Lowe’s-Home Depot Shares Lure Investors on House Recovery

Home Depot-Lowe’s Lead Market on Housing Market Recovery
A customer arrives to shop for home improvement supplies at a Home Depot Inc. store in New York. Photographer: Victor J. Blue/Bloomberg

Shares of Home Depot Inc. and Lowe’s Cos. -- the two largest U.S. home-improvement retailers -- are trading at the highest level in more than 10 years relative to the broader market amid signs the housing recovery is gaining momentum.

The Standard & Poor’s 500 Home Improvement Retail Index, comprised of these two companies, has risen about 14 percent since Aug. 20, compared with the S&P 500’s 2.1 percent gain. Prior to this recent rally, the home-improvement stocks closely tracked the market, lagging behind the broader index by 1.7 percent in the preceding four months.

Shares of these retailers are outperforming since Mooresville, North Carolina-based Lowe’s reported fiscal second-quarter earnings and sales that missed analysts’ estimates -- a sign that investors shrugged off these weak results, said Christian Bertelsen, who oversees more than $1.5 billion in assets as chief investment officer of Global Financial Private Capital in Sarasota, Florida.

Instead of focusing on one quarter’s earnings, investors are looking ahead to the big picture: housing’s shift from “a depressant to an enhancer” in the U.S. economic expansion, Bertelsen said.

Beating Estimates

New-home construction is the latest sign of improvement, as starts jumped 15 percent in September from the prior month to an 872,000 annual rate, based on data from the Commerce Department, beating the 770,000 median estimate of economists surveyed by Bloomberg News. Residential permits -- a proxy for future construction -- also exceeded the median forecast, rising to an 894,000 annual rate. Both were the highest since July 2008.

Housing appears to be “turning a corner” in what’s shaping up to be a multiyear recovery, said Gary Balter, a senior analyst with Credit Suisse Group AG in New York. The data have been “pretty supportive that things are getting better,” which has helped boost shares of Lowe’s and Atlanta-based Home Depot, said Balter, who maintains “outperform” recommendations on both.

Just how much an improving housing landscape benefited these companies’ fiscal third-quarter sales remains to be seen, as Home Depot is scheduled to release earnings on Nov. 15, followed by Lowe’s on Nov. 19.

‘Direct Play’

These stocks provide a “direct play” on the U.S. residential industry, Bertelsen said, adding that they provide more liquidity and cheaper valuations than homebuilders such as Lennar Corp. or D.R. Horton Inc. As a result, there’s a “funneling effect” that attracts large money managers, said Bertelsen, who has holdings in Lowe’s.

Lowe’s shares rallied after it withdrew an unsolicited proposal to buy Canadian home-improvement retailer Rona Inc. on Sept. 17. This provided some relief to investors who were disappointed by a potential acquisition that took many by surprise, Balter said.

The Federal Reserve’s program of purchasing $40 billion in mortgage debt a month until the labor market improves also is helping to embolden investors, said Jim Stellakis, founder and director of research at New York-based research company Technical Alpha Inc. The home-improvement index has experienced a “sustained follow-through” -- reaching a 10-year relative high today -- since the Fed announced its third round of quantitative easing on Sept. 13, he said.

Accelerating Renovations

Home renovation probably will accelerate into the first half of 2013, driven by gains in the housing market and record low interest rates, with annual spending projected to reach “double-digit” growth, according to Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts.

The average fixed rate on a 30-year mortgage has fallen to 3.46 percent on Oct. 17 from 3.57 percent on Sept. 12, according to Bankrate.com data.

“The seeds for what appears to be a very robust remodeling recovery have been planted,” the center said in a statement yesterday, citing its leading indicator of this activity.

Private-residential fixed investment, which includes spending on new-home construction and major replacements to existing houses, rose about 11 percent from a year earlier to an annualized $372.8 billion for the three months ended June 30. This was the strongest pace of yearly growth since 2005, according to data from the Bureau of Economic Analysis, which is scheduled to release advance third-quarter figures Oct. 26.

Regaining Confidence

This nominal measure of residential spending probably will increase to an annualized rate of $400 billion in the fourth quarter, according to estimates by Russell Price, senior economist at Ameriprise Financial Inc. in Detroit. Rising construction activity also could lead to more renovation projects as consumers regain confidence that their home values are increasing, he said.

“The somewhat faster pace of home sales and construction provided some encouraging signs of improvement,” the Fed’s Open Market Committee said in the minutes of its September meeting released Oct. 4.

Even so, momentum could slow as the supply of low-priced foreclosures begins to decrease, Price said. These residences have helped to sustain existing-home sales since the housing bubble in 2006, though that may start to “peter out,” he said. Sales of previously owned homes fell 1.7 percent in September to a 4.75 million annual rate, after the fastest pace in more than two years the prior month, the National Association of Realtors reported today.

Trading Up

When the market begins to normalize, the number of homebuyers looking to “trade up or move locations” will increase, accounting for a greater share of purchases, Price said. Still, that probably “will come back more slowly.”

While Lowe’s executives are “encouraged” by recent housing data, there still are “a lot of macro concerns,” including high unemployment, Chairman and Chief Executive Officer Robert Niblock said Sept. 5 at a conference hosted by Goldman Sachs Group Inc.

As a result, comparable-store sales in the last half of the year probably will be “slightly better” than in the second quarter, he said. Similarly, Home Depot is looking ahead to “kind of modest growth” in the final six months of 2012, aided by housing’s slow recovery, Chairman and Chief Executive Officer Frank Blake said the following day at the same conference.

“We’re in more of a workout mode,” Blake said. “It hasn’t yet really hit acceleration.”

That hasn’t stopped investors from betting on a comeback for the past year, as the home-improvement index has outperformed the S&P 500 by about 48 percent in the last 12 months. This optimism also is driven by investors who don’t want to risk missing a rally by remaining underweight these stocks for too long because they represent large components of portfolio benchmarks such as the S&P 500, Balter said.

With the industry on a firmer road to recovery, “these stocks are pretty well positioned to rally through the end of the year.”

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