our housing industry going again, Washington is taking another step toward the precipice of the fiscal cliff.  Even though speaker Boehner is optimistic that we’re going to get a deal done, the risk is real that they don’t.  That leaves investors with a bit of a quandary with how to position their portfolio if you want to profit from housing’s rebound yet still hedge against downside risk.

I believe I have just the solution.  There’s a top 20 US homebuilder that investors might miss because it’s hidden behind a forest full of trees.  That forest is actually the 20.3 million acres of timberlands that Weyerhaeuser (NYSE: WY) manages in North America.  While homebuilding represents just 12 percent of Weyerhaeuser’s revenue, the company is highly levered to housing through its much larger timberland and wood products businesses. 

The company, while structured as a Timber REIT, isn’t entirely like its peers.  Both Plum Creek (NYSE: PCL) and Potlatch (NASDAQ: PCH) are more of a pure play on timberland ownership, whereas Rayonier’s (NYSE: RYN) business is split between timberlands and performance fibers.  That performance fibers business has given Rayonier an edge over those pure play peers as housing’s slump has kept timber prices at bay.  With housing appearing to recover, I’d want to be an investor in a company with more leverage to a recovery than just timberlands. That's why I like the leveraged balance found in Weyerhaeuser which can be seen in its revenue breakdown:

<img src="/media/images/user_12784/picture2_large.jpg" />

That leverage toward housing has caused timber REIT's to struggle the past few years.  Housing starts have remained well below their historical average of 1.5 million per year for a couple of years now as we’ve worked off the oversupply from the housing bubble.  At some point we will need to return to the long term trend of between 1.6 and 1.9 million starts and that tipping point seems to have us close recovery.  Take a look at this slide from a recent Weyerhaeuser presentation:

<img src="/media/images/user_12784/picture1_large.jpg" />

All signs are pointing to the beginning of that recovery.  That is, of course, unless we fall off that fiscal cliff and head back into a recession.

Despite the bullish outlook on housing, I don't view buying a pure-play homebuilder as the best solution.  Those companies face a different set of risks ranging from operational to financing that are less than ideal.  I think investing in the security of timberlands with the upside of having a homebuilder embedded in the business as offered through Weyerhaeuser as a way to hedge a bet on housing. 

To take things one step further, I want to use options to hedge my fiscal cliff risk. The strategy that I’ll be employing is called a "covered strangle" and is actually quite simple.  I’ll be buying 100 shares of Weyerhaeuser for around its recent $27.50 share price and writing both puts and calls.  In this case, I’m writing the April $26 puts and the April $29 calls.  Both can be written for around $100 per contract at recent prices. I'll be making this trade in my paper trading “No Drip, No Mess” Portfolio as an effort to maintain complete accountability.

This trade accomplishes three things in that portfolio.  First, I'll get immediate access to Weyerhaeuser’s business by owning shares and will benefit from its two and a half percent dividend. Second, if we go off the fiscal cliff I'll buy more shares of this great company at $26 each (or around $24 considering the options income) while also obligating myself to sell the shares just above the company’s 52-week high.  Finally, no matter the outcome, that option income is mine to keep. 

While Washington could stall our housing recovery, at some point we’ll need to build more houses on an annualized basis.  Weyerhaeuser is levered to this trend without having the same degree of operational risks of a homebuilder.  That's why I like the thought of having several options at my disposal as I wait for housing to recover.  Meanwhile, I can sit back and collect the dividend and think to myself that money actually can grow from trees.

latimerburned has no positions in the stocks mentioned above. The Motley Fool owns shares of Weyerhaeuser Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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