By Stacy Trombino Despite talk of a housing bubble, demand for homebuilding has remained strong into the second quarter of 2005. Quarterly profits in this industry group came in ahead of Standard & Poor's expectations. And while U.S. housing-starts data for May, released June 16, were a little weaker than expected, the pace remains robust. "The data suggest that the housing market remains on solid ground," says David Wyss, Standard & Poor's chief economist.
Companies that build new homes have made some impressive gains. Year-to-date through June 17, the S&P 1500 Homebuilding Index rose 27%, vs. a 0.8% rise in the S&P 1500, following a spectacular 36% rise in 2004.
FUELING DEMAND. William Mack, the S&P equity analyst who follows homebuilders, maintains a positive investment outlook for the group. He says low mortgage rates have continued to encourage homebuying demand, and average price gains accelerated in the first quarter, resulting in margin growth across the industry.
While Mack believes the current homebuilding cycle is closer to the top than the bottom -- "It looks as though we are in the sixth or seventh inning" -- he thinks strong demand for homes continues. More importantly, low long-term interest rates are underpinning demand (see BW Online, 6/22/05, "Housing Bubble -- or Bunk?").
Even if there were a large move to a higher yield on the 10-year Treasury note, which he believes is unlikely in the near term, homebuilders would still trade at "comfortable" historical averages, in Mack's view.
BENEFICIAL RATES. Recent interest-rate friendly economic data should limit any short-term increase in mortgage rates, says Mack. He expects the benefits of these favorable borrowing rates will accrue to almost every homebuilder, pushing the group's average earnings multiple to about 9.5 times 2005 estimates by yearend.
Mack believes the typical homebuilder's fundamentals remain quite strong, and that the growth he forecasts for the S&P 1500 Homebuilders Index will be met with higher overall valuations.
Mack expects the group's fundamentals will continue to improve but at a more moderate rate after 2005, largely due to mortgage rates' likely upward trend from current levels. And what of earnings multiples in the longer term? Mack thinks they will "gently gravitate" upward.
SENSITIVE INVESTORS. The analyst anticipates most of the stock-price appreciation in this group will be driven by fundamentals rather than multiple expansion. Mack projects the average homebuilder's valuation will remain in the high single-digits until peak earnings are achieved -- not earlier than 2006.
As for profit growth, Mack sees an average earnings increase for the builders within his coverage universe of at least 30% in 2005 and 15% in 2006. However, because Mack thinks any widening in overall valuations will be kept relatively in check, as he believes investors are becoming increasingly sensitive to a potential cyclical turn, he says only some of the stocks in the group appear to be significantly undervalued.
Which homebuilders does S&P favor? Mack has a 5 STARS (strong buy) opinion on Lennar (LEN
; recent price, $62), Standard Pacific (SPF
; $87), M.D.C. Holdings (MDC
; $81), and Beazer Homes (BZH
WIDE MARGIN. Stocks ranked 5 STARS are expected to post a total return outperforming the total return of the S&P 500 stock index by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.
S&P carries a 4 STARS (buy) opinion on the shares of Hovnanian Enterprise (HOV
; $66) and D.R. Horton (DHI
; $37). Centex Corp. (CTX
; $69), Pulte Homes (PHM
; $83), Toll Brothers (TOL
; $101), and KB Homes (KBH
; $75) are each ranked 3 STARS (hold). Trombino is a reporter for S&P Global Editorial Operations