Saturday, February 4, 2023
HomeMarketThe Housing Boom Is Over. But Housing Stocks Could Still Be Winners.

The Housing Boom Is Over. But Housing Stocks Could Still Be Winners.

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Plunging orders. Widespread price discounting. Shrinking profits. These are just some of the factors weighing on home builders after surging mortgage rates burst the pandemic-era real estate boom.

Home-building stocks, however, are looking past the current gloom. Though many of them are down 30% or more this year, they’ve gained an average of 20% off the June lows—and even the latest downbeat housing data hasn’t knocked them down.

More gains may be ahead, particularly if a much-anticipated pivot by the Federal Reserve to a more accommodative monetary policy materializes in early 2023. That prospect looks likelier after Chairman Jerome Powell suggested this past week that the Fed will be more restrained with rate hikes.

“If the Fed succeeds and slows the economy and inflation, a leadership group coming out of all this will be home builders,” says Bill Smead, co-manager of the Smead Value fund, which holds positions in builders
D.R. Horton
(ticker: DHI),
Lennar
(LEN), and
NVR
(NVR).

Even now, there are positives for home builders. Valuations are low. The group trades at an average of eight times next year’s projected earnings and many are below book value. Profits are projected to fall over 25% in 2023, but the industry is expected to still operate solidly in the black. Costs are coming down with prices for lumber, the single biggest home-building expense, off 60% during the past year.

And despite the pandemic hangover, long-term fundamentals look good given a housing shortage and demand from millennials. As Smead says, “Millennials have gone from living in apartments, taking exotic vacations, and drinking craft beers to getting married, having kids, buying homes, and spending on the necessities.”

Smead sees home builders as just the kind of companies
Berkshire Hathaway
(BRK.A) CEO Warren Buffett would like to own. “If Horton or [Lennar Chairman] Stuart Miller called Buffett, they could get a deal done in a few hours,” he says. Berkshire has exposure to housing through its Clayton Homes business and companies making paint and flooring.

Company / Ticker Recent Price YTD Change Market Value (bil) 2022E EPS 2023E EPS 2023E P/E Dividend Yield Price / Book Ratio
Large-Cap Builders
D.R. Horton / DHI* $86.70 -20.1% $29.9 $16.51 $9.78 8.9 1.2% 1.5
Lennar / LEN** 88.16 -24.1 25.1 16.98 11.51 7.7 1.7 1.1
PulteGroup / PHM 45.15 -21.0 10.3 10.20 7.27 6.2 1.5 1.3
Toll Brothers / TOL*** 48.35 -33.2 5.5 9.31 8.49 5.7 1.7 1.0
Small-Cap Builders
Century Communities / CCS $51.88 -36.6% $1.6 $15.94 $8.06 6.4 1.6% 0.8
Meritage Homes / MTH 87.05 -28.7 3.2 26.63 13.73 6.3 None 0.9
Building Products
Fortune Brands Home & Security / FBHS $65.56 -38.7% $8.4 $6.25 $5.73 11.4 1.7% N/A
Masco / MAS 51.76 -26.3 11.7 3.75 3.68 14.1 2.2 N/A
Whirlpool / WHR 149.02 -36.5 8.1 19.11 16.66 8.9 4.8 N/A

E=estimate; N/A=not applicable; *Fiscal year ends Sept.; 2022 EPS is actual; **Fiscal year ends Nov.; ***Fiscal year ends Oct.

Sources: Bloomberg; company reports

However, there remain many negatives, some bigger than others. Housing affordability measures have plunged for first-time buyers and even wealthier move-up purchasers. New orders are off sharply, with
Toll Brothers
(TOL) reporting a 60% drop in the most recent quarter. Inventories have risen. “Industry contacts tell us that trying to drive sales is like pushing on a string,” writes Stephen Kim, Evercore ISI’s lead home-building analyst.

Echoes of the housing bust still linger. One big investor fear is that builders will have to take big impairments of land and inventories in the wake of a plunge in demand. That’s what happened after the housing bubble of 2005-06. But the situation looks different now, according to Kim.

Land holdings appear conservatively valued due to a significant amount of property purchased cheaply before the pandemic. Balance sheets have rarely been stronger, with industry leader Horton carrying virtually no net debt on its core home-building business. Builders also use land options to hold less acreage on balance sheets, reducing financial risk. And profit margins have been elevated, giving builders room to cut prices. “We reiterate our view that impairments across the group will be minimal,” Evercore’s Kim writes.

That doesn’t mean home prices won’t fall—they’re off nearly 4% from their June peak based on the Case-Shiller U.S. National Home Price index, and could be headed for 10%-plus declines. But if prices stabilize after a 10% drop, the comparison to the financial crisis will disappear, Kim says.

The wild card is the Fed. J.P. Morgan analyst Michael Rehaut recently turned more bullish on the sector, writing that if the Fed tightening cycle ends in the first half of 2023, it could be a “significant positive catalyst for the stocks.” He noted that the group has historically outperformed the market after the end of Fed tightening cycles.

Much of the bad news—and little of the potential good—looks priced into housing stocks, and waiting for fundamentals to improve might mean waiting too long. After all, investors look forward. Housing stocks fell earlier this year ahead of housing-market weakness, and they might now be anticipating better times by late 2023.

Investors who want to take the plunge have plenty of choices, starting with D.R. Horton. Horton, the biggest U.S. home builder, delivered over 80,000 homes in its latest fiscal year. With some of the industry’s highest margins and returns, its shares, at around $87 after falling 20% in 2022, trade for 1.5 times book value, one of the higher ratios in the group. Brian Bernard, a Morningstar analyst, isn’t put off by the valuation. He favors the company, noting its strength in entry-level homes, including its Express segment, which sells houses for $300,000 or less in many markets.

Still, there’s a risk that even those homes prove too expensive for typical buyers. That could make Toll Brothers, which operates at the opposite end of the market, a better bet. Toll sells homes with an average price of about $1 million, against some $400,000 for many of its peers; some 20% of Toll buyers pay cash. “If you’re concerned about affordability, Toll buyers are less sensitive to interest rates and often are exiting homes with a lot of equity,” Bernard says. Toll shares, at around $48 after falling 33% this year, trade at book value, and for six times projected 2023 earnings, below its five-year average of eight times.

Lennar, the No. 2. builder behind Horton, could prove attractive, as well. It plans to spin out noncore businesses, including a multifamily and single-family rental business, to shareholders. And while its stock at $88 trades for 1.1 times book value and eight times projected 2023 earnings, investors can scoop up the company’s supervoting Class B shares (LEN.B) that trade at $73, a 17% discount to the more-liquid A shares.

For investors who still find home builders too risky, makers of appliances and building products such as plumbing fixtures are more insulated from the weak housing market because much of their sales stem from repair and remodeling demand, or R&R, in industry parlance.

Shares of
Whirlpool
(WHR), the top U.S. appliance maker, have been hit as sales and margins have come under pressure. The company cut its 2022 earnings guidance to $19 a share from a range of $22 to $24 when it reported third-quarter earnings in October. That came after a 10% drop in currency-adjusted sales in the period. Whirlpool’s results might not improve until the second quarter of 2023, but it should benefit from cheaper raw materials, including steel, in the months ahead. Meanwhile, the stock, at around $149, isn’t expensive at nine times 2023 earnings, and yields nearly 5%.

“The dividend is rock solid,” says David MacGregor, an analyst at Longbow Research, noting that free cash flow is about three times the annual payout.

Morningstar’s Bernard favors
Masco
(MAS) and
Fortune Brands Home & Security
(FBHS), whose building-product markets are growing 4% to 5% a year. Masco gets most of its revenue from plumbing fixtures and Behr paint, while Fortune Brands sells plumbing fixtures, doors, locks, and security equipment. Fortune Brands also plans to spin off its kitchen cabinet business to shareholders in December into a new company called MasterBrand.

“Both stocks are very cheap,” Bernard says. Masco, at $52, trades for 14 times projected 2023 earnings, while Fortune Brands at $65 fetches just 11.4 times below its five-year average of 15. Both yield about 2%.

For investors who want a little bit of everything, the
iShares U.S. Home Construction
exchange-traded fund (ITB) has nearly half its assets in the major home builders, plus stakes in suppliers like Masco, Fortune Brands,
Sherwin-Williams
(SHW),
Home Depot
(HD), and
Trex
(TREX).

Housing may be down, but housing stocks, however defined, look far from out.

Write to Andrew Bary at andrew.bary@barrons.com

Credit: marketwatch.com

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