Why I'm Bullish on Homebuilders

A theme I have consistently discussed in my weekly newsletter EPIC Insights is that over the coming years, hard assets will drastically outperform paper assets.

Few things in this market offer any guarantees. However, there are two ideas about which I am certain. One is that the Fed will eventually create inflation. After all, it has started down the path of quantitative easing and will print as many trillions of dollars as needed to complete the job. The second is that the Fed will not properly remove the monetary stimulus from the system and a small level of inflation needed to revive the credit markets shall grow into a raging storm that imperils the recovery. In this environment paper assets suffer and hard assets shine.

Following this theme, we have positioned our portfolio for the turn. Profitable trades have been closed in the oil, cement, and deep-sea drilling industries. We still sit on profits in commodity-related, iron ore, and international markets. Scanning this list offers a fairly representative group of stocks that will do well in the years ahead. However, we are missing one industry that will also perform well- housing.

Housing is the most traditional of hard assets as it is owned by many groups who never invest in financial markets. However, given its role in the current financial crisis, it is unloved. At one time, investors believed a house offered the ultimate utility. It delivered cash via either rentals or home-equity extraction, increased in value, and allowed the owner to benefit by using it. As prices nationwide rose to bubble levels and subsequently crashed, investors have shunned real estate. Given its high financing needs, current demand of our excess cash, and dropping values, the aversion is logical.

Within this dislocation is where opportunity lies. Instead of focusing on select homebuilders, use an ETF as proxy-the SPDR S&P Homebuilders ETF (XHB). XHB peaked above $46 in April 2006, sank to a low of $8.23 on March 9, and currently trades at $11.50. The 75% drop in XHB exceeds the decline in housing values and indicates that investors have moved from euphoria to apathy. Eventually, as inflation returns, housing will be seen as an effective hedge. Combine inflation with increasing housing affordability, and it is merely time until the homebuilders prosper. By positioning ahead of the turn, profits can be made.

Obviously, housing's reliance on credit markets is a negative that could derail this investment. Therefore, we must pay as much attention to our trading technique as we do the merits of the investment, For that reason, we will start small and look to increase the trade as the market confirms our belief. Once we see that others are confirming our beliefs, we will average up into a winning trade as the position grows to a reasonable level. With that strategy, I recommend a 1% position in XHB as this week's fundamental trade.

Comments

[HardwoodFlo...:]

You must be kidding! The big home builders are going to be the last people to partcipate inthe market turn around.

Let me explain: First remodel will take off. This not based on home equity loans (you can't get one) but on real income spending on pent-up demand. Then the "Mom and Pop" will start back up. Then- not for another 12 months will the big home builders start building again. Even at that it will be another 12 months before they are selling homes.

I agree housing will be the first thing out of this mess- however, Wall Street won't see it this summer . But guys like us, on the front lines will- as remodel and small building takes off. I see what looks like a Bloomberg terminal behind you in your picture. I think your analysis is fundementally correct but this will be a regional recovery, sort of a "back to the future" recovery whereby "the little guys" lead out.

Apr 07 10:17 AM

[hmorgan:]

Sean,
I have to agree with you on this one. Nice post. Another beaten down inflation sensitive play is REITS (ICF). Obviously there is serious fundamental issues but those seem more than fully reflected in this ETF's price. What are your thoughts there?

Herb Morgan
Efficient Market Advisors, LLC

Apr 07 10:37 AM

[HardwoodFlo...:]

Hmorgan,
Reits- what like Plum Creek! REITS are some of the worst bets I could imagine right now. Like commercial REITS! You have to be kidding.

You must be talking your book. REITS! (lol).

Apr 07 11:31 AM

[crewman:]

Sean - your analysis is too simplistic (i.e. improvements in housing sector = increased home builder stock price). You need to go deeper with your research on public home builders. You'll discover that most shareholder equity is completely gone. With cratering land values, low sales, no bond market (for builders) and no debt market, most public builders have had to strike deals with hedge funds and private equity groups to get them through these tough times. These equity groups often require IRRs of 25% or more. When the housing market returns and home builders are making profit again, per agreements, the lion's share of these profits will go to these private equity groups and not to shareholder equity.

Apr 07 12:02 PM

[corybear:]

There is dramatic oversupply in the housing market. The homebuilders built too many homes last time around, and without 5/1 interest-only ARMs, there aren't enough people who can afford them. That's not to mention that in some cases they are competing against their own models that are now in foreclosure. How are the homebuilders going to prosper when they're selling into an oversupplied housing market?

Inflation will drive up rents which may drive people to purchase homes, but it will also drive up the cost of the inputs to build the house.

If you do expect housing to turn around, what are the top 3-5 markets that you think will drive this turn in homebuilder profitability?

Finally, your logic implies that there is a perfect relationship between house prices and homebuilder profits. "The 75% drop in XHB exceeds the decline in housing values and indicates that investors have moved from euphoria to apathy." This is a dangerous oversimplification of an incredibly complex relationship.

Apr 07 12:16 PM

[Angry Appra...:]

PREPARE TO LOSE MONEY....
go see what the REOs for the SAME models are selling for across the street.
ITS SHOCKING

Apr 07 02:28 PM

[Mad Hedge F...:]

Please spare me. I am more convinced than ever that real estate has another 25% to fall, and best case, it is dead money for another five to ten years. The New York Times produced some insightful data on inflation adjusted home prices for the last 120 years, which baselines at a $100,000 for a single family home in 1890. Few people realize how superheated the recent real estate bubble really got. Past bubbles very consistently peaked at $125,000 in 1896, 1979, and 1989. This last one peaked at $205,000 in 2005, almost double the previous record highs. And while we have dropped 34% since then, to $135,000, we haven’t even fallen to the past all time highs yet. If you look at historical lows, my call for a further 25% slump looks positively bullish. We saw lows consistently around $66,000 in 1920, 1932, and 1942. Postwar lows came in at $105,000 in 1976, 1983, and 1996. These figures suggest the best case low is down a further 28%, and the worst case is down another 51%. I think I’ll go find something else to trade.

Apr 07 05:44 PM

[Mad Hedge F...:]

The worst may be yet to come. The Manhattan residential market is now in free fall, after holding up better than every major market in the country for years. Rents have fallen up to 25% since the Lehman bankruptcy in September, dragging down condominium and co-op prices almost as fast. Hardest hit have been units priced in the $1-$2 million range that appealed to up and coming Wall Street traders. This class of newly unemployed former owners is now fleeing the Big Apple en masse. The stratospheric end of the market, the mega mansions and penthouses with those fabulous Central Park views and live-in nanny suites in the $30 million on up range, are still holding up. With industry job losses this year expected to exceed 100,000, expect this downtrend to continue.

Apr 07 05:45 PM

[ArkansasAngie:]

Hold on guys. I'm a home builder. Maybe Sean Hannon will buy me -- or at least, put out a buy recommendation for me.

Actually ... if we can mitigate uncertainty, there are indeed regions where new custom homes would start being built again.

Northwest Arkansas, where I live, has a steady stream of people moving in. Our climate is temperate, we don't have earthquakes or hurricanes and, believe it or not, hillbillies make good neighbors.

Apr 10 08:21 AM

[HardwoodFlo...:]

ArkansasAngie, Thank you for supporting what I believe. Housing isn't one big miopic blog. It's regional. The same thing with pricing. Prices are falling dramtically in some areas (70% in part of Florida) and in a few places they are rising (very few).

The problem with analysts is they look at numbers and say- "oversupply and shawdow inventory et al". Here's what they don't know is that small builders are building- in select places.

The problem with home values they get Case Schiller and say "prices are dropping" and they are but look at who is sellign and who is buying. Distressed sales and bottom feeders. It's crazy the lack of professionalism. And I'm just a hardwood flooring installer.

Big Builders won't see the recovery until it's too late- and so what who needs them.

Apr 10 05:07 PM