Morningstar Magazine - June/July 2017 - 99

is about 4%, that's still well below the longterm average. I think the 50-year average is about
8%. If you look at the 2000s before the crash,
the average rate was 6.5%. That's why, if you look
at affordability for the median buyer, it still
looks relatively good, despite the headlines that
prices are going up.

we normally expect over the next five to 10 years.
That makes them look really compelling in
our eyes. Canfor is trading roughly 30% below our
fair value estimate.

To get into what goes into building a house: Why
are lumber producers a better way to play a housing
recovery than the timber REITS?

Bernard: Fortunately, there are 20 public
homebuilders, and they have a robust set of data
that are reported, so we like looking at
forward-looking indicators. We look at their
backlog and their new orders. This is the time of
year where they start really trying to sell
their homes, the spring selling season, which can
make or break their year. Given the backlogs
that they have, the contracts that they reported,
and another good quarter, I'm expecting
a good year.

Gross: It fundamentally comes down to the way
you think about the business model. Think
about what the timber REIT business really is:
cutting down mature trees in a forest. At this point,
we're sitting on a huge stock of mature timber
after a very weak decade of demand, which means
that you have a lot of grow time on those
trees. There's plenty of supply on the timber side.

On the wood products side, it's a little bit less
flexible: At the end of the day, you're taking
the saw logs to the mill and that mill has a fixed
capacity. Right now, a lot of these big mills
are being used pretty fully. Canfor CFP, for example,
or West Fraser Timber WFT, two Canadian
companies, tend to have very high utilization
rates today.

Homebuilders had a strong 2016, but you believe
they're poised for further growth in 2017. What are the
key variables?

We also look at their average selling price.
If they're still able to push price that's another sign
that the demand is there. Beyond that: Are
they investing? Are they increasing their lot count
and community count? If they are, that gives
me confidence that they're looking beyond 2017,
that they see strength three to five years out.
And they are, so I feel good about that. And then,
look at their ROICs: Profitability and whether
they are turning their land are two things that
flow through that measurement.

As there becomes additional demand for wood
products, smaller and smaller mills need to
come on line to satisfy that demand, and they tend
to be more cost-ineffective. They might be farther
from good timber supplies, for example, so
you tend to see more price fluctuation there. That
just leads to much more benefit for the companies
that are already operating big, efficient mills
in the marketplace. It's just pricing. What we
expect is that prices will grow quite a bit more as
the demand pull starts to max out the available
capacity for lumber companies.

That's what we can gather from the public
homebuilders. Then, we really look at consumer
sentiment. Fannie Mae publishes a home
purchasing sentiment every month, a robust set
of data that gives you an idea of how the
consumer is feeling about the availability of
mortgages and such. We track that, too,
just to make sure that the demand is there from
that perspective as well.

Normally Morningstar's equity analysts are looking
for sustainable competitive advantages-the moats.
That doesn't apply here.

You emphasized in the report that it's important
to pay more attention to ROICs than gross margins. Are
other investors missing that point?

Gross: Exactly. Neither Canfor nor West Fraser
has sustainable competitive advantages; they're
both no-moat companies. From our perspective,
they are more of a valuation play. As prices
rise, as profits rise for these companies, we're
going to see substantially larger cash flows than

Bernard: Yes, they've really looked just at gross
margins. Several times now, homebuilders
had what I thought was a good quarter but then
gross margins came down and the stock
sold off. We have labor shortages and land is more
expensive, so that is hurting gross margins.

But if you're going to look at margins, at least
look at operating margin, because even though the
cost of these things is more expensive, volume is
up. Homebuilders are selling more homes, so
they're able to get operating leverage there, and
they're really trying to cut back on their selling,
general, and administrative expenses. For example,
online marketing is a cost-effective way to
reach potential customers, and more homebuilders
are using that channel to lower their customer
acquisition costs. Operating margins have actually
been pretty stable, even though gross margins
have been declining.
We like ROICs because that's a key driver in value
creation. And that's been improving because
they're moving to smaller, more affordable homes
that are quicker to build and quicker to sell.
That reduces their invested capital. These
affordable homes may have a lower gross margin
but better ROIC. We think ROICs have room
to grow. Note that that's what the homebuilders
themselves look at to take on a project: ROIC
is what's important to them.
You consider homebuilder stocks fairly valued. Are
there names that people should keep an eye on, even if
they are not a deal right now?

Bernard: Yes, we're bullish on housing, yet we
consider these stocks fairly valued. That's because
we're figuring out the intrinsic value of these
companies over the long term. I have a 10-year
explicit forecast: What is this thing worth
over a full normalized business cycle? If things
heat up, these stocks can trade over two
times book, so there's opportunity there, but using
our discounted cash flow model, I can't support
that this is really what the business is worth
in a normalized environment.

I think we cover some of the best homebuilders
out there. If there's some negative data for
a month or two and there's a pullback, I think that
they're all probably interesting. It depends
on what kind of strategy that the investor thinks
is best, because all five of them are different.
D.R. Horton is really focused on that first-time
buyer. They're a little bit more speculative, they'll
build homes without any buyer there. But
if the market's strengthening, I think they have the
greatest growth potential. Lennar is more

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