Data on new home sales is released at 10am on Wednesday with consensus estimates for an annualized pace of 380,000 homes sold, an increase of 1.9% from August and more than 27% above last year's release. The inventory of unsold homes held steady last month at 4.5 months, well off of the 6.6 months of supply seen last year.
The median price of new homes jumped 17% to $256,900 in August over the prior year, more than a third higher than the median price reported for existing homes at $183,900. The price difference between new and used homes has averaged just 13% since 1966 and analysts are pointing to the remaining high level of foreclosures as the largest source of the price difference. Foreclosures still account for more than a fifth of all sales and are driving buyers to bargain prices for fixer-uppers rather than top-dollar new homes.
Despite the strong gains seen over the last year in new home sales, the difference in prices between new and existing sales is keeping a lid on the recovery. There is evidence that forces will soon help the historical difference in prices return to the long-run average.
The recovery could be about to kick into second gear
Sales of existing homes, reported last Friday, showed a dip of 1.7% from the prior month but still managed 11% growth year-over-year. The report marked the fifteenth month in a row of improving year-over-year sales volumes on an unadjusted basis. Prices for existing homes were also up 11.3% over the year prior. The most interesting part of the release was the comment by Lawrence Yun, Chief Economist for the National Association of Realtors, when addressing the weakness in month-on-month sales. Yun attributed much of the dip to inventory shortages as the supply of housing on the market dropped to a 5.9 month supply. Despite all the talk of a shadow inventory and overhang of foreclosures, demand is starting to outstrip supply.
With prices already rebounding strongly in some regions, the dynamic could build momentum and surprise the markets with even more upside. A jump in the prices of existing homes will close the gap with those of new homes and more buyers will opt for new purchases. This means more new construction and higher sales for many of the companies in the sector. If Wednesday's new home sales report shows the same weakness from supply, look for construction to pick up and housing-related stocks to take off.
Not all construction companies are created equal
Of course, no one can talk of the housing recovery without talking about the homebuilders. This group has seen an amazing run over the last year and I am generally skeptical that companies can continue to meet heightened expectations. Investors need to start thinking about a long-short framework where a weaker name is shorted against a long position. This helps to hedge some of the macro-level risk in the portfolio.
Candidates for the long-short might be D.R. Horton (DHI) and Lennar Corporation (LEN). Horton has 17.9% of its market cap in cash and should be able to weather the seasonal drop in sales better than Lennar and its 9.5% ratio of cash to market capitalization. The companies trade for about the same price-tangible book value, but Lennar is much more expensive on a trailing earnings basis at 14.2 times trailing earnings versus just 8.5 times at D.R. Horton. Horton narrowly wins on management effectiveness as well with an operating margin of 4.3% and a return on equity of 29.3% versus 3.5% and 19.4% at Lennar.
I like to look beyond the homebuilders for possibly neglected names in the theme.
Masco (MAS) is a world leader in the manufacturing of faucets, cabinets, coatings and other building products. North America accounted for the majority (76%) of 2011 sales with Europe contributing the rest. Continued slow growth in Europe could act as a headwind but a rebound in the U.S. will drive revenue. Earnings are out on October 29th with expectations for $0.12 per share against a gain of $0.08 in the same period last year. The shares trade for 105 times trailing earnings of $0.14 per share, but earnings are expected to triple over the next four quarters.
After remodeling my home last year, I spent enough money on materials that I should have gotten some sympathy stock in return. One of the companies that owes me big time is the USG Corporation (USG), which accounts for 25% of total U.S. gypsum (wallboard) sales in the United States. The company came out of Chapter 11 reorganization in 2006 after asbestos claims prompted a bankruptcy filing. Earnings have been negative since 2007 and the company is expected to post losses until the first quarter of next year. This is definitely a contrarian play with short interest 23.7% of the float. Still, revenue increased 8.5% in the third quarter over the same period last year and the company has 20% of its market cap in cash.
Sherwin-Williams (SHW) is the largest producer of paints in the United States with customers in South America, Europe and Asia as well. While the company will benefit from both the rebound in construction and a continued trend in home remodeling, its relative price and geographic diversification make it a less likely bet on the recovery in U.S. housing. Revenue never really took much of a hit from the housing bust, only falling 11% to $7.1 billion in 2009 from a high of $8.0 billion in 2007, which begs the question whether the shares should be surging 84% in the last year on hopes of a recovery.
The company is expected to report earnings on October 25th with the consensus for a gain of $2.20 per share, well above the $1.71 per share in the same quarter last year. The shares trade for 26.5 times trailing earnings, above the historical average of 14 times. Even if forward earnings over the next four quarters meet expectations for an increase of 26%, the shares will still trade for more than 21 times trailing earnings. A moderation in sentiment or any weakness in housing data could bring the price multiple down and mean a selloff in the shares.
A stronger sector might not mean stronger shares
Stocks related to the housing theme have had a great run over the last year. While I firmly believe that the recovery is upon us and that the supply-demand dynamic may mean more gains ahead, investors need to start being picky about their next moves. While I advocated a long-short strategy in the homebuilders, the method can really be used across the sector. Materials companies like Masco and USG or homebuilders like D.R. Horton could be good options against weaker names like Sherwin-Williams and Lennar.