Investors have been hopeful that a bottom has been reached in the all-too-terrible real estate market. The decimation in the industry has left more pock marks than the moon being pummeled by asteroids. From that barren landscape a new beginning will eventually emerge — or so say the hopeful bulls.
The latest example of that thinking emerged late last year, when homebuilding stocks surged. Many names in the group, including Toll Brothers (NYSE:TOL), KB Home (NYSE:KBH), Lennar (NYSE:LEN) and Pulte (NYSE:PHM), all exploded higher during the last two months of 2010. The stock gains resulted in valuations that were 25%-50% higher than book value.
Historically, it has been a good time to buy these stocks when they’ve traded at a discount of 10%-20% of book value.
In late November, I thought the buying was a bit premature and suggested these 3 homebuilding stocks to sell. In addition to excessive valuations, I thought the industry had one more hangover to endure in the form of short-sale and foreclosure inventory on the market. Hope would just have to wait another year, in my opinion.
Now with half of 2011 behind us, we can make some assumptions about the homebuilding sector. For starters, these stocks are to be traded, not invested. My theory is that wild swings in price are likely to continue as we bounce along the bottom.
At the same time, long-term trends don’t suggest that growth will return in any sort of big way.
Without growth, book value becomes all the more important. Homebuilders can make money when and if the tide does turn, but don’t expect booming growth. The focus from an investing standpoint should be on book value, not profits.
What we have with homebuilding stocks is the fluctuation of dreams and dashed hopes. That cycle has played out any number of times over the last year or two — and will likely continue to for the foreseeable future.
My advice is to trade these stocks when they become cheap — or when there is hope on the horizon. In both instances, gains can be had when performance meets or beats expectation — or when dreamers are buying the stocks with the thought that big profits are around the corner.
Here are 3 homebuilding stocks to trade:
Shares of KB Home are down 10% so far in 2011. That loss is a bit deceptive, as the stock peaked in mid-January at $15.71. From that high, shares are down 24%. On the surface, one might assume that the hope trade will catch this stock from its fall and reverse course.
That would be the wrong way to play it in my opinion. There is more room to the downside based on current valuation. KB Home trades for 1.75 times book value. With 2011 now a wash for the company (Wall Street analysts expect the company to lose $1.75 a share in the current fiscal year ending Nov. 30), profits are not expected until 2012.
The company reports its quarterly earnings on Wednesday. KB Home is expected to lose 32 cents a share. Considering the company missed estimates by a very wide margin in the most immediate prior quarter, I would be concerned heading into the next report.
Play this one short in advance of earnings and wait for another 10% or more discount in share price before playing the hope trade.
Luxury home builder Toll Brothers has found a niche with high-priced homes. Fortunately for Toll, margins on its high-end product were so absurdly high, that they have been able to make money during this difficult market. It may not be fat profits, but it’s enough to encourage investors.
Shares of Toll are up 9% this year. The hope trade is alive and well. The question for Toll today is where do they go from here?
The stock trades for 1.35 times book value. That is neither cheap nor expensive. From an earnings standpoint, Toll is expected to make a small profit of 2 cents a share in the current fiscal year ending Oct. 31. In the following year, profit is expected to jump to 46 cents a share.
At current its current price of $20.80, Toll trades for a very hefty 42 times 2012 expected earnings. In the last reporting period, Toll missed expectations by 8 cents a share. That miss suggests that there is risk in owning Toll at these prices.
Slow and steady growth is likely to be Toll’s future. Single-digit profit growth once the market does stabilize will be its new normal. It would be hard to pay more than 10 times earnings for this stock let alone 42 times earnings in a period still more than a year away.
Shares of Lennar have had a nice boost over the last week after the company reported results that beat expectations — the stock is up a solid 5%. Before the turnaround, the stock had been down about 24% from highs earlier this year.
With shares trading at 1.3 times book value, investors are squarely focused on earnings. The hope there is that the company will return to levels seen before the stock market collapse. Analysts have Lennar making a profit of 53 cents a share for the year ending Nov. 30.That number nearly doubles to $1.01 a share in the following year.
This is where traders can ride the wave of hope to big profits. The growth might be fantastic on the surface, but once Lennar hits that peak, profit growth can be expected to slow. The recovery fanatics won’t worry about such trivial thoughts — they will just blindly buy shares because the company is doing well on an operating level and profits growth in the near term is huge.
It would simply not be wise to hold any homebuilding stock for the long term. These stocks are now trading vehicles. The days that we lost in 2008 aren’t returning any time soon.