Top 10 Pick: Buy D.R. Horton

| About: D. R. (DHI)

My Top 10 list for 2013 is halfway home as I allocate my fifth pick to America's No. 1 homebuilder, D.R. Horton (NYSE:DHI). It's the second homebuilder I've picked for the list, as Hovnanian (NYSE:HOV) was recommended earlier this month. Other picks posted so far include Amazon, NCR, and NCR (I made NCR a "double pick"; as I explained in my last article, the $22 stock should be trading in the low $40s). If you'd like to see how my prior Top 10 lists have fared, here is the record.

With two of five picks (so far) in the homebuilding space, it goes without saying that I'm anticipating a strong rebound in housing. Housing, which led the way down in 2007, will lead the way back up in 2013 and beyond. I'll discuss the reasons why, then I'll talk specifically about the stock of D.R. Horton.

The Rebound in Housing Will Be Surprisingly Strong

Housing starts have doubled, from a run-rate near 400,000 at the nadir to about 800,000 currently -- and it's just the beginning. Expect a rebound to normal levels in the next year or two, and normal is nearly double current output, or about 1.5 million starts per year.

What's the impetus behind the move? As I've maintained in earlier articles, it's all about price. Simply put, home prices in America overcorrected during the credit crisis. Prices are astonishingly low and it won't last. Affordability is off the charts, with rents in many markets more than double what new homeowners pay in principal and interest. The supply of new homes is at a historically low level as well, and in light of "near-free money" (as one builder described mortgage rates), buying interest shows no sign of abating.

Before this cycle is over -- and I'm guessing it'll take us to 2020 -- most publicly traded homebuilders will exceed prior records in earnings and sales. The earnings leverage embedded in the models I've studied is quite impressive. Here are a few factors that will allow the homebuilders to post record earnings over the next few years:

1. Dramatically lower interest rates.

The drop in interest rates is a powerful earnings tailwind. Every publicly traded homebuilder I've reviewed has refinanced debt at a fraction of what it cost them in 2005 and 2006. D.R. Horton, for example, recently issued debt at rates I'm sure it never thought it would ever see: 4.5%.

2. SG&A has been cut to the bone.

Homebuilders survived the worst market since the Great Depression by cutting expenses to the bone. As sales pick up, you'll see rock-bottom SG&A levels facilitate strong gains in earnings.

3. Competition has vanished.

For the most part, local builders -- the primary competition for publicly traded homebuilders -- are no longer around. The downturn was so long in duration (six years) and was so deep that local builders have moved on, and the resulting competitive vacuum has made it easy for publicly traded homebuilders to expand their earnings base and increase market share.

4. Pricing power is increasing.

Across the country, prices are perking up. This will result in windfall gains to homebuilders as prices return to normalized levels. Incentives are being reduced, home prices are being increased, and there's even evidence of competition among buyers for a limited supply of new homes.

Why D.R. Horton, Specifically?

Among the homebuilders (and ancillary industries that stand to benefit), bargain stocks are plentiful. Besides the fact that it's the No. 1 builder in America, D.R. Horton is attractive because of its solid balance sheet ($1.3 billion in cash, with modest debt) and hefty pipeline of finished lots (about a three-year supply).

Don't pay attention to the P/E ratio in the case of D.R. Horton, by the way. It'll only mislead you. It supposedly sells at 17 times earnings estimates of $1.09 for the current fiscal year (which started Oct. 1). Earnings will be a lot higher than $1.09. Here's what you need to know: Normal gross margins are 20% (they're 18% now), and normal SG&A is 10% (it's about 12% now). Couple the margin leverage with revenue leverage -- the backlog, measured in dollars, is up 61% -- and you can see that this model's earnings power packs a wallop.

Disclosure: I am long DHI, AMZN, HOV, NCR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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