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A bubble? Not for housing stocks
Sure, interest rates are rising and homeownership is at high levels. But the growth prospects for home builders are better than you think.
By Robert Walberg
Boom or bubble? End of the beginning or beginning of the end? The debate over the fate of the housing sector, a recurring event over the past couple of years, is at a fever pitch yet again. Sparking the latest round is the recent rise in long-term interest rates, an earnings warning from The Ryland Group (RYL, news, msgs) and mixed housing data.
Considering that the sector was off 9.5% for the month through Tuesday, more and more investors are beginning to question the sustainability of its incredible run over the past five years. During that period, home-construction stocks have risen relentlessly and dramatically; the Dow Jones US Home Construction Index ($DJUSHB) is up 513%. And the builders have routinely defied predictions that a real estate bubble was about to burst. Don't count them out now.
So why are a growing number of investors so eager to turn their backs on the housing sector now?
The short answer is these investors can't believe that residential real estate is experiencing anything other than a bull-blown bubble, with big price increases and near-record or record sales and construction levels.
And yes, long-term rates have finally begun to creep up in response to the pressure being put on the short end by the Federal Reserve. The Fed's stated anxiety over the possibility of growing inflation has only added to the upward pressure on rates. But frankly, the recent rise in mortgage rates hasn't been significant enough to dampen the demand for housing.
A 30-year fixed mortgage can still be had for about 6.3%, near its multiyear lows and at levels consistent with strong demand in recent years. The general view on the Street is that mortgage rates need to climb about another full percentage point before they'll have material effect on demand.
Half full or half empty?
Admittedly, the stock market is a forward-looking entity, but only the most pessimistic of investors expects rates on 30-year fixed mortgages to jump to 7.3% or higher in the next six to nine months.
Of course, the rise in long-term interest rates isn't the only concern among investors -- it's just the most obvious. Equally problematic for the group is the level of homeownership in the United States hit a record 69.2% in the fourth quarter of 2004. The rate was consistently around 64% from 1968 until the mid-to-late 1990s, when a combination of a booming economy and low interest rates turned ever more American households into homeowners.
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Why is record ownership a problem? Homeownership rates in the United States would need to continue to set records for the sector to continue its tremendous earnings gains of the past five years. But much of the next stage of growth would need to come from middle- to lower-income buyers, because the percentage of ownership among the upper-income people is approaching 85%, leaving little room for growth.
Unfortunately, the rise in real estate values throughout much of the country, combined with the modest jump in rates, is apt to have a disproportionate influence on the buying power of those same mid- to lower-income groups. If that's indeed the case, then the pace of home sales is almost certain to slow.
More money into real estate
Rising rates and slowing sales sure doesn't sound very promising. But before you run out and unload the remaining home-building stocks that you own, it's important to understand two crucial dynamics at work within the group.- Real estate has significantly outperformed the stock market over the past five years. And that doesn't include the tax and living benefits provided by a home. With stocks struggling in the early going this year and rising rates threatening the bond market, money flows into real estate should continue, especially considering that home prices have posted double-digit gains throughout much of the country in recent years.
- The industry continues to experience modest consolidation. Though still pretty fragmented, the top 10 home-building companies have seen their market share nearly double over the past eight years to about 23%. But none has a market capitalization larger than $9.4 billion. Interestingly, two of the best years for market-share gains occurred when the industry was experiencing a general slowdown in sales.
In other words, even if sales slow down modestly because of higher rates, the bigger home builders can continue to post solid sales and earnings growth so long as they continue to win market share from smaller builders.
Average annual earnings per share gain of the group over the past five years has been an eye-opening 31.4%. Despite recent concerns, the Street expects the group to post an average earnings-per-share gain this year of 26.7%. It should be noted that the Street has also consistently underestimated the group's performance. But even if the consensus figures are dead-on this year, that's the kind of growth that usually wins support among investors.
| The earnings picture for big home builders | | Company | March 29 close | 200-day moving avg. | 5-year avg, annual EPS growth | 2005 projected EPS growth | Forward P/E ratio* | | The Ryland Group (RYL, news, msgs) | $61.21 | $50.54 | 43.3% | 18.0% | 11.8 | | Toll Brothers (TOL, news, msgs) | $76.20 | $56.32 | 24.9% | 59.0% | 9.5 | | Pulte Homes (PHM, news, msgs) | $72.23 | $60.03 | 30.0% | 18.0% | 8.1 | | Lennar (LEN, news, msgs) | $92.96 | $48.92 | 33.8% | 24.0% | 8.0 | | D.R. Horton (DHI, news, msgs) | $28.88 | $25.62 | 34.6% | 22.0% | 7.9 | | Beazer Homes (BZH, news, msgs) | $50.05 | $40.75 | 31.2% | 25.0% | 7.4 | | Standard Pacific (SPF, news, msgs) | $71.20 | $58.21 | 28.1% | 16.0% | 6.9 | | KB Home (KBH, news, msgs) | $115.21 | $88.26 | 27.0% | 37.0% | 7.6 | | Centex (CTX, news, msgs) | $57.11 | $52.44 | 29.7% | 22.0% | 8.0 |
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* Based on projected 2005 earnings.
Looking beyond this year, Wall Street is beginning to factor in a slowdown, with earnings growth seen slowing to an average of 13%. While that's a considerable drop-off, the growth rate is still almost twice the sector's average price-to-earnings multiple, which suggests that the group remains a compelling value even after its five-year run.
An end to easy money
There are plenty of signs that the days of easy money in the group are over. But owning the right housing stocks -- those in position to build market share through superior execution and/or acquisitions -- should still prove very rewarding over the next 12 to 18 months.
Recent declines, combined with abnormally wide divergences between current stock prices and their respective 200-day moving averages, suggest that there's no immediate rush to buy the current dip. Still, patient long-term investors will want to start building positions over the next few months in anticipation of a late-year recovery.
Which stocks are best positioned to reward investors over the long term? Two that stand to benefit from discounted valuations, strong financials, relatively high profit margins and potential market-share gains are Centex (CTX, news, msgs) and Pulte Homes (PHM, news, msgs).
While Ryland's multiples are a bit higher than the group's average, its return on equity of 30% is the best in the industry. Still, its market cap is modest -- less than a third of Pulte's -- and that makes Ryland an intriguing buyout candidate as the consolidation trend picks up steam late this year and into 2006.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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