By Amy Tsao Betting on a decline in the homebuilding sector's red-hot stocks has become a popular investing strategy of late. Too bad for the short-sellers, though, because they haven't had much to crow about. Thanks to record low interest rates, the homebuilding boom has continued -- and housing stocks continue to shoot through the rafters, despite the lackluster economy. The Standard & Poor's homebuilding index is at an all-time high, up about 45% since January, while the broad S&P 500-stock index is up 10% over the same period.
Can this go on? Yes and no. Homebuilding stocks were a clear buy after being beaten down during the uncertain months prior to the Iraq war (see BW Online, 3/03/03, "Homebuilder Stocks: Nice Fixer-Uppers?"). But given the year-long runup, the high percentage of short-sellers, and nagging concerns that the boom can't last, investors will need to be more selective. Still, those with a high tolerance for risk can find some good buys.
One way to play the sector is through companies whose geographic presence and pricing gives them above-average growth prospects. James Wilson, an analyst at San Francisco-based JMP Securities, figures homebuilders that focus on the midprice market and growing regions like the Southwest and Florida are best-positioned for the long-term. Companies he rates as strong buys are D.R. Horton (DHI), an Arlington (Tex.) builder that was trading around $30 as of June 20, and Miami-based Lennar (LEN), now about $74. (Wilson personally owns shares in D.R. Horton.)
BIG GAINERS? Wilson figures D.R. Horton's shares could climb to around $36 in the near term, a 20% increase. In its most recent quarter ended Mar. 31, Horton reported a 44% jump in net income and a 19% increase in revenues. He expects earnings per share for the fiscal year, which ends in September, to rise to $3.60, up 25% from a year ago. Over the longer term, the outfit's strong position in the Southwest's fast-growing markets will give it an edge, he figures.
Lennar may have the added attraction of being a consolidation play. It has been on an acquisition binge, with 11 buyouts in the last year-and-a-half. After it reported strong results for the quarter ended May 31, Wilson increased his 52-week target price on Lennar to $93, from $85.
Cary Nordan, an analyst at BB&T Asset Management, owns NVR (NVR), a builder in McLean, Va., that operates primarily in the mid-Atlantic. She also owns Atlanta-based Beazer Homes (BZH), which caters to the entry-level homebuyers, and Hovnanian Enterprises (HOV) in Red Bank, NJ. "These companies won't have problems meeting next year's numbers," Nordan predicts. Though he expects some volatility over the next 12 months, he sees gains of as much as 20% to 25% in that time.
Beazer, which trades at around $90, might have the most short-term upside, Nordan believes. He views it as an attractive acquisition target that could command a premium if it's taken over.
"CRESTING." Hovnanian, whose stock was trading around $63 as of June 20, also could see strong gains, Nordan thinks. His reasoning: In late May, it said it would beat previous EPS guidance by at least 23% in fiscal 2003. Fiscal 2004 will likely be another stellar year, with expectations of an EPS rise of as much as 15%, to $7.50, thanks to low interest rates on mortgages, acquisitions of rivals, and rising home prices.
Then there's NVR, whose stock was trading near a hefty $413 as of June 20. But it has good prospects because its Northern Virginia base is benefiting from increased government spending in the capital region.
Of course, none of these stocks is a sure thing. Some analysts believe the nearly ideal conditions driving the housing market -- a combination of low interest rates, strong demand, and a comparatively weak stock market -- will start to fade if a recovery gains steam. The housing boom overall "is cresting," says Sherry Cooper, chief economist at Montreal-based bank BMO Nesbitt Burns.
FREDDIE FALLOUT. Most important, interest rates probably can't go much lower. The typical rate on a 30-year-fixed mortgage is now just 5.21%, the lowest since 1971, when such data began to be tracked. Many analysts worry that rates may start ticking up as early as 2004, when the Bush Administration's $350 billion stimulus package finally starts to revive the economy. "It's hard to imagine that a year from now rates won't be higher," Cooper says.
Then there's the waning demand for new homes in some areas. Home-ownership levels are already at record highs, and many believe the 2-to-1 ratio of owners to renters can't get much higher. Meanwhile, with the unemployment rate still rising, the pool of qualified new buyers is likely diminishing. Says Cooper: "It's hard to imagine there's a lot of pent-up demand left."
Finally, there's the potential fallout from accounting concerns at mortgage megafinancier Freddie Mac (FRE). So far, the reasons for the management shakeup that included the firing of Freddie's president and the resignations of its CEO and CFO aren't clear, but "as one of the major financers in the country, anything that would put that at risk would be a very strong negative," Cooper says. A disruption at the country's No. 2 mortgage company could have a chilling effect on mortgage lenders generally.
The bottom line: If the housing market cools and the equity rebound can keep its footing, investors will probably start looking around for new growth sectors. But even if homebuilders lose their luster, some could still outperform -- at least for awhile. "A premium is warranted on top of [homebuilders'] forward-looking prospects," argues Chris Jarvis, associate director of research at financial-advisory company Advest in Hartford, Conn. In select cases, what has gone up could keep rising -- even if the housing boom can't go on indefinitely. Tsao covers the markets for BusinessWeek Online in New York