by Michael Shulman 04/10/08
There's an old traders' saying that, "A rising market floats all boats." But when it's a specific sector that's falling apart, a similar logic holds true. That is, when the biggest names in an industry start to sink, the ripple effect causes the pain to spread to other names with nowhere to hide.
For example, several homebuilding stocks got killed in the subprime-mortgage debacle. Early on in the game, the best of the worst names -- D.R. Horton (DHI), Centex (CTX), Pulte (PHM) and Lennar (LEN), to name just a few -- had their foundations literally rocked out from under them, and my ChangeWave Shorts subscribers made a lot of money by buying put options on those stocks and riding them down.
However, our momentum for making profits on the short side was only starting to -- forgive the expression -- build.
You might have even wondered how to make money in a sector that's still finding a bottom when so many of its stocks have fallen off a cliff. But there's no need to skip the party if you've come late to it -- in the case of the housing sector, the pickings at the short-side buffet were anything but slim.
There's another saying I like to use: "When you hear hoofbeats, don't think zebras." It's often used in the medical profession, to remind doctors not to overlook the obvious. So, when we were looking for the next batch of stocks that were going to fall, common sense and some digging told us to look at where the housing contagion was going to spread.
Meaning, don't aspire for some exotic solution to making money on the short side when the obvious answer is horses -- or, in this case, dog stocks.
Think about it -- why were the homebuilders hurting? Because people aren't paying their mortgages, which means more existing homes are standing empty and, thus, demand for new homes to be built is non-existent.
And that, my friends, opens up some very fertile short-side ground. Why? Well, if new homes are not being built, then the companies that supply building materials don't have anyone to sell their products to.
The home-renovation market is impacted by how housing stocks are performing. That is, when housing is in the tank, it takes down its suppliers, which serves as the cherry on top of the short-side sundae for those of us who are buying put options on these troubled companies' stocks.
Based on this premise, in September 2007, I identified a trio of building supplier kings -- Louisiana-Pacific (LPX), Masco (MAS) and Universal Forest Products (UFPI) -- whose stocks I was certain we would be yelling, "Timber!" as they fell.
Masco manufactures all of the stuff that goes into both new and renovated houses -- i.e., building materials, windows, wallboards -- and the stock was in a steady decline since May.
It was a big, $12 billion to $13 billion outfit that was profitable -- but its business prospects became so bleak that it was too good of a short-side opportunity to pass up.
Masco was a market leader, and one that's very solidly run. For this reason, lots of value investors piled in, thinking that they were getting shares "on the cheap." But those bargain-hunters were wrong.
Oftentimes, we establish short-side positions in poorly run companies, but when good ones like this are losing people to sell their products to, this sets up a great "short" outlook.
We invest on failing fundamentals, not on what the charts say, so with the stock trading at $24, my research told me that the stock would dip to $15 long before it would spike to $30. And because of its stance as a strong company, its puts were dirt-cheap -- in fact, it only cost 95 cents to buy its April 20 Puts.
So, while the value guys were thinking they were getting a good deal on the shares, I knew my short-side investors would be the ones laughing all the way to the bank instead.
And laugh, they did -- we held the position from Sept. 12 through Jan. 10. And in those four months, our 95-cent investment more than doubled to $2.10 for a not-too-shabby 121% gain.
Similarly, Louisiana-Pacific was a $2.2 billion outfit whose branded line of building products had too much exposure to the low-end home and home renovation market. The company creates paneling, siding, decking, molding and trimming materials.
When we shorted it back in September, it was losing money … and had been for a few quarters. At the time, it was a $17.50 stock that had the potential to fall to $12 within six months.
In fact, it only took two months for our puts to become profitable. We had bought the Feb 15 Puts for 90 cents on Sept. 13, and on Nov. 27, we banked a nice 122% gain when the stock plummeted to $13.50 and our puts jumped to $2.
Universal Forest Products is another story -- a $2.6 billion company that makes all sorts of lumber, wood, plastic and other building products that are sold in North America. The stock was also a mess, down from $80 a share in mid-2006 to trade at $30 when we were looking to ride its downside by buying put options.
Its puts were well-priced -- actually, they were downright inexpensive compared to where they should have been trading. But that's the beauty of what we do -- we look for great entry points and get situated before Wall Street comes to its senses and gets the same idea. And then we sell them our puts at a much higher premium than we paid for them!
This was the case with Universal Forest Products.
On Sept. 13, I predicted the stock, then around $35, could easily hit $25 by February. So, we established a position in the April 30 Puts for $1.70 (or $170 per contract to control 100 shares). Thus, we were making a bet that the stock would drop at least five points in the space of a few months.
It actually took less than two months for shares to dip to $28. At the end of November, our puts skyrocketed to $3.80. That was my cue -- I sent my subscribers a special sell alert, and we took our 123% winnings off of the table.
These companies have the same story as many of the material suppliers and homebuilders who are still in our ChangeWave Shorts portfolio -- decent management, but shrinking sales, prospects and profits.
I don't expect any of these guys to go out of business. And, in fact, when housing does find a bottom, they may even get started on the long, hard road to recovery. But in the meantime, it doesn't hurt to make some money from their misery.
In fact, after the beating that many of our long-side holdings might have taken, it behooves us to make profits wherever we can … and as often as possible!
Home may be where you hang your hat, but my hat is definitely off to the homebuilders and their suppliers for giving us many spectacular short-side profits … and many more to come.
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