Looking to Buy Homebuilders?

Do you think that homebuilders are a buy? Or are you getting less bearish on the group but not yet bullish? Well, that describes my feelings today. I think the group as a whole may have bottomed. Unfortunately I also believe there are going to be some bankruptcies as well. I am not sure that Standard Pacific (SPF) or Beazer (BZH) or Hovnanian (HOV) will survive intact. As a group, though, the worst may be over.

May I suggest a play that may make sense for this scenario? Let’s look at the SPDR S&P Homebuilders ETF (XHB). This index has an interesting composition. Not only does it contain the companies you might suspect, such as Pulte Homes (PHM), DR Horton (DHI) and Ryland (RYL), among the other 19 companies represented are two touted value stocks - Home Depot (HD) and Lowe’s Companies (LOW). Also included are Mohawk Industries (MHK) and Sherwin-Williams (SHW). The 22 (21 if WCI Communities (WCI) is dropped) stocks are currently weighted roughly equally at between 4 and 6% .

With XHB currently trading round 19.50, Morningstar shows this portfolio yielding around 1.7% , trading at a PE of 6 and 2.4 times cash flow. Sales are generally declining and earnings for many of the components are nonexistent. But if you believe, as I do, that the housing market will stabilize over the next two years, then stocks will price that likelihood well ahead of the actual upturn. I also believe that Home Depot and Lowe’s will provide a cushion for the index with their 9.5% weighting in the event one of the builders files for bankruptcy.

Ok, so I may or may not have convinced you that the index is a buy at 19.50. How about at 8.40? I think I would buy it there. Better yet, I‘ll bet that it never trades below 10 over the next two years and I will collect roughly 18% over that period of time making that bet. I suggest selling the XHB January 10 puts expiring January 2010. I would sell them cash secured posting T-bills as the cash necessary to buy XHB in the event of assignment. Using the equity options worksheet on www.cboe.com (cash secured put strategy applet), we can see that total cash required is $8,400 (plus commissions). If the put is unassigned the return on the strategy is $1,600 on an $8,400 investment or 19% annualized returns of roughly 9.9%.

If XHB should go to 10 or lower your breakeven is $8.40 per share.

Disclosure: Coastal Management Group LLC manages hedge funds that have positions in any or all of the securities mentioned in the above article.