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I have been pretty skeptical of the recovery and rebound in housing. However after doing some research I have warmed up to the group that I haven't had any interest in since 2005. When the Federal Reserve in the fall of 2012 started buying $45 billion per month of mortgage backed securities and brought the 30-year mortgage rate down below 3.5% the residential real estate market changed dramatically. The national median home price had actually bottomed in February of 2012 and the Fed's actions had the effect of lighting a fire in the market with ultra-low interest rates not seen since the 1950s.

This happened for a number of very simple to understand reasons:

1. 3.5% mortgage rate increases the affordability and buying power of millions of buyers.

2. The reduced monthly mortgage payment made it more affordable to own than to rent and rising rents for many years exaggerated that gap to the widest in decades.

3. In Non- judicial foreclosure states the lender doesn't have to go through the backed up court system for years to foreclose and repossess houses. This took prices down more initially but it has cleared the market and created a scenario for a healthy recovery in prices.

4. Housing investors and speculators have returned at the individual level.

5. Institutional money has and continues to flow in. Institutional money has been buying, fixing up and converting to rentals. That is a function of the search for anything that yields above 6% and offers some inflation protection and future appreciation.

6. Foreign investors who were taking advantage of the weak U.S. dollar were buying especially in South Florida.

7. Like the current stock market the public is still very skeptical and is not widely participating.

8. Lending standards are still fairly strict and 25% of purchases are for cash.

9. While some cities have had 10-25% gains in price. The national median home price is still off about 25% from the former high. While a 25% gain sounds huge, if that market fell 50% like in Phoenix, it has to then double to reach the old high.

For example: A Phoenix 2006 home was purchased for a price of $425,000 falls 50% to $212,500. The same house now has gone up 25% from $212,500 to $265,625. So while the 25% increase sounds huge like half of the preceding drop in prices recovered, however that is deceptive. In fact the house would have to go up another 60% from its new recovered price of $262,500 price to reach its former high. Now you can argue this is being driven by an artificially stimulative easy monetary policy by the Federal Reserve and I would agree with you. It is important to understand that because the more you understand what is driving the fundamentals of a company the better you can be at timing your sell decision. More importantly you have a better understanding of what is driving the powerful fundamentals in the sector.

Now let's look at Meritage Homes (NYSE:MTH) and I will cover why I think it is the best stock to invest or trade in the homebuilding sector. Meritage has a $2.12 billion enterprise value versus $7-11 billion for the large-cap builders like Toll Brothers, Lennar and Pulte. This is a positive because it is much easier to have a large percentage increase in the stock price on a $2 billion company versus the others that are 3.5-5.5 the dollar amount. Meritage will have about $1.75 billion in revenue in 2013 while its total enterprise value including debt equals $2.1 billion so the business trades at only 1.20 times revenue. That is versus 1.25 for KB home, Pulte and 2X for Toll and Lennar. The best thing about Meritage is that it trades at less than one times revenue estimate of 2012, which is 2.25billion. That is cheap and makes it a very nice acquisition target of a larger builder that needs numerous lots of land that are ready to develop. Because the larger builders trade at much higher valuations, an acquisition of Meritage would be accretive to their balance sheet and financials. Meritage also has more solid earnings so it has a lower price-to-earnings ratio. It trades at only two times book value as opposed to up to three times book for some of the large-cap favorites in the sector.

The most important reason I like Meritage Homes in the homebuilding sector is that it has a large exposure to the Phoenix, Denver, Texas, and Florida markets. You would think those would be some of the worst markets to be in as they were hit the hardest in the downturn. Ironically though because Arizona and California foreclosures cleared the legal system much quicker, saw prices fall more extremely but the market has now cleared. That set the stage for a solid recovery and when cheap money was added and super low interest rates, prices have taken off. Florida is a state where foreclosures are hopelessly backlogged but prices are actually recovering there.

Ironically, the environment that saw so many people walk walk away from their houses or occupy them only for as long as possible, is mostly finished, so it has set up a wonderful situation for new homebuilders. The remaining homeowners can't sell at a profit and many wouldn't even get their equity back so they are sitting tight and won't sell. This has caused the number of months existing homes for sale are on the market to fall from over a year to just two months, which is absurdly low. A balanced market is considered six months; there were places that had as low as two months in the real estate boom so that says the market is really hot. So now the builders are in the catbird seat and can raise prices pretty much at will.

That leads to the next reason I like Meritage so much. In 2011 it significantly expanded its raw land lots, which in its business is essential. These lots started coming on in 2012 and should last until the end of 2014. So unlike other builders, it has the lots, the balance sheet and ability to power earnings higher. I think this will make the stock increasingly attractive compared with the other stocks in the group. Look at the number of developments it has in the best markets in America:

  • Phoenix 23
  • Tucson 11
  • Southern California 11
  • Northern California 6
  • Sacramento 3
  • Denver 14
  • Dallas/Ft. Worth 25
  • Austin 14
  • San Antonio 17
  • Houston 26
  • Raleigh 11
  • Charlotte 4
  • Tampa 6
  • Orlando 18

I think the stock by the end of 2013 could be $50 or 16% higher than today's price of $43.11. That would only equal a valuation of 1.5 times revenue if revenue grows to $1.65 billion like I estimate it will. The final reason I like Meritage is that most of its homes are up to 50% more energy efficient than competitors for no additional cost. That gives it a strategic selling advantage especially since its markets are all in places where utility costs are important when making a purchase decision. So Meritage has the financials, the assets, good management and location, location, location. That is why Meritage is in the sweet spot of the homebuilding and still offers value in the homebuilding sector right now.

Source: Meritage Homes Still Offers Value