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The recent action in the stock market reminds me of the storyline of Don DeLillo's classic
. In that novel, an airborne toxic event unleashes a lethal black chemical cloud that floats over a small city in Middle America, forcing residents to evacuate their homes to prevent acquiring the resultant disease.
These days, the toxic cloud that's spreading on Wall Street is a brutal bear market in equities. Investors are fearfully fleeing their stock portfolios. The market's industrial accident has been a mix of several violent incidents: the unwinding of the credit crisis, a terribly battered U.S. housing market and skyrocketing oil prices.
My Bricks and Mortar mock portfolio has not been immune to this carnage, but it has outperformed the
thus far this year. The long-short mock portfolio was down 2.1% year to date as of Tuesday's market close, compared with a 12.5% decline in the S&P 500 and a 5.6% drop in the U.S. MSCI REIT Index.
So with the first half of the year over, I'd like to offer a breakdown of the portfolio and my take on where I see stocks and sentiment headed in the homebuilding, casino, lodging, construction and REIT sectors.
Casinos: Hedging the Bet
The long-held theory that casinos are recession-proof blew up earlier this year, as weak results rolled in from Las Vegas operators. Stocks have now nosedived across the space. Analysts are warning about more pain ahead in the sector due to high gas prices and reduced air travel to the region. Worries are also circulating about how increased competition in Macau will hurt profit margins.
Melco Crown Entertainment
, a pure-play on the Macau casino market, continues to get beaten down. Analysts recently have been arguing that Macau casinos deserve to trade at lower earnings multiples today given that profits have become more uncertain.
Melco's first casino, the Crown Macau, dominates the VIP market in Macau. However, there is uncertainty as to what sort of return on capital Melco's next casino developments will generate.
I continue to like Melco and believe the stock is worth significantly more than its Tuesday close price of $9.32 if you give proper credit to the casino development pipeline. I will write a more in-depth update on Melco in coming weeks, but it's worth noting that on a relative basis, Melco has significantly outperformed
Las Vegas Sands
, an operator of regional casinos and racetracks across the U.S., has tumbled about 50% this year to trade around $30. This decline came despite a $67-a-share buyout offer from
, an agreement that remains in place.
The stock's price today, however, signals the buyout deal is likely to be cancelled or renegotiated at a much lower price. Penn National trades around 8 times estimated 2008 EBITDA (on an enterprise value-to-EBITDA multiple basis). Between 2001 and 2003, Penn traded in an EV/EBITDA-multiple range of 6.5 to 7.9, according to data from SNL Research. While some downside risk to Penn remains, at these levels you can buy the stock near its historically low multiple and receive the cheap implied option of any sort of buyout happening.
Last week, I added two new positions to the portfolio in a "pairs trade" that's emblematic of how I view the gaming space. In this pairs trade -- in which one stock is bought and another in a related sector is shorted --
buying casino owner
and shorting construction firm
. The structure of the trades provides a hedge against some of the risks inherent in the bullish casino bet.
Homebuilders: The Shorts Have It
Homebuilder shorts have been the reason my portfolio has held up well this year. I
The building industry stinks, but I believe there could be some trading opportunities in some of the more distressed names -- such as
-- and I am keeping both of them on my radar as possible buys. These stocks are trading at very steep discounts to book value and may be close to pricing in the negativity that lies ahead for the sector.
Nonetheless, I expect earnings across the homebuilding space will remain elusive until 2010, as margins remain under pressure and home prices fall at least another 10% through 2009, predictions several analysts and economists have offered.
Lodging: Beaten-Down Long-Term Plays
has been my worst-performing pick, but I continue to love the long-term thesis on the lodging operator. Starwood spins off a tremendous amount of free cash flow, and its shift to a more asset-light management fee business model allows for substantial growth at high margins in the future.
Nonetheless, more Wall Street analysts have been cutting estimates and price targets on Starwood and
Starwood is currently trading around 9 times expected 2008 EBITDA, which is cheaper than it ever traded from 2001 to 2007 (when the average multiple was 12), according to SNL Research data.
I believe buying at this price is great for long-term investors.
Commercial Real Estate: No Short-Term Relief
After offering strong performance earlier this year, commercial real estate has since taken a beating. As noted above, the U.S. MSCI REIT Index is down 5.6% for the year, which is still not as severe a drop as the S&P 500's 12.5% decline.
, an office landlord I own in the mock portfolio, is trading at a discount to the private market value of its properties. However, the fear in the industry is that office fundamentals are set to slow further, and finding debt to place on buildings today is proving a much tougher task, which affects valuations of properties.
Wall Street banks remain mostly unwilling to lend on commercial real estate buildings because it is hard to securitize the debt. Meanwhile, the large portfolio lenders such as
are only lending at roughly 55% loan-to-value maximum and at levels below $200 million, industry source says. These insurance companies may reach their targeted debt allocations by the end of the year.
These issues and more are also playing out internationally, which helps explain why the
SPDR Global Real Estate ETF
, an exchange-traded fund held in the mock portfolio, is down more than 18% this year.
I continue to hold both positions in the Bricks and Mortar mock portfolio, but I wouldn't recommend buying either today.
Home-Improvement Industry: Counting on a Recovery
Rounding out the portfolio is
, the nation's largest home-improvement retailer. The thesis here remains simple: Home Depot is the best way to play the eventual recovery in the housing market.
The stock today offers a 3.7% dividend yield and is trading at just 12 times expected 2009 EPS. The company spins off a ton of free cash flow and will likely use those proceeds to buy back shares once the credit markets improve.
The stock is cheap, but it has unfortunately gotten 22% cheaper since I recommended it in January. On Tuesday, Merrill Lynch slapped an underweight rating on Home Depot.
I don't expect the stock to turn around until investors get comfortable with the idea that the economy will improve in 2009.
Then again, I don't mind owning it in the mock portfolio today, since it was originally paired up with a short on Pulte Homes earlier this year.
The First-Half Takeaway
In order to protect a portfolio of stocks in the broader real estate sectors, you need to have both long and short exposure.
The level of fear across casino and real estate stocks today is unprecedented, since the sectors remain at the vortex of the weakening economy.