Contrarian Value in Housing

Jelly Roll Capital Equity Research

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Housing Stocks: Seeing a Bottom?

As I’m always on the lookout for contrarian plays that show a divergence between price and value, homebuilders are a natural area to examine. In talking about Builders FirstSource (BLDR) last week, I ended with comments that the overall pessimism being shown in relation to housing starts might be an indication that housing (at least the stocks) has bottomed. Although there are various measures - both fundamental and technical - one can use to try to call a bottom, one of my preferred ways is to simply look for a beaten down stock or sector that doesn’t move down on the release of more bad news. Last Sunday, my analysis led me to conclude that the market was underpricing BLDR, whose revenues are largely tied to the housing cycle. So, in addition to BLDR, I looked for ways to add exposure to what looked to be an underpriced sector.
The housing market is a classic case of a boom/bust sequence. The “boom” period typically occurs over a period of several years and runs to the point where the uptrend accelerates at an unsustainable rate. Perhaps it is no coincidence that shift to an unsustainable trend normally occurs when individual investors start to jump into the market, but I digress…
The responsibility for the downturn in housing is not a lack of vigilance on the part of homebuilders, but rather speculation in the general real estate market that pushed up the prices of all homes; I knew the end of the party was near when a neighbor decided it was a good time to flip a house. A loosening of credit also helped, but the primary cause of the bust was the unjustifiable run-up in home prices that made building more homes profitable on paper. Now that credit is back under control - and even in danger of being regulated a bit too tightly - the housing market can make a return to alignment with fundamental supply and demand. The generally accepted number of new houses need annually due to population growth, destruction, replacement and the like is about 1.7 million annually.

The red line shows the bound where supply of new homes is about equal to equilibrium demand, and the area highlighted in red shows the recent overproduction of houses. Yes, there is some excess to be worked off, but one year of housing starts in the present area of 1.5 million should be sufficient to get inventory levels back in balance with demand. All the publicity about housing woes and declining prices have put buyers in charge, and there is money on the sidelines waiting to purchase housing at attractive prices. For some reason, the markets seem to be expecting a prolonged period of lower starts and little pricing power, when in reality those negatives should subside within 12 months or so. Because of all the negativity surrounding housing, it seems like many market participants are ignoring the anatomy of a typical boom/bust sequence: a prolonged, multiyear run up to unsustainable territories that is then corrected swiftly. As the plummeting rate of housing starts shows, we are actually well along the path of correction; my best estimate is that this will be a twelve month problem, and we are four months into it. It may be a sign of the fast-money times that any industry going through a natural downturn and facing a year or two of struggles is discarded, but that description seems to fit many homebuilders.

For favorites, the best housing play actually appears on the list of top stocks in April, and that is NVR. NVR was actually a very successful play for me this week, as it managed to rally from $700 to $800 on a better-than-expected earnings report and what looks to be a short squeeze, and anticipating both of those were factors in selecting this stock. Right now, NVR looks to be about fairly priced, which I can’t say for several other homebuilders. While investors looking for general exposure to the sector can buy XHB, the ETF, that includes good and bad - and there are certainly some bad housing stocks one can be in right now (Technical Olympic - TOA - has been a whipping boy), my interest is in highlighting the good plays. The solid housing stocks include NVR, Toll Brothers (TOL), KB Home (KBH), D.R. Horton (DHI), and Centex (CTX). Of particular note, DHI missed greatly lowered estimates by 40% and took a large writedown, and the stock still moved up, as did Pulte (PHM) under similar conditions. I see the market action as very encouraging, because it seems to imply that everyone who is already negative on housing has taken their position, so that only strong holders are left.

Buying housing stocks right now is not for headline watchers or the volatility-adverse. The numbers coming out will look ugly compared to the year ago period, and the companies will be taking hundreds of millions in writedowns. The expectations for these companies are so low, however, that homebuilders are the ultimate contrarian play. I feel that those taking a short-term outlook on housing will be kicking themselves for missing the opportunity to get in when prices were dirt cheap like they are right now.