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Just when it appears the outlook for real estate could not possibly get worse, out comes a report showing that it is. Last week, we learned home prices are sinking in hot spots like Florida at the greatest rate in 25 years. On Monday, we learned pending home sales nationwide are down 13% from a year ago. On Tuesday, we learned that mortgage borrowers are defaulting at rates not seen in decades -- and a major luxury home builder reported earnings down 40% amid a stunning wave of construction cancellations.
It's enough to make you think that the sky is falling, the earth is melting, our biggest investment is rotting below our feet and we're all going to have to crawl into heavily discounted caves to live out shabby, depressed lives on food stamps.
Unless, of course, you are invested in the stocks of the companies that build homes, rather than in the homes themselves. In the perverse, circus-mirror world of Wall Street, the time to buy companies is when it seems business is terrible and will never improve. Like now.
Check it out: Just as home builders were reporting second-quarter results over the summer that were bad and getting worse, their stocks were bottoming and turning the corner. Shares of most of the major builders, such as KB Homes (KBH, news, msgs) and Centex (CTX, news, msgs), are up 20% to 30% since Aug. 1, still have a great head of steam and are bloody cheap. When Toll Bros. (TOL, news, msgs) reported a terrible third quarter Tuesday, the stock rose 3%.
Not too late to buy
In a July 26 column titled "Your Christmas-comes-early portfolio," I urged you to buy the builders on the premise that 17 straight interest-rate increases by the Federal Reserve had led investors to become overly pessimistic on their prospects. Higher rates had smashed their shares to levels previously seen only during recessions, which we were not experiencing.More from MSN Money
If you didn't bite then, I hope you'll give it a shot now. Because even though there is still a lot of potential for mischief in the sector over the next 12 months, you've got to buy these stocks when their outlook looks crummy. If you wait with everyone else for absolute certainty that the sky is not falling, you're going to end up buying them much higher.
Think of it this way: You could buy shares of home builders' stocks equal to 5% of the value of your home. Then if your house falls in value by 5% and your shares go up as much as I expect -- like 20% to 30% -- you'll be way ahead. No chance you'll end your days eating cat food in a trailer park.
Why consider the home builders now, when it looks like the industry is going the way of the automakers, with a one-way ticket to oblivion?
You must understand this: The housing industry is not the auto industry. There are no foreign competitors building cheaper, better homes and taking business away. U.S. builders have the market here to themselves, quality is high, mortgage rates are low and falling -- figure back to the 5% range in 2007 -- and demographic demand is implacable.
One of the most important drivers of the home-construction market is the U.S. birth rate. It peaked in the late 1940s with the baby-boom generation, then sagged for a couple of decades, but is now rising again primarily due to the fecundity of our immigrants. Economists figure 2 million new homes are required annually in this country both to replace teardowns and to fit all our new people -- including 1 million net legal immigrants per year. Yet slow-growth restrictions in key markets like California and Texas prevent home supply from swamping demand, except for modest exceptions.
Drawing down the surplus
One of those exceptions is happening right now. Skeptics point out that there are at least 1 million homes sitting vacant -- units built by overzealous construction companies nationwide over the past 12 months just as demand was lagging. True enough. But that surplus -- the main cause of the collapse in home builders' shares earlier this year -- will be worked off fairly soon. Figure the inventory overhang will cause housing starts to come in below average, at around 1.5 million in 2007. After that, builders' business will turn positive and trek back toward normal levels.If this scenario plays out as expected, count on home builders' earnings to decline by as much as 40% more next year. That's ugly to be sure, yet it's likely to be the trough. And seasoned investors are accustomed to looking past earnings troughs toward the next advance, which accounts for why many of the home-builder stocks are moving higher now and will gather momentum next year.
Video on MSN Money: Home prices
Will home prices keep dropping? Wachovia Securities expert Rich Gordon reveals his forecast for the home price index. Click here to play the video.
In short, I think fears of further home-price declines are still overblown and continue to provide cover for brave investors who will take risks now in the sector. Indeed, some government measures defy the conventional wisdom that prices are falling at all. An index maintained by the regulator of super-lender Fannie Mae (FNM, news, msgs) shows that home prices nationwide were up 0.8% in the third quarter.
In the next two years, we will discover whether the 2003-2005 era of sharply rising home values constituted a "blow-off" peak that will never be surmounted or the noisy transition to a higher range. Major institutional investors who are buying home builders' shares now are betting on the latter, figuring that after a relatively short adjustment period this year the industry will start growing again at a sustained and profitable pace.
The book-value bounce
If you can get past the craziness seen in some regions of the country, as well as media hype about a "bubble," you can see an industry that has a lot going for it. Analyst Steven Kim at Citigroup points to six key positives for the group:- Consolidation. The top 10 builders still only have a 15% share of the U.S. market, which means that the potential for mergers should keep a bid under the sector.
- No foreign competition. There are no low-cost rivals who can leverage cheap foreign labor to force price deflation. There's no Toyota (TM, news, msgs) of home building.
- Big-box retailers. Stores like Home Depot (HD, news, msgs) have driven down the cost of building materials and lowered the expense of ownership, improving home values.
- No pension liabilities. Builders subcontract out most of their labor, so they're not afflicted by the health and retirement benefit woes of other major industries.
- Cash business. For the most part, builders receive cash from the mortgage lender right away after a transaction is complete. They don't finance their customers.
- Clean financials. Restructuring and other special accounting charges are uncommon in this industry, streamlining their balance sheets.
In a market that is stretching toward new highs, it should actually be refreshing to focus on a group of companies whose stocks that are beaten down -- with many still 50% below their peaks -- and yet show a lot of promise. The bottom line, as I said over the summer, is that valuations of home builders tend to hold their ground at around one times book value. That is basically their liquidation value, since most of their assets are land or structures under construction. Kim notes that builders reached that valuation on seven occasions over the past two decades and on average have rallied 71% over the next year.
While some builders will trade below current book value as they write off land for which they may have paid too much, for the most part I don't think we will see anything close to the debacle witnessed in the late 1980s in the wake of the savings and loan scandals. Citigroup's analysis suggests that only 10% of builders' land investments were negotiated in 2005 or later, at the peak of the cycle, and thus potentially at risk of write-offs.
If few builders trade below book value by the time this period of readjustment is over, it's going to surprise a lot of bears and provide a great base for the stocks' recovery. In the following table, I've listed five home builders that are top-rated in the MSN StockScouter system for their potential to advance over the next six months with a minimum of volatility. The next 16 on the list are rated neutral; I've ranked them from low to high by book value.
KB Home, Avatar (AVTR, news, msgs) and Tarragon (TARR, news, msgs) were my top picks in July. I'll stick with those, and add D.R. Horton (DHI, news, msgs) and Brookfield Homes (BHS, news, msgs). Both Brookfield and Tarragon have been under heavy accumulation by insiders this year at around the current prices.
| StockScouter rating | Price/book ratio | P/E ratio | P/E: 5-year high | PE: 5-year low | Market cap | Recent price | |
|---|---|---|---|---|---|---|---|
9 | 3 | 4.7 | 19.7 | 3.3 | $958 M | $39.70 | |
9 | 1.5 | 7.2 | 95.6 | 9 | $576 M | $72.05 | |
8 | 0.8 | 5.9 | 11.1 | 4.5 | $524 M | $38.10 | |
7 | 1.6 | 4.9 | 22.1 | 4.1 | $4.6 B | $52.57 | |
7 | 1.3 | 6.8 | 13.6 | 4.3 | $8.2 B | $26.79 | |
4 | 0.6 | 5 | 14.8 | 2.2 | $560 M | $9.38 | |
5 | 0.7 | 6.6 | 13.4 | 3.1 | $787 M | $19.30 | |
5 | 0.9 | 4.4 | 18.1 | 3.3 | $255 M | $14.02 | |
5 | 0.9 | 4.7 | 13.6 | 3.3 | $1.6 B | $26.99 | |
6 | 1.1 | 18.5 | 815.3 | 5.9 | $321 M | $11.65 | |
5 | 1.2 | 5.6 | 19 | 3.5 | $2.2 B | $37.39 | |
3 | 1.2 | 6.2 | 13.6 | 3.7 | $2.5 B | $56.73 | |
5 | 1.3 | 4.2 | 18.5 | 4 | $1.2 B | $49.47 | |
3 | 1.3 | 7.1 | 13.3 | 4.9 | $8.5 B | $34.10 | |
5 | 1.3 | 7.8 | 13.8 | 4.9 | $6.6 B | $56.91 | |
4 | 1.4 | 6.2 | 14 | 4.9 | $8.2 B | $53.62 | |
5 | 1.5 | 6.5 | 22.6 | 4.8 | $4.9 B | $32.96 | |
6 | 1.6 | 5.7 | 13.9 | 4 | $2.3 B | $54.06 | |
4 | 3.3 | 6.4 | 15.9 | 4.8 | $3.5 B | $650.93 | |
6 | 4.5 | 16 | 26.3 | 9.2 | $584 M | $99.88 | |
5 | - | 5.1 | 13.5 | 4.4 | $1.7 B | $46.48 |
Fine print
To learn more about Brookfield Homes, click here. This page lists its insider accumulation. . . . This page lists insider accumulation at Tarragon.I like its urban-focused strategy. . . . The National Association of Realtors, a trade group, does a nice job of keeping track of trends in the business.
Meet Jon Markman at the Money Show
SuperModels columnist Jon Markman will appear along with many other top investment professionals at The World Money Show in Orlando, Fla., Feb. 7-10. Free registration for MSN Money users includes seminars with Markman as well as access to more than 320 workshops, panel discussions and general sessions, and to an exhibit hall featuring more than 350 top financial product and service providers. For complete details or to register for free admission, call 800-970-4355 (be sure to mention priority code #007419), or visit the Money Show Web site.Jon Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman did not own or control shares of companies mentioned in this column.
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