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Not Too Late to Short the Homebuilders

By Michael Shulman

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: 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.

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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 washed 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. However, there's no need to skip the party if you've arrived late. In the case of the housing sector, the pickings at the short-side buffet were anything but slim.

When looking to make money on the short side, remember not to overlook the obvious. 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.

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. When housing is in the tank, it takes down its suppliers.

How We Bank the Big Ones

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

Masco manufactures all of the stuff that goes into new and renovated houses -- i.e., building materials, windows, wallboards -- and the stock had been in a steady decline since last 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 MAS are losing customers, it 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.

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.