It is no secret that Warren Buffett's baby-turned-giant, Berkshire Hathaway (NYSE: BRK.A), has been piling up a record level of cash on hand. This can only mean two things are top of mind for the legendary investor: one is the lack of any decent deal in today's market, and second, he may be expecting a downturn on the horizon.
The case is the former in that there isn't enough juice today to justify a large purchase by the oracle of Omaha. However, he did find enough merit in a few names lately, which uncovered a much bigger trend happening in today's market.
Many market participants were shocked to learn that Buffett started buying names like D.R. Horton (NYSE: DHI) and Lennar (NYSE: LEN); after all, these stocks are trading at 89% to 91% of their 52-week high prices, hardly a discount, wouldn't you say? However, as is typical of Buffett, he found the value of playing three chess moves ahead of everyone.
It goes deeper than you think
Remember the days of low-interest-rate mortgages? Well, according to the Intercontinental Exchange (NYSE: ICE), the majority of existing loans in the United States carry an interest rate between 2.5% and 3.5%, a shadow of today's much higher 7.8% to 8.0% rate on the average mortgage.
Well, what do you think happened to real estate supply when all of these mortgages were being offered at such cheap rates? It all got scooped up, and today, homebuyers enjoying the favorable financing terms are unwilling to let go of their homes! No matter how much the prices begin to decline.
Despite the Vanguard Real Estate ETF (NYSEARCA: VNQ) breaching into bear market territory, defined as a 20% discount from recent highs, the average homeowner today is holding on to properties. The FED thought that by raising rates and getting a grip on inflation, the housing market would start cooling.
They were right on only one side of the equation, as demand for housing has cooled down. Still, prices have remained stubbornly high on homes despite this decline in new homebuyer populations. The average home price today is still above $500 thousand, whereas before the COVID-19 pandemic, it was below $400 thousand.
Going back to economics class, you can probably guess what will unfold if this continues. If nobody is willing to sell their home due to the fear of taking on a new mortgage at much higher rates, and if no buyers are coming in due to unaffordable home prices, there's a stalemate.
Build a way out
So, what is the sensible solution here? Well, it would seem that the only way to decrease home prices, to make them more affordable despite the high rates, is simply to build enough supply so that the forces of macroeconomics bring the price down.
That's a bundle for Buffett, isn't it? Why else would he be willing to buy these stocks near their 52-week and all-time highs. Price is what you see, value is what you get, and in the case of D.R. and Lennar, a respective 8.4x and 8.2x P/E multiple makes sense as a discounted deal.
There's a reason analysts are placing a price target of $135.5 a share on Horton, which implies a 15.0% upside from today's prices; they know this is happening under the hood, and building more homes is the only way out. The same goes for Lennar, and it's a 12.4% upside.
However, there is another side to this story, one that the average investor is sure to miss by only focusing on the homebuilder names. You are not the average investor; you want to beat the market, so stick for a bit more.
If you really think about it, all of these homebuilders have but one thing in common: They all need building materials and supplies to turn a buck! Enter Builders FirstSource (NYSE: BLDR).
This stock shares a few common themes with the builders; it is trading at 80% of its 52-week high, implying price momentum to be bullish, and it can be bought for as cheaply as 9.2x P/E, placing it close to the builder valuations.
Moreover, analysts are also pointing to a double-digit upside in the stock, this time in the realm of 12.0%. There is a slight gap in logic here, though, as they also expect earnings per share to fall by 3.5% in the next twelve months; perhaps there is an upgrade overdue for the price target.
In any case, you bet your bottom dollar that if Buffett gets his way - as he likely will - then Builders FirstSource will be first in line to receive the expansion benefits. But you can also ride the homebuilder's wave up with a solid thesis behind it!
