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Recession Investing: Look to the unexpected

Posted February 2, 2008

"I’m betting that the bull market will have some legs. As such the place to put your money today, is a place that no one wants to be. In this case it’s the homebuilders. Specifically SPF that’s trading at an all time low, with extreme value, insider buying, the chance of a short squeeze and positive cash flow." — Chris DeHaemer, RedZone Profits

Baltimore – (TFN): The following was taken from this week's Market Insights with Krista Das featuring Chris DeHaemer, editor of RedZone Profits. Watch this video.

Krista Das: What goes up must come down. Even if Sir Isaac Newton wasn’t referring to the US economy, or the world markets for that matter, I’m sure he would have understood the gravity of the situation. That is why my guest today wasn’t overly surprised by the revelation last week that a minor functionary at the second largest bank in France, Société Générale, created a long equities futures position that resulted in a $7.1 billion loss.

Chris DeHaemer is the editor of Red Zone Profits, which focuses on undervalued, high-reward small caps, and GRESSOR, a trader's dream. He spent the early part of his career careening around the world in search of profits for Taipan's World Investor. He sought out undervalued bargains in Eastern Europe in the aftermath of the Soviet Union's collapse, and made a killing after the maiming of the Asia Tigers. Chris also called the October 2002 bottom, recommending handfuls of stocks when panic reached its zenith.

Chris, give us some insights into the markets these days and the strange occurrences that are making history, such as Société Générale’s $7.1 billion dollar loss and continual rate cuts.

Chris DeHaemer: Société Générale uncovered its losses and had to puke them out last Monday into the biggest sell-off in some years. Furthermore, Monday was MLK day when the U.S. markets were closed and thus the global market was illiquid which extended the downside.

The fear in the markets on money was palatable. My own sweet wife was begging me to switch to bonds to which I replied, “stay the course and get back in the kitchen.” Ok, I’m mostly joking about that one.

But our friend Bernanke at the Fed was sweating like a mule dear in the rut and panicked a bit with a premature 0.75% rate cut.

The market rallied. And has been going up ever since. This chart from the late 1990’s bull market shows that there were 10 corrections of five percent or more before that bull broke trend and turned bearish. It's on the backs of preverbal bodies that bull markets are built. Giant margin calls ring bells at bottom of corrections.  It was Nicholas Leeson who kicked off the biggest bull market of all time on Janaury 19, 1995 by hiding losses $1.4 billion and bringing down the Barings, the august British bank.

Krista Das: You’re an experienced trader in crisis situations. If you could bet on any sector in this crazy, volatile market, which one do you predict has the strongest chance of making a comeback?

Chris DeHaemer: I’m betting that the bull market will have some legs. As such the place to put your money today, is a place that no one wants to be. In this case it’s the homebuilders. Specifically SPF that’s trading at an all time low, with extreme value, insider buying, the chance of a short squeeze and positive cash flow.

Rather watch the financial video? Click here.

Krista Das: Really? The homebuilders? Why is that?

Chris DeHaemer: A few days ago, news came out that U.S. mortgage applications rose 8.3 percent in the week ending Jan. 18. Two-thirds of the new applicants were refinancing to take advantage of falling interest rates. And this was before the Fed's surprise move Tuesday.  Which means that rates will drop further and adjustable-rate mortgages won’t reset to higher rates, which in turn means fewer foreclosures.

Krista Das: Chris, I certainly understand your reasoning, but is it really time to buy up the homebuilders? How do we know that the bottom is here?

Chris DeHaemer: Buying SPF isn’t a bet that the homebuilders will soon enter the land of milk and honey. It is however, a bet that the sell off from $45 to $3 is overdone. Insiders think so as they have bought 55,000 shares over the past six months. Further evidence of value is that SPF has a price to book of 0.15 and a price to sales of 0.07 and a positive change in cash flow.

According to their latest quarterly report:

“As demand in our markets decreased and our volumes slowed during 2006, we implemented a plan to adjust our operating strategy, transitioning from a focus on growth and diversification to an emphasis on generating positive cash flow, strengthening our balance sheet and improving our liquidity. As part of this strategy, we are focusing on the following:

• Continuing to reduce the level of investment in our homebuilding inventories, including a meaningful reduction in the allocation of capital to land acquisitions, using the cash to pay down debt;
• Carefully managing our speculative starts and the timing of our new community openings to better align production with sales;
• Continuing to refine our pricing strategy to find the right balance between margins, volume and cash flow generation; and
• Making the necessary adjustments in our headcount and overhead structure to reduce the size of the organization to respond to lower volume levels in the near term.

We believe that these measures will result in the generation of positive cash flow in 2007, which will be used to pay down our debt and strengthen our financial position. During the last twelve months ended September 30, 2007, we generated positive cash flows and reduced our level of consolidated homebuilding unsecured debt by approximately $265 million.”

Krista Das: Do you have a particular homebuilder SPF that you can recommend?

Chris DeHaemer: Buy Standard Pacific Corp (SPF:NYSE) under $3.50 (now at $3.30) based on the idea that it can’t get any worse – the bottom is here.  New lower mortgage rates will spur an uptick in home sales and value buyers will move back into the homebuilders. SPF has achieved positive cash flow unlike its competitors, has insider buying, a massive short position which must cover and a chart which shows the end of a trend. This is a stock that could easily double from here. Use a 20% stoploss and buy SPF. Q4 earnings call will be on February 2, 2008.

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