A Ground-Floor Rally for Home Builder Stocks

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Home Construction

If the American home building industry were looking for a wry motto, it might be something like: "Been down so long it looks like up to me."

By many industry metrics, the picture is bleak, after five years of declines from the golden days of 2005. But it's safe to say the worst is over, and bloodied home builder stocks are crawling back to life.

The ISE Homebuilder Index is flat so far this year, but having tanked 75 percent from its 2007 peak, the pummeled barometer has a long way to go.

The industry is coming off its worst two years of housing starts since 1959 and its performance this year is year likely to be so-so, just like the stocks.

“There’s large excess supply that will take a few years to work through,” says Michael Widner, a homebuilding analyst at Stifel Nicolaus, who has been bearish on the sector for three years. “Things aren’t getting better rapidly, but they’re not getting worse either.”

Positive signs, even if of the modest kind, however, are evident throughout homebuilding industry.

Housing starts (single-and multi-family) in January hit an annual rate of 596,000, up 12.6 percent from December, but 1 percent below last January.

Widner expects new home starts to hit 700,000 this year, after 587,600 in 2010 and 554,000 in 2009.

The National Association of Home Builders is less optimistic at 673,000 units for 2011 with a big jump to 986,000 in 2012. Nevertheless, that's well below the 2-plus million peak rate of July 2005.

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And the rate of foreclosures is slowing.

During the homebuilding lull, companies rebuilt their finances, and are now sitting on over $1 billion in cash, says Eric Landry, director of industrial research at Morningstar.

Companies did that by selling inventory at cut-rate prices and slashing new production, as they tried to get in sync with demand.

Most say the sales slump has finally bottomed.

New home sales in 2010 totaled 320,00, a drop of 14.4 percent from 2009, the fifth consecutive decline. Sales could hit 360,000 this year. Even though sales fell far more than expected in January, inventory fell to a 7.9 month supply, the lowest in a while.

Sizable pent-up demand as well as new household creation—1.4 million people enter the homeowner market each year—should turn the tide.

Analysts are now bullish long-term, and say that patient, long-term investors could see home builder stocks double in three to five years. (All have underperformed versus the S&P 500 by quite a lot in the last 12 months.)

“Almost all the group will participate,” says Widner.

The trick, as always, is pegging the updraft. When the stocks start moving, they can rocket. That’s why investors typically invest in them six months to a year before homebuilding stock earnings start rising.

They're also one caveat; the stocks can be volatile.

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Be extra careful choosing stocks, though, add Widner and others. Some companies are weighed down by huge inventories of unsold in homes in states like California, Arizona and Florida.

Morningstar likes KB Home , which is down the most in the past 12 months. “It’s cheap and has a good presence in the low end,” says Landry. Lennar is another pick, because it owns lots of inexpensive land and has made good progress transforming its balance sheet, he says.

Josh Levin, a homebuilding analyst at Citigroup, likes Toll Brothers , which is also down year over year, because it's a major player in the high-end market where’s there’s little competition. And home builders don’t need to sweat their financing.

He also likes Beazer. It courts first-time buyers. But it has a weaker balance sheet and margins than other homebuilders.

Beazer trades at a big discount to other stocks, though, “with lots of leverage on the upside,” adds Levin.

Diversification is also a key, say analysts, which is why many recommend exchange traded funds. Their diversification makes them less exposed to special situations like regional variations.

James Paulsen, an economist and market strategist at Wells Capital Management, among other analysts, like ETFs that track the housing index such as iShares Dow Jones US Home Construction and SPDR S&P Homebuilders .

The former is up 12.11 percent over the past 6 months (through March 7), while the latter is up 16.7 percent during the period. Both are slightly lower thus far this year. ETFs also have lower fees than mutual funds.

For those more comfortable with mutual funds, however, be aware that there are no pure-play mutual funds for the sector. The two that hold the most residential construction stocks are Alpine Cyclical Advantage Property Y and Fidelity Select Construction & Housing .