Springing for the long boom

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If it was a boxing match, the referee would have already called it off. Homebuilder stocks have been so battered in recent months that the spectacle is bordering on gruesome, with the sector still down about 50 per cent from its recent highs, in spite of a slight rebound.

But the markets have no mechanism for sympathy, so the beating continues. This is so much so that as such stocks enter deep-value territory – fetching prices that are near (or even below) book value, with price/earnings ratios often in the low single digits – some fund managers are tempted by what they see.

“A lot of value investors are looking at the group,” says William Mack, equity analyst at Standard & Poor’s, pointing out that investing legends such as Ron Muhlenkamp and Legg Mason’s Bill Miller have dabbled in Centex, one of the biggest builders in the US. “But housing is a very long-cycle business, with issues that take several quarters to work through, if not years. That’s why valuations have really been taking a hit.”

The massacre has been due to a witch’s brew of sluggish orders, rising inventory, sagging land values, cancelled contracts and higher interest rates. Among the glum news is a forecast by the National Association of Home Builders of a 12 per cent drop in new-home sales for this year – and six months’ worth of inventory of new homes is sitting on the market. Speculative buyers and second-home aficionados, who helped fuel the long housing boom, are in retreat.

No wonder the builders’ confidence index has slid for seven consecutive months, plumbing depths not seen since early 1991. Mr Mack says that when a usually rock-solid performer such as DR Horton slashes its outlook with only a few months left in the year, you know the sector is in dark days.

The hope for homebuilders is that much of the savaging could be over. With half their value already lopped, and some builders trading well below book value – a traditional buy signal for bargain-sniffers – there could be opportunities; especially now the Federal Reserve has paused its consecutive interest rate rises. If it holds, that would bode well for the housing market.

So which homebuilders might be a buy for an investor with a longer-term outlook and a weakness for the discount bin? “Almost our entire list of homebuilders is rated four- or five-star, which indicates an attractive buy,” says Arthur Oduma, senior analyst for Morningstar, the research firm. While hedge-fund money is making the group highly volatile, Mr Oduma says three different metrics of price/earnings, price-to-book and discounted cash flow are making builders look undervalued. Standouts include Toll Brothers, DR Horton, Lennar and Pulte Homes.

The discount is particularly striking when viewed against historical norms. In a research report, Morgan Stanley analysts Kristin O’Connor and Robert Stevenson say that some big names are looking downright cheap compared with traditional levels. Technical Olympic, Standard Pacific and WCI Communities look like bargains on an earnings basis, while the price-to-book ratios of DR Horton, Toll Brothers and Hovnanian are historically low.

Stephen Kim, Citigroup analyst, says the conventional wisdom – that homebuilders are “dead money” for another year or two – is more sour investor sentiment not supported by the underlying fundamentals. He forecasts a rebound in this year’s fourth quarter, with “impressive” gains once inventories drop, cancellations slow and the low price-to-book ratios become too juicy to resist.

But investors should be cautious. Book value could turn out to be something of a mirage if companies are stuck with land that is not worth the cash they paid. A series of writedowns, as occurred during past housing slumps, could leave your buying rationale in tatters.

And a low p/e does not automatically indicate a steal. Mr Mack suggests prudent investors wait for sector prices to drop another 15-20 per cent. One example is the risk of owning land that is not selling, which will represent a steady drain on homebuilders’ coffers. “Having too much inventory is the greatest risk these companies take,” Mr Mack says. “Even if land values rise another 20 per cent over seven or eight years, you might still be losing money if you can’t get rid of that real estate, because it costs money to hold that land.” Perhaps the most bedevilling factor for homebuilders is the lack of clarity about the general economy. The prospect of rising inflation and more interest rate rises, mixed with slowing job numbers, could tip the economy into a more serious slowdown. And that could lead to additional stock-price carnage for homebuilders if consumers go into a spending lockdown.

This lack of visibility has many investors waiting to be tempted by homebuilders’ rock-bottom valuations but unsure how supply and demand will shake out. Mr Mack expects the picture to be clearer by spring. But for homebuilders, spring won’t come soon enough.

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