Time to Buy the Homebuilders

Yesterday’s report from the FHFA showed a very robust 1.7% increase in home prices from December to January. The .1% increase previously reported in December however was revised to a .2% decline. Regardless, this is a very good sign pointing towards stabilization of the housing market. Eight of nine regions reported an increase with only the Pacific region showing a .9% decline. The Pacific region is obviously dominated by California where buyers were likely holding back in anticipation of a $10,000 state tax credit for first time home buyers that is now law. Particularly interesting is this tax credit only applies to purchases of newly built homes.

Homebuilders wisely took any and all losses possible last year in order to receive checks from the federal government. They had to show losses to benefit from rebates of taxes paid during better times. This was a gift from the 2008 stimulus bill. It is even rumored that many sold land holdings at losses with agreements to repurchase the same property in the future in order to obtain these lucrative rebates. No need for me to pontificate here on the tax payer fleecing. My job is to look for investment opportunities.

Fundamentally, business for home builders and their supporting industries has to improve. Our population grows by about 3.5mm people annually. This represents a need for about 900,000 living units. Currently, we are building less than half that amount.

iShares Dow Jones US Home Construction Index (ITB) is the best pure play, being largely concentrated in home builders themselves. It also includes home improvement retailers Lowe's (LOW) and Home Depot (HD) along with furnishings sector members Leggett & Platt (LEG) and Mohawk Industries (MHK).

Spider S&P Homebuilders ETF (XHB) is a less concentrated play with Home Depot, Lowe's, Bed Bath & Beyond (BBBY), Sherwin Williams (SHW) and Masco (MAS) in the top ten.

Shorts are likely to cover soon as stabilization numbers continue to trickle in. Add some new long positions to that and some anticipated better news over the next year and you have the makings for a very nice multi year investment.

Comments

[conceptwizard:]

Well.... I cant see how new homes are going to be built without bringing down the 13-15 month surplus inventory substanstilally. Prices are still on the decline and 44 Billion dollars worth of variable rate mortgages are known to reset this year. The housing pricing charts are still on the delcine and foreclosures are going up faster than the purchases. Employment rates are still declining and this will have an effect on defaults as well. So I would have a hard time investing in home builders at this time unfortunately. They must be having a really rough year, it grieves me to say, that next year will probably not be great either.

Mar 25 02:49 PM

[Lee Eugene ...:]

I agree with the last two comments. Just taking a quick survey of people I come into contact with (I know, not scientific) tells of more pain. There are people out there in la-la land that are on the verge of foreclosure that can't even admit it to themselves. They do not show up in surveys and for right now can make their house payments. The problem is, they are burning through their assets, including their 401k’s and all that is needed to push them over the edge is a few credit cards that get pulled. Another wave is coming. I would look elsewhere.

Mar 25 06:34 PM

[Angry Appra...:]

YOU ARE COMPLETELY WRONG

REO'S for the same models across the street priced 20% less than new models.
REOs selling BELOW COST TO BUILD
TOLL BROS uses inflated appraisals and their own mortgage company to finance their deals.

BUILDERS ARE DEAD IN THE WATER......

Mar 25 08:23 PM

[PROXIMO:]

The ETF's and companies you recommend are excellent candidates---TO SHORT.

Mar 25 10:10 PM

[mac.barron:]

I saw the title of the article and my B.S. detector started to go berserk. I'm glad to see that the posters who got here ahead of me already debunked this.

Mar 25 10:10 PM

[Lightway:]

This article is irresponsible. Home builder stocks may have started the stabilization process, but they are not something that will turn around in the short term. If you want to get some now and hold for 5-10 years, that may make sense, but there is still alot of downside.

If you're looking for real estate exposure, REITs NLY or O are good choices since they provide healthy dividends.

Mar 26 12:36 AM

[Jae Jun:]

What about the REIT's? Not home builder but the mall owners have been hammered down so much that the risk-reward could be advantageous.

Mar 26 12:37 AM

[hmorgan:]

Thank you all for your comments. I'm honored somebody reads my posts. I find buying when fundamentals are poor based on conviction they will ultimately improve has rewarded investors over and over again. In fact, the only way things get really cheap is for fundamentals to get very bad. I expect the homebuilders to rise substantially well in advance of significant improvement in their fortunes. Two to three years from now when business is booming, I will recommend exit from this trade. Finally, my skin is thick but still this site's value would impove if more participants would express their opposiving viewpoints in a more civil tone.

Mar 26 10:40 AM

[Eric Boughton_:]

A few problems with your analysis, Herb. First, the U.S. Census Bureau estimates that U.S. population grew by only 2.8 mln people between 7/1/07 and 7/1/08. (www.census.gov/popest/...)
Second, even this data is fraught with potential errors, with extremely limited data on net migration leading to reliance on extrapolative techniques.
Third, the net movement of people from single-family houses into multi-family dwellings, which may be starting and may persist on a secular basis for quite some time, could offset any population growth.
Fourth, the total number of families owning multiple houses is likely to decline for some time as well, offsetting new home construction.
Fifth, when viewed over a long period of time, the average age of houses is lower than normal.
Sixth, from about 1997-2006, the total number of new homes was far in EXCESS of the number demanded purely by population increases. So, why would we think population changes going forward over the next 10 years would be at all correlated with the number of new homes built?
Seventh, specifically related to your bullish position on homebuilders, homebuilder stocks are, by and large, already pricing in the return of demand, and the ridiculously high margins achieved at the peak of the bubble. For example, consider TOL. During its best twelve months (5/1/05-4/30/06), TOL achieved $6.4 bln in sales, $1.4 bln in operating income, and $870 mln in net income (approx $5.15 per share with adjustments). This was a 22% operating margin, and a 14% net income margin. Consider, however, that from FY94-97 ("normal years"), TOL's operating margins averaged 14% and NI margins 7%. Which is more representative of TOL's business over the coming decade? You can have your opinion, but mine is that the 14% and 7% are much more likely, and in fact that 10% and 5% would be likelier still. The opulence of the past 20+ years is gone... for good!
In any case, assume for a moment TOL generates a revenue run rate 25% HIGHER THAN its trailing twelve month sales (so from $2.7 bln all the way up to $3.4 bln). Keep in mind, that would EXCEED their average annual sales in 2003-2004! A generous assumption, to say the least! By comparison, analysts expect only $1.6 bln in sales in FY2011.
Now, apply, say, 6%, net income margins to the $3.4 bln, and you get $204 mln of net income. That's a PE of 15.8, several points higher than the S&P 500! With a bunch of generous assumptions. Clearly, the market is already banking on quite a turnaround.
I use TOL as an example simply because it is one of the least leveraged of the homebuilders. Clearly, with several other homebuilders where bondholders own more of the company than shareholders do (9 of the 17 homebuilders I follow have net debt in excess of market cap, and only 3 have investment-grade (BBB-) credit ratings.), the stock represents much more of a call option on survival. Good luck with those!

Mar 26 01:33 PM

[Jack Flint:]

Eighth....the massive amount of homes owned by retiring baby boomers coming on the market. This constiuency bought these homes 20+ years ago. They can sell at a 50% discount and still be making money.

Mar 26 05:29 PM

[Harry L:]

House poor? Most of us have had to stretch to buy houses, particularly first time buyers. Builders have typically had huge margins in home prices and losses taken in 08 will be quickly overcome when the now "fairly priced" inventory cleans up. Real estate developers will make money. Good time to buy.

Apr 03 01:08 PM

[HardwoodFlo...:]

Wait until Mohawk report earnings. It's going to be a blood bath.

There will be a recovery but these big companies will be late to the party.

Apr 07 11:34 AM