If you are looking for sure bets in the stock market, or even bets that promise decidedly more upside than downside, you are generally not living in the real world - and asking for trouble.
Still, there are some things that are pretty safe bets at times, and can be said to be plays that under almost all scenarios do have much more upside than downside.
Now, it seems pretty clear that one of the big drivers of the U.S. economy will have to be housing. Despite some recently strong statistics, this important sector remains far and away the most depressed, and therefore the one that has the most room for growth over the next several years. So a bet on housing is to a large extent informed not only by the depressed state of the industry, a growing population and pent up demand, but also by the Fed's single-minded focus on this sector. Keep in mind that the Federal Reserve has committed itself to buying tons of mortgage securities until the entire economy - not just the housing market - is on the mend. In other words, the Fed is saying housing has to improve enough to lift the rest of the economy out of the doldrums.
Whether the Fed fully succeeds and fosters a housing phoenix that in turn leads to an overall economic phoenix is another question. A housing phoenix seems to be an unusually good bet, though. And for investors looking to identify the biggest and most likely beneficiaries of a recovery in housing, we can mention a few with very high odds of success.
We have four candidates: First, Wells Fargo (WFC) is by a wide margin the nation's largest originator of mortgages. Indeed, it wouldn't be wrong to call Wells a near franchise in the mortgage market. The company's largest shareholder is Warren Buffett, and he is on record saying that Wells Fargo should aim for a trillion dollars in mortgages. Although it's already very large - even for banks - the company still has enormous room for growth. By virtually every measure Wells is ahead of the banking pack: Its Tier One Capital measure is in double digits, and although there have been a couple of bumps regarding credit quality over the past several years, Wells has been improving dramatically. The company is exceptionally well positioned to finance a nation-wide housing recovery. Earnings will grow close to 20% in 2012 and likely maintain at least a mid-teen rate for the next 3-5 years. Trading at less than 9 times 2013 earnings, by any reasonable metric the stock is deeply undervalued. It would be hard to find a better risk-reward combination to play the housing recovery.
Next we'll mention NVR Inc. (NVR), our favorite homebuilder. This company so totally stands out from its highly cyclical and risky sector that you could call it sui generis. The company has no debt and has remained profitable throughout the entire housing debacle. Indeed, since housing peaked in the 2006-07 period the company has purchased about 5% of its common stock thanks to strong positive free cash flow. The company rarely speculates on land purchases and has focused on specific geographical areas such as the Mid-Atlantic States, which is the reason why its profitability has remained so high.
Another factor is the company's mission to be the leading player in any market it enters. Thus, the housing debacle has opened other markets to this one-of-a-kind player as it has become very active in the Mid-West. These additional markets probably come close to doubling the company's potential. The stock price has topped its all-time high - it's the only home builder that can brag about that. Some might say with a mid-20 multiple the share price is expensive. We don't agree. Free cash flow yield is well over 5% based on expected 2013 results, and by mid-decade its free cash could easily exceed $100 a share. This company has continued to use excess cash to retire shares, which compounds earnings growth. During the first five years of the century its profits - without leverage or speculative land purchases - multiplied by ten-fold. NVR's profits in 2011 were about $23 a share and will be well over $50 in 2013. Spectacular profits of $150-$200 dollars a share are not out of the question by 2015-16.
Our other two picks are REITs that profit from the demand for wood and thus are clear and sure beneficiaries of more home building. Plum Creek Timber (PCL) has a massive resource base of over 6.5 million timberland acres in the United States. The company manufactures lumber and plywood, so it is clearly leveraged to housing construction. Cash flow peaked in 2006, roughly coincident with the peak in housing. Since then, this metric (which is most important for a REIT) has drifted lower, but not to the extent that the company has had to cut its dividend, which has remained at $1.68 a share. A jolt to the housing market will lift cash flow, and with a lag also lift the company's payout. By 2015 the payout could easily approach $2 a share.
Our second REIT pick, Rayonier (RYN), is more dynamic and diversified than Plum Creek, but also somewhat leveraged to the housing market. Rayonier's timber acreage is less than half that of Plum Creek and divided between the U.S. and New Zealand. The company serves a wide variety of industries in addition to housing. Most of those outside of housing are non-cyclical, such as cigarettes, food products, and pharmaceuticals. The company began trading as an independent company in 1994. Virtually all important metrics - cash flow, profits, and dividends - will hit highs in 2012 and will likely continue to grow at a robust pace for at least the next 3-5 years. One reason is that the company has proved very adroit in shifting its resources wherever the action is. Thus, with a housing recovery you can expect a lot more of the company's resources to find their way into the housing market. Dividends which have grown nearly four-fold over the past decade will likely continue to march ahead at a double digit rate. The combination of dividend and profit growth, plus a modest (for a REIT) valuation in terms of earnings, should make Rayonier an exceptional total return vehicle.
So there you have it: our four top picks for profiting from the key role the housing sector is poised to play as the economy recovers. Again, while we would never claim that any of our recommendations are "sure" things, you can be assured that each company in this high-caliber quartet offers you excellent chances for success.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.