Adviser Soapbox: Time To Buy Homebuilders?

Adviser Soapbox
Time To Buy Homebuilders?
George Putnam, The Turnaround Letter 04.25.07, 1:00 PM ET

Every day now, the news is filled with questions about the residential real estate market: How much further will home prices drop? How soon will they begin to rebound? Will the real estate downturn affect the rest of the economy? These are important questions, but we don't feel qualified to try to answer them. Instead, we'd like to tackle the related but narrower question: Is it time to begin buying homebuilding stocks?

Our best guess is that the answer is "No, it's too soon." To be sure, as contrarians we are tempted. All of the negative news whets our appetite. And many of the large homebuilding stocks are trading at about half of their 2005 peak.

However, we think we may be coming off a "bubble" in residential real estate, and it often takes a long time and a lot of suffering before a market recovers from a bubble. Remember the Internet and telecom bubbles of the late 1990's? Even now, nearly 10 years after the peak, neither group has fully recovered. Many of the stocks that soared during those bubbles are still trading at tiny fractions of their highs--if they haven't disappeared entirely.

Ultimately, any market depends on a rough equilibrium between supply and demand. In the housing market, there has been a huge increase in supply over the last few years. For example, inventories of new homes at some of the large, publicly traded builders have tripled or even quadrupled between 2000 and 2006. For a while, demand kept pace. Many people were buying second, third or fourth houses as investments. Moreover, low interest rates and the explosion in subprime mortgages brought many people into the market who previously couldn't afford to buy a home.

Unfortunately, that demand has proved unsustainable. In many markets, the number of investment properties that are for rent far exceed the number of potential tenants. As investors find that their rental income falls far short of the cost of owning the property, they are forced to sell into an already weak market.

Similarly, many lower-income borrowers who were enticed into buying houses by low mortgage rates now find that they cannot afford the monthly payments as interest rates have risen or low promotional rates have expired. Foreclosures are headed to record levels in some markets, further adding to the oversupply.

There is another characteristic that we have observed about markets in general that make us pessimistic about the housing market. Over the years, we have noticed in many different markets that both the good times and the bad times last longer than you expect. Just as the run-up in home prices lasted longer and went higher than many experts predicted, we expect the same to happen on the downside.

The homebuilders had a six-year run from 2000 to 2005. While we don't expect perfect symmetry on the way down, the 18 months of rough sailing that the builders have experienced since the peak is probably not enough to get things back into equilibrium. Also, while a 50% drop in stock price is nothing to sneeze at, it pales in contrast to the run-ups in the homebuilding stocks since 2000. Many of them rose 800% to 1,000% or more between 2000 and 2005.

Of course, we could be wrong about the housing market, and this could be a good time to jump into the homebuilding stocks. However, if you are inclined to do so, we recommend only considering the strongest players at this time. While the weaker players may have greater upside potential, they also have much higher risk. Some of them could be forced into bankruptcy (and their stocks wiped out) if we are correct that the housing downturn has considerably further to go. Six large homebuilders that we consider to be likely survivors are discussed below.

D.R. Horton is the largest home builder in the U.S. With operations spanning 84 markets in 27 states, the company is well diversified. It also has considerable real estate holdings that have thus far held up in value rather well. Horton appears to have a very realistic view of its markets. At a recent investor conference Horton's CEO said bluntly "2007 is going to suck, all 12 months of the calendar year." He sees oversupply crimping home prices until 2008.

Lennar has grown as fast as anyone over the past five years, but it still generates strong cash flow in spite of the industry slowdown. The company has exposure to some of the weakest geographic markets, as well as more exposure to subprime borrowers than some of its competitors. On the positive side, it has shown good discipline in controlling inventories, and it appears to be suffering fewer order cancellations than many other homebuilders.

MDC Holdings is a regional builder with a focus in the western part of the country. While the West has had some of the most over-heated markets in recent years, MDC has been conservative in managing its land and home inventories. As a result, the company has decent measures of financial liquidity and leverage.

Pulte Homes does a lot of business in Florida and the Southwest, which are troubled markets, but this risk is offset by relatively low leverage on its balance sheet. It has shown cash flow deficits, but they appear manageable.

The Ryland Group has activities in 28 markets across the North, Southeast, West and Texas. Unlike many of its peers, Ryland achieved profitability in its fourth quarter, though revenues, new orders and its backlog have declined. The company's CEO has commented that only a small portion of its backlog is financed with subprime mortgages. Like Lennar and MDC, Ryland has shown restraint in inventory build-up and land purchases.

Toll Brothers has concentrated on the higher end of the residential market, and so it has more limited exposure to the subprime and first-time buyer markets. In addition, it focuses in the mid-Atlantic region, which appears to be less vulnerable than some other areas. The balance sheet looks reasonably solid as well. Also, Toll is still controlled by the founding family, which suggests that it may be more conservatively managed.

Excerpted from The Turnaround Letter.