Homebuilders Take Another Knock

by: Ockham Research

To claim that homebuilders have had a tough year would be somewhat of an understatement. As evidence of this, released Monday was data on new home sales which was the weakest in 12 years. There were 41% less new homes sold this year than in the prior year. This lack of demand for new homes also pushed the median new home price down 10% for 2007. The credit crunch has definitely hit the housing market especially hard as some of the first signs of distress originated with the sub-prime mortgage mess.

At this time major homebuilder stocks (Centex (CTX-OLD), Lennar (NYSE:LEN), Ryland (NYSE:RYL), Beazer (NYSE:BZH), Toll Brothers (NYSE:TOL)) have lost anywhere from 50%-80% of their market value because of the carnage in housing. These stocks were inflated during the housing bubble that developed during the boom years from the late nineties until 2006. While, our value investing methodology has a very positive Ockham rating on these stocks, we are not eager to go long on these securities just yet. It is likely that most, if not all, major homebuilders will recover from this mess, but the housing recovery will take more time than a general stock market recovery. Homebuilders are clearly feeling a crunch and could be tempted to cut corners in order to cut their costs. If homebuilders cut costs too deeply and quality suffers then these companies will increase their risk of future litigation from displeased customers. While such worries are speculative in nature, it is a logical concern for investors to ponder before committing capital to this sector of the stock market.

Homebuilders built more homes than were needed during the housing boom, and now there is little that can be done to resolve the glut quickly. Until housing supply comes into line with demand, home prices will continue to drop and the home builder’s financial picture will be bleak. Ideally, these companies would have invested their profits wisely when the market was booming so that they would have a solid cushion to fall back on in lean times. However, it seems that many builders kept the “pedal to the metal” as the real estate market began to show signs of excess over the past couple of years. This would explain why, despite the fact that new home starts are at their lowest point since 1991, prices continue to fall.

It is important to note that Ockham currently has over 94% of our coverage universe rated positively. We regard this as more of a general market indicator than a reason to go long on all of these stocks. If you were to buy all of these stocks right now, in five years you would probably be pleased with the performance, but there are some stock sectors (e.g. homebuilders, bond insurers) that although attractively valued, are not yet suitable for investment until a clearer picture of their economic prospects going forward emerges. For an idea of one company loosely related to home building that we do like, see today’s company research report on Home Depot (NYSE:HD).