With Housing on the Mend, Should You Bet on this Buffett Stock?

By Adem Tahiri - September 27, 2012 | Tickers: HD, LEN, XHB, TOL, USG | 0 Comments

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Is the housing market on the mend? It sure looks that way with this week's housing numbers showing that home prices rose in July (if only 1.6%), marking six straight months of improvement, according to Reuters.

More impressive is the recent data has shown that new home sales in August gained ground in addition to resales. This is worth noting because the new sales (along with the price increases) and home builder confidence show that the market might finally be absorbing its glut of foreclosures; a necessity for the market to truly move forward.

It feels a bit bizarre but it seems like the housing market could be finding its footing while the market as a whole is becoming less stable. With that in mind it's no shock that stocks affected by this sector have been on an absolute tear.

One in particular that has seen an incredible gain is USG Corp (NYSE: USG), a building material producer closely linked to housing and heavily owned by Warren Buffett's Berkshire Hathaway. The stock has risen from a low of $5.75 to a recent high (before pulling back slightly) of $24.23 in the past 52 weeks -- over a four bagger in just this past year! With gains like that and Buffett's blessing, the question is if you should be piling your money into this stock?

The Ugliest House in a Great Neighborhood

There are many things to like about USG. Its products, which range from wallboard to tile and flooring products to exterior (roofing/sheathing), are an absolute necessity in new home construction and home or building repair. This means that USG can (hypothetically) do well in any market whether it favors new home sales, foreclosure sales, or commercial building sales/resales. It doesn't matter, builders and re-habbers need the product.

USG also enjoys dominant market share with its wallboard product and, as previously mentioned Buffett's firm holds a heavy position in the company, 15.91% to be exact. That has to be a good sign, right? In addition to these positives, USG has recently received a few upgrades both on its stock and financial footing. Pair these factors with a rebounding housing market and you come to the reason (in my opinion) USG's shares have soared.

But with its rise in share price and the aforementioned positives it might be surprising that I find this company to be the ugly house in this "neighborhood." The reason is that once you get past the speculation and look at some numbers, USG has a pretty rocky foundation. Take a look at its most recent earnings as well as its projections for the near future.

*analysts' consensus estimates

While typically a Berkshire pick would grab my interest, it's worth mentioning that this position was established years ago when USG was in a much different position; it's my opinion that USG still benefits too much from this stamp of approval. Today it finds itself an unprofitable company becoming more unprofitable over each of the last three years.

So what (aside from the housing market) is making the stock move? Certainly the analysts' upgrades help. Longbow, for one upgraded the stock at around $20 a share stating that they are bullish on the housing market but found USG more attractive than the home builders because the stock was "too cheap."

It's important that investors realize two things here: (1) a company is only worth the earnings it can produce for its shareholders, and (2) analysts' estimates of future earnings are wrong over 50% of time. Analysts tend to get it wrong because they usually arrive to the party late, meaning once a stock has had a big rise they'll get bullish (and vice versa). To me USG feels like a much overhyped new fall sitcom -- the critics all want you to love it and there's plenty of buzz, but deep down you know the show is going to get cancelled. There's just not enough substance to keep it going, despite the all-star cast.

It's clear that by any multiple the valuation of USG is incredibly overpriced, and with its current negative earnings it could be considered worthless if not for its assets and brand recognition. 

Let's try to value the stock at the S&P mean of about 15x earnings. We obviously can't look at recent years EPS because the value would be $0, but let's say the analysts' consensus for 2013 are correct. At 15x 2013's projected earnings USG's share price would be valued at $2.85, well below its 52-week low of $5.75. That of course is if we are to trust analysts' projections and believe that everything will go right for a company that has failed to execute in recent years. I cannot get behind that, especially when you consider the fact that USG has exceeded analysts' expectations only 4 times in its past 14 quarters! That combined with annual losses that have accelerated in recent years gives me little reason to think that the stock should rise on valuation.

Of course, not everything comes down to a strict P/E evaluation when it comes to value. Perhaps the company is improving its sales, expanding into new markets or doing something that would leave shareholders feeling warm and fuzzy about the future?

Sadly, if it is doing something, I can't find it; USG missed analysts earnings expectations in its most recent quarter by nearly 25%. Furthermore revenue was nearly flat last year and has declined at a rate of 12% over the past 5 years. The company's total cash from operations decreased to ($19.4M) last year compared to ($9.4M) in 2010 leading to a sizable decrease in shareholder equity. Simply put, things have not been going well for the firm.

Finally, the other upgrades for USG have been mostly in regards to its credit rating as they've been upgrades from Fitch and S&P. USG has been making some good moves to improve its cash position by selling off an $80M piece of their European business and announcing plans to reduce their workforce by 4,700 in 2012. This news is good but only in regards to USG's ability to stay solvent -- it's not the kind of news that should send a stock up four fold in a year. The only thing driving this stock is speculation of the most ridiculous variety.

You can do Better

Please, take a deep breath, look in the mirror and in your best Stuart Smalley voice tell yourself, "I can do better." In all seriousness, if you are bullish on housing there are much better ways for you to play the recent run up. First, if you tend to believe that the pent-up demand (and lack of supply) for new houses will lead to strong new home sales, you may want to take a look at these homebuilders that are already profitable.

*analysts' consensus estimates

Toll brothers specializes in building luxury homes while Lennar is more of a moderately priced builder. Both companies have been profitable (or at least closer to it) during the dark days of real estate and have bright futures ahead. In fact both have had recent positive quarterly earnings beats of roughly 35% (LEN) and 75% (TOL), respectively! These are the firms producing positive earnings and substantial positive EPS surprises that analysts are hoping USG can latch on to.

Perhaps you, like me, feel that a good deal of foreclosures will still be hitting the market and that new home sales may stagnate. You still may want to take a look at these top stocks that will continue benefiting from the remodeling and renovation that follows foreclosure purchases.

*analysts' consensus estimates

Not only have these two home improvement retailers been producing serious cash for their shareholders but they are both easier to stomach as a "value play" than USG, by a mile. The Home Depot trades at a forward P/E of about 17 with a dividend around 2%; while Sherwin-Williams has a forward P/E near 19 with a dividend around 1%. These aren't bargain basement values but if the sector and these specific companies continue their current growth rates, today's prices will seem more than fair down the line.

Wanna play chicken?

Finally if you're bullish on housing but don't have the stomach to pick an individual company or theme (new home sales vs. resales, etc.), you'd do well to choose a home builder index fund or ETF like SPDR S&P Homebuilders (NYSEMKT: XHB). This ETF holds a basket of home builders as well as construction stocks (including USG) and retailers that benefit when the housing market does well. 

Shares of this ETF have more than doubled in price this year and it owns every piece of the sector, including most of the stocks I've mentioned. Buying into this ETF will give you the rewards of a growing housing market with enough diversification to let you sleep at night. The ETF doesn't have more than 5% of its holdings in a single stock, so while it may not give you a ten-bagger, you won't have to worry about a single company going bankrupt.

Summary

While recent data bodes well for the housing market, it's important to evaluate companies individually and not make the mistake of thinking you can buy any stock in a hot sector, regardless of performance. USG is a company that does have some outstanding products and could eventually turn the corner, but there is a serious disconnect between its current share price and the performance of the underlying company.

While I think it's probably wise to wait for a bit of pull back before buying any housing stock, if you plan on buying, go with a proven performer. There are plenty of them and plenty of ways to play the housing market. I personally prefer to invest in companies that are currently earning a profit, not ones that hope to do so in a overly optimistic version of the future. You should do the same.

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