Home sweet homebuilders

[notiCIas]

Home sweet homebuilders

Despite increased talk of a bubble, shares of homebuilders keep soaring. Are they due to cool off?

June 20, 2005: 7:23 PM EDT
By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) – Housing bubble? P'shaw! Many investors clearly don't believe that the torrid housing market is going to collapse anytime soon.

And why should they? The soaring price of real estate from coast to coast has caused many to view homes as a solid short-term investment. Relatively low mortgage rates have helped fuel demand for housing as well.

Homebuilder KB Home (Research) reported stellar fiscal second quarter results last week. Earnings surged nearly 80 percent and profits topped analysts' forecasts by 16 percent.

These kinds of results have made homebuilder stocks among the biggest winners on Wall Street this year. The S&P Homebuilding index is up 32 percent year-to-date.

Momentum remains strong...
This clearly has some investors worried. (For more on why veteran fund manager Ken Heebner is bailing on homebuilder stocks, click here.) But many think that homebuilders still are a good bet.

"While housing prices and margins may be climbing to stratospheric levels, it is important to recognize that they are still climbing and driving earnings higher," said Citigroup Smith Barney analyst Stephen Kim in a report on Friday in which he upgraded six homebuilding stocks to a "Buy" rating.

Kim thinks that the homebuilding group still has room to run since analysts will likely need to keep raising their earnings forecasts. To that end, analysts lifted their fiscal 2005 projections for KB Home by 8 percent during the past week and boosted their 2006 outlook by 11 percent.

"The fact is that housing demand has not slowed meaningfully, nor have supply constraints been noticeably undermined, and the large, public builders are set to post significantly higher price growth, margins and earnings than the Street currently expects," said Kim.

Gregory Gieber, an analyst with A.G. Edwards, said a drastic increase in long-term bond rates, which influence mortgage rates, has yet to materialize as well. The yield on the 10-year U.S. Treasury is about 4.1 percent, lower than where it was at this time a year ago even though the Federal Reserve has raised short-term interest rates by 2 full percentage points.

"As long as low rates remain, housing is going to continue to do better than expected," said Gieber, adding that homebuilders have also benefited from low long-term rates because it has enabled them to raise money fairly cheaply through the bond markets in order to finance the purchase of property.

...but investors should be careful
Still, investors need to be selective. Todd Campbell, president of E.B. Capital Markets, an independent research firm catering to institutional clients, said that now is probably not the best time for investors that don't already have exposure to the group to start buying.

"I wouldn't be a brand new buyer of most companies," Campbell said. "But old money should keep riding the wave. Don't get off the moving bus until it stops."

He does see some ways to play the group that are a little less risky though. Campbell said his favorite homebuilder pick is Technical Olympic USA (Research), a large builder of vacation homes in Florida. He also likes Orleans Homebuilders (Research), which also has a presence in Florida, and Meritage Homes (Research), which has exposure in Arizona and Nevada.

Campbell argues that companies like these that cater to a growing demographic of retirees should probably still benefit from healthy demand regardless of what happens to mortgage rates and home prices.

James McBride, co-manager of the TrendStar Small Cap fund, also said that investors should look at niche homebuilders. His fund owns WCI Communities (Research), which develops retirement communities in Florida. "Interest rates aren't as critical since half their customers pay cash for their purchases. That protects them a little bit from housing cycles," he said.

Housing may cool but it probably won't collapse
Finally, there's the issue of valuations. Most homebuilder stocks, despite their strong earnings, continue to trade at earnings multiples, based on 2005 estimates, in the high single digits.

Gieber said that homebuilders have historically traded at such a big discount to the overall market because of the cyclicality that's typical in the housing market. In other words, the stocks are currently priced on expectations that a bust is just around the corner after a multi-year boom.

But Gieber thinks that it's a mistake to not own the highest-quality stocks in the group just because the housing market may eventually cool off since he is not predicting a precipitous drop in real estate prices.

"There will always be a class of investors saying, 'What's next?' But we're not going to see a sharp decline in past housing cycles. At worst, the better run companies will have flat earnings growth," he said. He likes KB Home, Lennar (Research) (due to report second-quarter results Tuesday), D.R. Horton (Research) and Pulte Homes (Research).

Don Hodges, manager of the Hodges fund, agrees that fears of a big decline in housing prices are overdone. So comparisons to the tech stock bubble of the late 1990's and other stock market manias are not good analogies, he said.

"When you talk about a bubble in housing it's different than a bubble in the stock market. You don't have to sell your home. (You) usually see a leveling out, not a collapse," he said. Hodges owns Centex (Research) in his fund and argues that because valuations are so low, the stock still looks attractive.

Centex trades at about 8 times this year's earnings estimates even though earnings are expected to increase at an average of 15 percent a year for the next few years.

"It is a very comfortable place to have money. Centex is well managed and very conservative. I view it as a growth stock without the growth multiple," Hodges said.