Homebuilders: Climbing The Walls of Worry

by: SA Editors

Barry Webb, Senior Research Analyst at Legg Mason, comments on the situation with homebuilder stocks in a recent article. Excerpt:

The Homebuilders

Homebuilder stock prices were slammed in 1990 as everyone concluded that earnings were going to take a big hit. The same thing happened in 1982 and it also occurred more recently as housing weakness became more apparent and sub-prime worries spread.

From the peak on October 9, 1989, the S&P 500 Homebuilders Index fell 52.9% to its bottom on October 29,1990. On an average annual return basis the homebuilders fell -51.02% versus a -12.36% drop in the S&P500. Earnings did take a big hit, but that came in 1991 after stock values had fallen sharply.

Nevertheless, stock prices rebounded sharply beginning in the fourth quarter of 1990 ~ right in the middle of a recession ~ and by 1991 they had recovered most, if not all of their 1990 losses, although company earnings were less than half of 1990 levels in many cases. This recovery took place before the housing market recovered. In November 1991 it was noted in TIME that housing starts remained “dismayingly weak” despite drops in mortgage rates from 10% in 1990 to 8.75% in 1991.

More recently, stock prices fell sharply from peaks that occurred around the time of the peak in starts and permits. Following a rebound in late 2006, homebuilder stocks again fell sharply amid the sub-prime lending fallout and increasing concerns about full-blown recession.

From recent peaks in mid-2005 some homebuilder stocks have seen their prices decimated, falling by half or two-thirds in the last couple of years. From the peak on July 28, 2005, the homebuilders index fell 67.7% to its most recent bottom on September 25, 2007, under performing the S&P 500 dramatically. On an average annual return basis the homebuilders index lost 40.21% versus a gain of 11.71% in the S&P500.

The gain for the broader S&P500 differentiates this period from the previous one, which witnessed a decline in the overall index. This could be a sign that the market is not pricing recession presently, as it was seventeen years ago.

Whether or not and how much homebuilding stocks recover from present levels remains to be seen. However, what is worth consideration is that buying homebuilding stocks the last time that sentiment was so depressed proved to be a productive strategy. In 1990, homebuilder stocks generally bottomed around the end of the third quarter. Five years later from that October 1990 trough, the S&P 500 Homebuilders Index was up almost 175% in price terms and this includes the sell off that occurred as the market priced the mini-housing-recession in 1995-1996.

Comparatively, the S&P500 advanced in price by a cumulative 93% from October 29,1990 to October 31, 1995. On an average annual return basis the S&P 500 Homebuilders Index gained 24.41% versus a 17.38% gain in the S&P500 between October 1990 and October 1995.

Walls of Worry

In early 1990 it was widely reported that the excesses of the 1980s would make it very hard for the housing market to do well in the 1990s. This was the general sentiment about the economy as well. After the ‘go-go’ ‘80s it was said that Americans would have to live through the ‘slow-mo’ ‘90s. That sounds outlandish now that the roaring 1990’s are history, but captures the psychology of 1990.

Then, as now, there were concerns that Americans were way too far in debt and a day of reckoning was nigh. The American consumer was in trouble we were told then because they were spending more of their incomes on mortgages because they bought ‘more house’ in the 1980s than they could now handle. We hear the same now.

However, it was not all doom and gloom with respect to housing in pages of TIME and BusinessWeek back in 1990. One demographic argument stood out as offering reason and foresight amid the trepidation, although the benefit of hindsight is admittedly at work here. The argument at the time was that baby boomers were getting older and were therefore more likely to own a home than rent a home. The statistics then were while just 53% of Americans aged 30-34 years tended to own their homes, by the time they are 55-64 years old, 80% own their homes. This, it was correctly argued, would invigorate the housing market in the 1990s.

Among the several reasons that Legg Mason Capital Management (LMCM) has acquired large stakes in several homebuilders is that demographics continue to support the sector, in their opinion. Baby-boomers have grayed since 1990, but remain in their peak earnings years with many at the age when second-home purchases are more likely to occur. Meanwhile, their children ~ the echo boomers ~ are arriving at the age when people typically begin to buy their first home.

Additionally, according to Census data, immigrants eventually achieve homeownership rates higher than do native-born Americans, which is a supporting statistic for housing given the high level of immigration in recent years. Furthermore, worker mobility could be a positive trend for homebuilding and housing in some regions. Moreover, minority ownership rates have also been trending up.

Demographics are not the only reason that LMCM likes homebuilders. One thing that is likely to happen given time is further consolidation in the homebuilding industry. The top 10 homebuilders more than doubled their share of the market between 1989 and 2005, but still represented just 20% of the industry.

Some of the top builders today took advantage of the turmoil in 1990 to expand operations and strengthen their position in the industry. Perhaps more importantly, valuations are very compelling with many builders trading for a fraction of book value. Last April portfolio manager Bill Miller wrote: “Buying builders around book value or below has historically been a prescription for excess returns for anyone willing to look out a couple of years. But whenever they reach book value, investors don’t want them because they are looking out the next few months or so, and are fearful of what new bad news may occur.”

In April 2006, LMCM portfolio manager Sam Peters wrote that homebuilder valuations were “low enough to generate very attractive long-term equity returns under most scenarios.” While today’s noise surrounding homebuilders is as bad as ever, recoveries have always followed recession, at least so far, and best values are often found amid the ashes. The key here is a sufficient time horizon.

©2007 Legg Mason Investor Services, LLC