Battered Builders

Some Wall Street pros are piling back into homebuilding stocks, despite a bleak outlook. What on earth are they thinking?

by Mara Der Hovanesian

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Is it time to call the bottom in homebuilder stocks? The sector showed some signs of life after one of the Street's top-rated housing analysts, Citigroup's (C) Stephen Kim, released a new research report on Oct. 1 saying the worst was over. If the past three decades of downturns are any indication, Kim figures, a three-month decline in homebuilder stocks greater than 30% typical leads to an average return over the next three months of 31%. As a result, Kim upgraded all the biggies: Centex (CTX), D.R. Horton (DHI), Lennar (LEN), Pulte Homes (PHM), and Ryland Group (RYL) to a buy recommendation, up from hold.

But a week's rally, or even three months of gains, won't be enough to recoup the year-long drubbing of the sector, which has wiped out more than $30 billion in value for the top 20 stocks. Investors should take their cues from builders' chief executives. After a universally lousy showing in third-quarter results, no builder's CEO was willing to offer investors any upbeat messages about a recovery.

"These continue to be very difficult times for the home-building industry. In fact, there are times when the market speaks loudly and clearly and gives an indication that it is time to pull back, to retrench, and to wait for another day," said Stuart Miller, president and chief executive of Lennar—which had its worst quarterly results in its 53-year history—at the Sept. 25 earnings conference call. "These are those times."

No Turnaround in Sight

The lists of builders' woes are many. Buyers aren't motivated. Cutthroat competition is eating away at profits, and an unprecedented overhang of inventory, accumulated after years of rampant overbuilding and faulty forecasting looms large. It gets worse: Some $1.2 trillion of adjustable-rate mortgages will reset to higher monthly payments this year and next, most likely adding to the increase of troubled borrowers and foreclosures already clogging the market. Even without factoring in the record foreclosures and resets, the homebuilding industry already has some 10 months' worth of housing supply to work through.

"You've got to go back to the early 1980s when it was that bad—and it took four years to work that off," says Jeffrey Laverty, head of high-yield and distressed debt research at J. Giordano Securities in Stamford, Conn. "I don't agree that there's a turnaround in sight. It's ugly out there."

Those seeing an imminent turnaround in homebuilder stocks are relying on the predictive value of one key metric: book value. Right now, homebuilder stocks are trading at about 0.5% to book value, a level that has been reached only twice in three decades. They've traded down to that level because many on Wall Street figure residential builders still face aggressive writedowns of their inventory, which includes the model homes, the subdivisions in the middle stage of construction, raw land holdings, and so on. "If you have some stocks trading at 0.3 or 0.4 times the book value, you are assuming that they are going to have 60% to 70% writedowns," says Joshua Spencer, a research analyst at T. Rowe Price (TROW). "That might be right, but it might not be. I think that's a draconian estimate."