Housing stocks decline hurts some big investors

Value investors such as Legg Mason's Bill Miller and Harris Associates' Bill Nygren, as well as other managers such as Tim Cohen of Fidelity Investments seem to have been caught in a 'P/E trap,' where these stocks were cheap for a long period and only went lower as the firms reported their earnings.

Now in the Dow Jones U.S. Home Construction Index, 10 of 15 stocks have no price-to-earnings (P/E) ratios because they have no earnings. A year ago, their P/E ratios were between three and 5.5, making them appear attractive. (See table below).

P/Es are tough when earnings change that fast, said Ron Muhlenkamp, a value investor and manager of the $2.3 billion Muhlenkamp Fund, which in the past owned more than $300 million of housing stocks. The fund was down 4.37 percent at the end of August against the S&P 500's 3.9 percent gain.

Last year, Meritage earned 10 bucks a share. This year they are likely to lose money. So what's the PE? Is it 2 or is it infinite? said Muhlenkamp.

Muhlenkamp recently sold his holdings of Meritage Homes Corp and Toll Brothers Inc and got rid of Beazer Homes USA Inc and Centex Corp a few quarters ago.

The Dow Jones home construction index closed up about 1 percent on Tuesday at 372.15 points -- its lowest since May 2003. Sales and prices of homes in the United States have slumped as home-loan borrowers with patchy credit histories are defaulting and credit availability has tightened.

Home builders are now writing down the value of their unsold homes and the land they have bought for future development. The lower value is reflected in each builder's tangible book value -- what a company could get if forced to hold a fire sale.

Over the last several months, we concluded that the whole thing was going to take longer than we thought. And we are almost out of the sector, said Muhlenkamp.

Miller, who bought housing stocks in his $20.6 billion Legg Mason Value Trust fund about a year-and-half ago, said in a recent letter to investors the sector was partly responsible for the fund's poor performance this year, but he defended the holdings.

The fund -- which owned KB Home, Pulte, Centex and mortgage lender Countrywide Financial Corp as of the end of June and which accounted for 6.2 percent of its portfolio -- is down 2.8 percent so far in 2007.

The environment has become worse than he expected, said Greg Carlson, a fund analyst at research firm Morningstar.

Like Miller, Fidelity's Cohen and Nygren, who co-manages the Oakmark Select fund, have said their housing picks hurt their funds' recent performance.

Cohen's $22.4 billion Fidelity Growth & Income Portfolio had more than $1.5 billion invested in home builders, Countrywide and the large amount in retailer Home Depot Inc as of end-July.

Fidelity's $38 billion Low-Priced Stock Fund, run by Joel Tillinghast, was the biggest fund investor in D.R. Horton Inc, the largest U.S. home builder, with a nearly 10 percent stake as of end-April. Since the end of April, D.R. Horton shares have fallen nearly 40 percent.

The Oakmark Select Fund said in a filing on June 30 that it added a million shares of Pulte to its holding, making it the company's second-biggest fund investor behind Miller's Value Trust. Pulte shares are down 32 percent since the end of June.