Only Halfway Home?

The homebuilding-stock rally may have a ways to go

Building permits and housing starts have been sliding since April. And new home sales are expected to be off 4% for the year. Not the ideal time to jump into homebuilder stocks, right?

Think again. In fact, now may be a very good time to snap up homebuilding shares. Savvy investors tend to take a contrarian approach to the notoriously cyclical housing group. They buy when the market cools a bit and robust earnings growth slows, taking those trends as signs the sector is stabilizing. "No one wants to own a builder when things can't get any better," says analyst Stephen Kim of Salomon Smith Barney. "Homebuilding stocks should begin to respond favorably to evidence of a minor slowdown in fundamentals." And we're seeing that now.

Indeed, for much of the past two years, homebuilders' shares slumped as investors ignored strong earnings growth. Wall Street's obsession with technology and the Internet didn't help these Old Economy stocks, either. In March, they were so battered that the entire group traded at a mere five times estimated earnings.

Since that low point, the stocks have made a strong recovery. Mortgage rates peaked and started to come down, and so did the tech-heavy Nasdaq Composite. UBS Warburg's index of 18 homebuilding stocks is up some 70% since mid-March-- 33% year to date. That compares with declines of 1.7% for the Standard & Poor's 500-stock index and 8.4% for the Nasdaq (through Sept. 18). Valuations are coming from such depressed levels that the stocks are not even halfway through the rally, says UBS Warburg analyst John Stanley.

He may be right. Consider the last two rallies in homebuilders' stocks, in 1995 and 1997. Both times, housing starts were heading down and companies' earnings growth rates flattening. Yet in both years, homebuilders rallied over 50%, says Kim. In 1995, the price-earnings ratio rose to 11 from 6.5; in 1997, the p-e went to 13 from 8. Kim estimates that over the next 6 to 12 months, the average p-e for the group will expand to about 9 from the current average of 6 times next year's earnings. Prices are "still extraordinarily cheap, so [potential investors] haven't missed out on anything," says Kim.

Most analysts see large upside potential in builders such as Kaufman & Broad, D.R. Horton, and Centex. All three have been making acquisitions and gaining market share--a trend expected to continue (table). Los Angeles-based Kaufman also gets high marks because it is the largest U.S. homebuilder with a huge presence in California, the strongest housing market in the country. Warburg's Stanley expects Kaufman & Broad to earn $4.60 per share in 2001, up from $3.95 this year. His 12-month price target is $57, up from its current $26.

Those three are mass-market plays. Investors may also want to consider Toll Brothers, the only major player focused on the luxury market. Toll's higher-income buyers are more resistant to economic swings. Trading at 8 times 2001 estimates, Toll may see its EPS climb 12% from this year to $3.75 in 2001, Kim says. He figures the stock will rise to $40 from $31.

That's the kind of gain dot-com investors would have laughed at a year ago. But after the beating that many New Economy stocks have taken, a solid 30% sounds pretty darn good.

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