In the late 1990s, U.S. Home’s revenues were growing faster than I had projected, and the company was gaining market share. For example, in 1999 the company sold 12.0 percent more homes than in 1998, while the total number of housing units built in the United States increased by only 1.5 percent. My curiosity was aroused, so I checked the recent growth rates of other publicly owned homebuilders. They also were growing much faster than their industry. What was going on? If the public homebuilders were growing faster than their industry, then the private homebuilders must be lagging. Why were they lagging? I picked up the phone and called a friend who built a few homes each year in lower Westchester County. My friend thought that my inquiry was ill informed—in fact, dumb: hadn’t I ever heard of the S&L crisis?

In the 1980s, savings and loan banks (commonly known as S&Ls or thrifts) were badly squeezed by high interest rates. Many of the mortgages that the S&Ls issued in the 1960s and 1970s were at fixed and relatively low interest rates. Then, in the late 1970s and in the early 1980s, interest rates increased sharply. To attract the requisite level of deposits, the S&Ls were forced to pay high interest rates on deposits. As a result, their net interest margins often were insufficient to cover their overhead expenses. Furthermore, when the real estate market softened in 1990, many of the loans issued by the S&Ls went into default. The S&Ls were in deep trouble. Many declared bankruptcy and closed. Others were forced to merge. The crisis became so severe that the Federal Savings and Loan Insurance Corporation, which had been established by an act of Congress in 1934, had to be abolished because it became too insolvent to save.

Historically, the S&Ls and community banks provided the bulk of the financing needed by small homebuilders to purchase land, develop land, and construct houses. During the housing recession of 1990, many small homebuilders suffered operating losses and could not repay their loans. As a result, most of the S&Ls and banks that did survive the crisis were less eager to lend to small builders. With less financing available and with tightened lending standards, many small homebuilders lacked sufficient capital to build nearly as many homes as they had built previously. Some small builders decided to finish existing projects and then retire. Others decided to build at reduced rates. Between 1990 and 2000, the number of homes built by small builders continually and materially declined. The vacuum was filled by the publicly owned homebuilders. This explains why the large builders were growing at a much faster rate than their market.

I quickly calculated the growth rates of several large builders. In 1999, Centex built 27 percent more homes than in 1998.¹ Comparable growth rates for Pulte and Lennar were 20 percent and 17 percent. Something was happening that was big. Stick building had become a growth industry. Stick builders were growing as rapidly as most Internet companies. I made a model of Centex’s earnings. I assumed that, for the next several years, the company sold 12 percent more homes each year and that the average price per home increased at a 2 percent annual rate. Next, I looked at profit margins. Centex’s pretax earnings in 1999 equaled 8.1 percent of sales. Surely, if the company’s revenues increased at a 14 percent annual rate, its profit margins would benefit from positive leverage over fixed costs. After studying some historical numbers, I estimated that Centex’s pretax margins would reach 10 percent by 2003. Thus, my model estimated that the company’s revenues would increase from $6,008 million in 1999 to $10,150 million in 2003 and that its pretax earnings would increase from $482 million to $1,015 million. After taxes at a 35 percent effective rate and based on a share count of 125 million, my model projected 2003 after-tax earnings at $5.25 per share. Because the homebuilding industry was becoming a growth industry (I would no longer call the companies “stick builders”), I valued Centex at 12 times earnings. Therefore, I estimated that the shares would be worth about $63 in 2003. At the time I reached this conclusion, the shares were selling at less than $12. I did not wait a minute. I immediately started checking my thesis with anybody who had knowledge of the homebuilding industry and who would listen. I did not learn anything from my checking that would cause me to change my model. I then read Wall Street reports on the industry. I could not find a single Wall Street report that concluded that the public homebuilders would enjoy accelerated growth at the expense of the private homebuilders. Thus, it appeared that others were not on to my idea. I was gaining confidence that the homebuilders were an unusually attractive investment opportunity. I was literally jumping up and down with excitement. I could not wait, and immediately started purchasing shares of Centex and several other homebuilders.

I faced the question of how many shares of Centex and other homebuilders to purchase. There is no single correct answer to the optimum diversity in a portfolio. My own policy is that no single stock should equal more than 12 percent of the total value of a portfolio and that no single industry should equal more than 25 percent of the total value. When measuring the percentages, I use the cost of the stock rather than its market price. That way, I am not forced to reduce the size of a position that appreciates faster than the portfolio as a whole.

Our concept that the large homebuilders would grow rapidly at the expense of the small homebuilders was a creative idea. Because I have been interested in how we can optimize our creativity, over the years I have tried to learn how others successfully generate original ideas. I have yet to find an answer, but I did find that the following excerpts from an analysis by Professor Robert Harris were helpful:

Creativity is the ability to generate new ideas by combining, changing, or reapplying existing ideas.

Very few works of creative excellence are produced with a single stroke of brilliance or in a frenzy of rapid activity.

Creativity is also an attitude: the ability to accept change and newness—a willingness to play with ideas and possibilities, a flexibility of outlook, the habit of enjoying the good, while looking for ways to improve it. Creative people usually do not have a need to conform and are not afraid of failure.²

It is difficult to find creative investment ideas. Thinking is hard work. Most investment ideas that run through one’s head already have run through the heads of others, and therefore likely already have been largely discounted into the prices of stocks. If you have reason to believe that the price of oil will increase sharply, but if the likelihood of sharply higher oil prices already has become the conventional wisdom among investors, then it probably is too late to purchase the shares of companies that own oil reserves. Morning after morning, lunch after lunch, afternoon after afternoon, I try to find new creative investment ideas—but the vast majority of the time I strike out. Thus, my research efforts usually are tedious and frustrating. I have hundreds of thoughts and I study hundreds of companies, but good investment ideas are few and far between. Maybe only 1 percent or so of the companies we study ends up being part of our portfolios—making it much harder for a stock to enter our portfolios than for a student to enter Harvard. However, when I do find an exciting idea, excitement fills the air—a blaze of light that more than compensates for the hours and hours of tedium and frustration.

Our idea that the publicly owned homebuilders would enjoy materially accelerated growth is consistent with Professor Harris’s analysis. We generated the new idea by observing trends in an old idea (U.S. Home). We were unwilling to conform to Wall Street’s general view that stick building was a relatively unattractive cyclical business. We were not afraid of failure.

By mid-2000, we had built a large position in Centex and a few other homebuilders. Centex was by far the largest of the holdings, largely because I was particularly impressed by the company’s CEO, Larry Hirsch, and by the company’s general reputation for quality. Now, we just had to monitor our holdings, try to relax, and wait to see if our analyses and projections would prove to be accurate. I note that we are most relaxed at the times when we purchase a security and when we sell a security, but it is often difficult to relax in between. There is a reason for this. Greenhaven’s goal is to achieve average annual returns of 15 to 20 percent on its investments. Because we make mistakes, to achieve 15 to 20 percent average returns, we usually do not purchase a security unless we believe that it has the potential to provide a 30 percent or so annual return. Thus, we have very high expectations for each investment. After we purchase a security, there are two possibilities. The unlikely possibility is that the security starts appreciating at above a 30 percent or so annual rate, in which case we are relaxed and smiling. The more likely possibility is that the security fails to appreciate at a 30 percent or so annual rate, in which case we are disappointed and unrelaxed.

There is another consideration. We are prone to sell securities that have exceeded our expectations and hold securities that have yet to meet our expectations. Thus, at any one time, because we have sold our winners, our portfolio is heavily weighted toward stocks that have lagged our expectations. Owning laggards is neither fun nor relaxing.

Because the homebuilders had become a sizable investment, over the next several years, we continually and particularly carefully monitored the progress of the companies. I was generally happy that the large homebuilders continued to gain market share. Centex sold 61 percent more homes in 2003 than in 1999. Furthermore, Centex’s pretax margins had increased to 11.1 percent and its earnings per share had increased to $6.01 in 2003 versus $2.11 in 1999. Responding to the sharply higher earnings, the price of the company’s shares had appreciated to about $40, more than three times the price we had paid for the shares three years earlier. However, the shares still were selling at far less than 10 times earnings, which was a frustrating disappointment—and an enigma.

On a warm and humid day in mid-July 2003, I found a number that intrigued me. The U.S. Census Bureau keeps track of the number of housing units being built in the United States. On the twelfth business day of each month, the Bureau releases data for the previous month. The data for June showed that the seasonally adjusted annual rate of housing starts during the month was 1,867,000, up 6.7 percent from May and up 8.7 percent from the previous June. Those are large increases for an industry that should only grow in line with the growth of the U.S. population. Something was going on. I needed to find out what. The answer seemed to lie with the economy and mortgage rates. In the late 1990s, there was a boom in the prices of technology stocks. In fact, the boom developed into a bubble. The increased wealth created by the boom contributed to a strengthened economy. In turn, the strengthened economy triggered an increase in interest rates. Thirty-year fixed mortgage rates increased from about 7 percent in 1997 to about 8 percent in 2000. Then, the technology bubble burst and the economy softened. Thirty-year fixed mortgage rates declined to about 7 percent by early 2001. The terrorist attacks on 9/11 were a second and severe blow to the economy. Immediately following the attacks, many Americans were not in the mood to travel or to purchase large-ticket items. Responding to the weak economy, the Federal Reserve Bank sharply reduced interest rates. Ninety-day T-bill rates fell from about 3.5 percent just before the attacks to about 1.7 percent by year-end 2011. 30-year fixed rate mortgages fell from about 7 percent before the attacks to just over 6 percent a year later and then to about 5.2 percent by mid-2003. With mortgage rates at 5.2 percent, the purchase of a new house was more affordable than it had been for quite a while. Many families decided to take advantage of the affordability, which was the apparent reason why the demand for new houses had increased to above-normal levels.

The number of houses that can be built at any one time is limited by the availability of permitted and developed building lots. Because of local opposition, it often requires several years to receive permits to develop raw land. Opposition due to environmental impacts often is particularly sticky. I once read about a proposed housing development that was delayed several years because of local concerns about the well-being of a family of frogs that reputedly lived in a stream that crossed the property. My kidding and impolitic solution to the concerns and delays was sautéed frog legs, but the local conservationists evidently did not care for frog legs, and they dragged their opposition into the courts.

Because of the time required to permit and develop land, by mid-2003 the demand for new homes was increasing faster than building lots could be permitted and developed. The result was a shortage of new homes in many parts of the country. When a new housing development finally was ready to accept orders, often there were many more hopeful purchasers than available homes. Long lines developed in front of the selling offices. To be near the front of a line, some families camped out at the development for one or more nights. With demand exceeding supply, housing prices started to increase at above normal rates. Newspapers started carrying articles about the price increases. Many newspaper journalists and economists predicted that housing prices would continue to increase quite sharply for the foreseeable future. These predictions incentivized additional families to purchase new homes before prices did increase further. Hence, the boom fed on itself. By the fall of 2003, seasonally adjusted housing starts reached an annual rate of 2 million—and likely would have been higher had there been a greater availability of developed lots.

It may seem counterintuitive, but I was unhappy about the sudden boom in single-family houses. We believed that the normal annual demand for new housing units in the United States was about 1,600,000. Over time, the average annual demand is relatively fixed because there are only a certain number of people living in the United States who need a home. A recalcitrant wayward teenager who hates his parents is unlikely to run away from home and purchase, to quote from an advertisement, a “new perfectly proportioned 4 bedroom, 3.5 bath house with cathedraled ceiling master bedroom; large beautifully landscaped 0.8 acre yard contiguous to a permanently deeded nature preserve; close to nationally awarded schools and fine shopping.” With housing starts at a 2 million annual rate, clearly more houses were being built than needed. Future demand had been pulled forward, first by the attractive affordability and then by the expectation of continually rising prices There may have been some pent-up demand for houses coming out of the 2001–2002 recession, but, sooner or later, if housing construction continued at late 2003 levels, there would be a surplus of unsold homes—and the housing industry would cycle downward. When we purchased Centex and the other homebuilders, we hoped they would grow steadily for many years at double-digit rates as they gained market share. We also hoped that their shares would sell at higher price-to-earnings (PE) ratios as they became viewed as growth stocks rather than cyclical stick builders. However, if the industry cycled downward, we might suffer through a period of declining earnings and declining PE ratios. That is why I was unhappy about the spurt in the demand for new houses.

The housing boom continued through 2004 and 2005. Centex continued to benefit from the boom. The company was projected to sell about 39,000 houses in 2005, up from 30,358 in 2003 and 18,904 in 1999. Furthermore, the company’s pretax profit margins in 2005 were expected to exceed 14 percent and the company’s earnings per share was projected to equal or exceed $9. Centex was on a roll.

In the fall of 2005, Centex’s shares were selling at about $70. We had earned close to a sixfold profit on our investment. I should have been ecstatic, but I was not. The shares still were trading at far less than 10 times earnings. Furthermore, the housing boom could not continue forever, and when it ended, Centex’s earnings likely would decline sharply. Also, the company was aggressively purchasing additional land at a time when land prices had risen sharply in response to both strong demand from the homebuilders and limited supply due to frogs and other environmental concerns. At the end of 2004, Centex owned 96,945 building lots, up 25 percent from the end of 2003. To finance these purchases, Centex’s net corporate debt increased by more than $500 million in 2004. I thought that the company was making a large and dangerous mistake. At a time when the housing industry was abnormally strong, Centex should have been husbanding its cash and minimizing its purchases of high-priced land. The risks in owing shares in the homebuilders clearly had increased. I started to call them stick builders again, and I started to reduce our holdings.

I badly needed to speak to Centex’s management. Larry Hirsch had retired as CEO in 2004 and had been replaced by Tim Eller. I called Tim and arranged an appointment to see him on November 15. I decided to bring along an acquaintance, Jim Grossfeld, who previously had been CEO of Pulte Homes and whom I had met and respected when we both were directors of Interstate Bakeries. The meeting with Tim Eller was stormy. I tried to understand the thinking behind Centex’s strategy of paying high prices for land at a time when home construction was at an unsustainably high level. It was clear to me that an excessive number of houses were being built in the United States and eventually there would be a correction that likely would lead to lower prices for houses. If Centex received lower prices on new homes that were sitting on top of high-cost land, the company could suffer serious operating losses and value impairments. Tim did not agree with my reasoning. He maintained that the large homebuilders would continue to gain market share and therefore that Centex would need all the land it was purchasing. He thought it unlikely that housing prices would decline, even during a slowdown. His argument was that house prices never had declined before. I took strong exception to this reasoning. It is dangerous to project past trends into the future. It is akin to steering a car by looking through the rearview mirror (which is OK while the road remains straight, but a catastrophe when the car comes to a curve). We agreed to disagree. I was frustrated. I was angry. My father always told me to slowly count to 10 whenever I was angry, and then the anger would disappear. I counted to 10 very slowly. I was still angry. I counted to 10 again. I remained angry and frustrated. The large homebuilders were gaining market share and were selling at low prices relative to their current earnings, but there were material risks of permanent losses if excessive inventories of unsold homes triggered a downward cycle in the business. Tim Eller seemed oblivious to the risks.

I decided to sell all our holdings in the homebuilders. I could not wait for signs that the demand for new homes was weakening. When purchasing or selling securities, we try to act ahead of developments. We were out of our holdings by early 2006. We sold our Centex shares at roughly $70, or close to 6 times what we had paid for the shares. The investment was a complete winner, but I felt that it could have been even more profitable if the housing bubble had not occurred because the homebuilders eventually would have earned respect and sold at much higher PE ratios.

While I was happy with the outcome of our investments in the homebuilders, I was not completely happy or fulfilled. I usually am that way: a happy and optimistic person who, at the same time, is unhappy that he is not doing better. Put it this way: I would be less than happy if I were not constantly striving to do better. A desire and striving to do better seems to be part of human behavior, at least my human behavior.

The housing crisis that followed the bursting of the bubble was worse than I would have imagined. Who is to blame for the crisis? Certainly the banks, Wall Street firms, and mortgage brokers that aggressively oversold risky mortgages are partially to blame. And certainly the homebuilders, who misjudged the fundamentals of their business and overexpanded, are partly to blame. But also to blame are the many families who overpaid for houses—the Tom and Jane Smiths who were not at all interested in purchasing a house at a reasonable price in 2002, but who then camped out and overpaid for a house in 2005 because they believed that prices would continue to rise. According to U.S. Census Bureau data, the average price for a new single-family home increased from $228,700 in 2002 to $292,200 in 2005. Even adjusting for inflation, the Tom and Jane Smiths materially overpaid—and then likely financed their purchases with mortgages that were larger than the houses would have been worth in 2002—and materially larger than the houses were worth after the bubble burst. No wonder there was a financial crisis. In my opinion, greedy bankers and Wall Streeters contributed to the housing and financial crises, but the families who purchased homes in 2004–2006 at inflated prices were the root cause of the crises. Wall Street and banks, of course, became the scapegoats and received nearly full blame for the crisis. It would have been impolitic to criticize the Tom and Jane Smiths for their indiscretions.

Several months after we sold our holdings in Centex and several other homebuilders for happily large gains, I received an unhappy telephone call from Bill Summer, a client who was in the real estate business. Bill complained that, because of the large realized capital gains in the homebuilders, he now was faced with an unhappily large tax bill. He added that he did not like paying taxes to the government and that, in his real estate business, he had found ways to permanently defer paying taxes. He asked me to review his portfolio and sell all his stocks that had unrealized losses so that he could offset the realized gains with losses. I explained to him that we luckily did not have any sizable unrealized losses. Furthermore, if we realized losses in stocks and then repurchased the stocks 31 days later, clients would establish lower cost bases and therefore eventually would realize larger gains when we sold the shares. The larger gains would negate the tax savings of realizing the losses. Greenhaven typically holds stocks for two to four years. Thus, clients who sell shares to take tax losses merely would be deferring realized gains for a few years. And there are some distinct disadvantages to selling attractive stocks for the purpose of realizing losses. There are transactional costs when stocks are purchased and sold. Also, there is an upward bias to the stock market, so, on average, it will cost something not to own a stock for 31 days. Further, and importantly, if a stock is sold and then repurchased, the stock needs to be held for one year and a day from the date of repurchase to be treated as a long-term capital gain. If we desire or need to sell a repurchased stock at a profit within one year of when it was repurchased, any gain on the transaction would be taxed at ordinary rates. Thus, while tax loss selling permits clients to, in effect, borrow money from the government at no cost, I believe that the disadvantages of tax loss selling normally outweigh the advantages—and I told that to Bill.

A few days later, Bill called back, still grumbling about his tax bill. I told him that we were committed to making investment decisions that were in the best interest of our clients and that, while tax loss selling made sense to us a small fraction of the time, it did not make sense to us most of the time. I suggested to Bill that if not paying taxes was a major investment objective, he should leave Greenhaven, which he did.