Housing Sector Gains Will Continue

Includes: KBH, LEN, TOL
by: Regarded Solutions

Now might be a great time to take a look back at this article. I wrote it on January 18th. There were 81 comments, and not many favorable ones actually.

All I did was suggest buying 3 homebuilder stocks; Lennar (NYSE:LEN), Toll Brothers (NYSE:TOL), and KB Homes (NYSE:KBH).

I especially like the following comments:

"apberusdisvetComments (2495)

Yes mortgage aps are up; but actual approvals are a mere fraction of the total submitted. Then there's the shadow inventory, which by most objective analysis could be as high as 9 million homes. Also, median H/H income is falling and consumer debt is rising. While it is true that the government statistics proclaim both growth and recovery, only the mentally challenged believe that they are true, and not massaged and obfuscated, especially in an election year. The true unemployment, for example, is probably in excess of 20%. Eliminating a significant population from home ownership. What drives this point home, and what the recovery pumpers refuse to ackowledge, is that the Labor Participation Rate is the lowest in decades. The icing on the cake is that the next generation of home buyers is burdened with over $1 trillion in student debt.

Nationwide, housing will eventually recover. However the reality is that it may take one or two decades to do so. Certainly not in the few years that the author infers."

I think the comment was well meaning and actually quite good, even though I completely disagreed with it. The housing recovery might not have been firmly in place, but isn't that when we want to buy stocks?

Here is another "special" comment:

FLbuilder Comments (11)

"With some of these stocks up over 50% in the last 90 days I think you missed the call here. Also if you look at a chart of where homebuilder stocks trade compared to their book value you will see that most trade at a peak range of 2x book value. Well I can tell you today that many of the builders are closing in on 2x book value. And with the exception of Lennar most builders will continue to lose money (and decrease book value) for another year..

The problem, that pundits and yourself are not focusing on, is that for a homebuilder to make money they need to have a gross margin of about 20% on the houses they sell. How does that happen? Either by increasing the selling price of the house or decreasing the cost of the land or materials used to build the house. The builders are still facing headwinds of not being able to raise prices because of the years of foreclosures still to work through the pipeline and they are also starting to face inflation, where the costs of the commodities used in their materials are going up. So they have flattish revenue and increasing costs.

I would buy builders at 1x book value and sell them at anything above 1.5x book value.

If you buy the homebuilders today you will lose money"

I especially love the last sentence; "If you buy the homebuilders today you will lose money". I did buy the stocks actually, and while this article is not about my gains, it is pertinent to show how we have fared:

Stock 1/18/2012 9/14/2012 % Gain
LEN 22.03 36.47 65%
TOL 22.42 36.31 64%
KBH 9.01 13.65 52%

These increases have been wonderful. I continue to have a position in them as well. That being said, where do they go from here?

The Fed Has Given The Homebuilders An "All Clear"

With the Fed taking action the other day, (continuing their zero interest rate policy (ZIRP), buying mortgage backed securities to the tune of $40 billion per month, and continuing to buy longer term Treasuries) the sector will flourish even further in my opinion.

The financial sector will have more cheap money to borrow. Then they can lend mortgages with a decent spread, and with their tougher lending requirements, the banks will wind up with much better loans that have less risk.

The interest rates for mortgages are at all time lows already, but the Fed is saying that they will keep the rates down for as long as it takes for "things" to get better. What could be better than folks finding a job, buying a home, and affording the mortgage payments?

If the housing sector recovers, then the entire economy will recover at a quickening pace. So many construction jobs were lost when the housing bubble burst that it had a cascading affect on virtually every business you can name. It became a snowball that became an avalanche.

What would happen if we did the same thing but in reverse? To me, that would mean a healthier economy overall-- more folks back to work, and a housing market with much stronger underpinnings.

Take a look at this simple chart:

Interest rates are down obviously. The average new home price is 20-30% lower than it has been in 5 years, and new housing starts have been creeping up since 2011.

There seems to be a perfect storm here; lower prices, affordable mortgages, and more new homes being built. If the Fed can chop another .25 to .50% off of the 30 year mortgage rate, who knows how many homes could be built and sold.

The homebuilders can borrow cheap money and build affordable homes. The banks can make money on mortgage loans more easily in a stable interest rate environment.

Sounds like a recipe for growth all the way around.

Which Stocks Will Benefit?

I still believe in the variety of homebuilder stocks that I discussed before; Lennar, Toll Brothers, and KB Homes .

The basic reasons are quite simple; they each target different market segments.

  • Lennar is quite mainstream with an average new home price in the $200k--300k range. This reflects the average new home price around the nation and is the most popular.
  • Toll Brothers targets the upper end price range. Their new home prices lean towards the $250k and up segment. This allows TOL to maintain high margins as well as appeal to an upper end home buyer.
  • KB Homes is strongest in the lower price ranges. They target the $125k to 200k market segment and have a larger stable of condominiums. (They all build condominiums, but KBH seems to have an edge here)

All three of these builders are the best of breed in each of the pricing segments they target, and each of them already own vast amounts of land that is ready to build on.

They are well capitalized (KBH could be better), and have made additional land purchases while prices were extraordinarily low. Therefore, they have a competitive edge over spot builders and smaller builders with less land inventory.

With raw material prices at historic lows, each of these builders have the opportunity to increase earnings, as well as revenues, quite significantly. If I had to select 2 of them, I would go with LEN and TOL due to their superior balance sheets right now, but I would not count KBH out of the mix.

My own allocation, only with risk asset funds, is as follows:

  • LEN- 4%
  • TOL- 4%
  • KBH- 2%

My Opinion

Even though the homebuilding stocks I suggested back in January have surged ahead, I believe we could be on the verge of a new home boom.

Decide if these stocks are for you. They have done quite well for me thus far.

Disclosure: I am long LEN, TOL, KBH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.