Earnings Are Good, Outlook Is Bad for Homebuilders

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As we came into this year there was an expectation that housing would drive the economy higher. Analysts and pundits hoped that very low interest rates would lead the economy higher as homebuilding activity surged to meet pent-up demand.

homebuilders, housing

The problem with this rosy scenario was that the pundits inverted the basic equation. The housing market does not lead the economy out of the doldrums. The economy has to lead the housing market higher.

We simply don’t have enough first-time buyers in the market to justify robust building activity from homebuilders. First-time buyers are down below 28% of all buyers, well below the norm of about 40%. There are a number of reasons for the low number of first-time buyers, but at the heart of it is the simple fact that the economy is not crating enough full-time, high-paying jobs to spur first-time buyers.

Tighter credit standards and larger down payment requirements are also keeping first-timers on the sideline. Last year, investment and institutional buyers took up a lot of the slack in the housing market. But as prices have risen, value-conscious buyers have pulled back from the single-family market.

The high end of the market has held up pretty well, as evidenced by luxury builder Toll Brothers’ (TOL) strong earnings. Revenues and deliveries were up more than 50%, and profits more than doubled over the prior year. However, even this market is showing signs of weakness: Orders slowed at Toll Brothers, which could lead to less sparkling results in the second half of the year.

CEO Robert Toll has always been very plain-spoken about the housing market, and he said in the earnings release,

“The national housing data has been somewhat volatile in recent months. Without real urgency pushing buyers to make a decision, general industry demand continues to be impacted by uncertainty about the economy and world events, improving but fragile consumer confidence and reduced affordability due to rising prices and limited personal income growth.”

I think he is spot-on, and that outlook means that investors should avoid homebuilders. I have been doing this for a long time, and the right time to buy the builders is when they trade at steep discounts to book value, or when a few are teetering on the edge of bankruptcy.

That time was 2010-2012, and investors who bought homebuilders like Toll Brothers, Ryland Homes (RYL) and Pulte Homes (PHM) have done extraordinarily well. Now home builders are more likely to be filing an IPO rather than for bankruptcy, and none of the builders are trading at a discount to book value. Expectations are too high, and the stocks are too expensive.

I know that some pundits are predicting a housing collapse part two. I am not in the camp, but I do think that the market needs to bump along near current levels for a period of time. Housing appreciation averaged between 2% and 2.5% since World War II, and that is what we need to see today, not a V-bottom with 20% annual gains.

Housing will eventually recover, but it isn’t going to happen as fast as economists had hoped.

As of this writing, Tim Melvin did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2014/09/stay-away-homebuilders/.

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