3 Homebuilders to Evict From Your Portfolio

by Jamie Dlugosch | November 10, 2011 12:51 pm

Looking for a good read on the state of the long beaten-down homebuilding sector? Pay attention to DR Horton’s (NYSE:DHI[1]) earnings report for the quarter ending Sept. 30, due out on Friday. With the economy on the precipice of a recession, but still growing for now, DR Horton’s numbers will be less important than its future guidance.

Investors in homebuilding stocks have been acting bullish on stocks in the group without confirmation of a true turnaround based on the numbers. It’s all hope that at some point homebuilding will be profitable, and consistently so.

After many false starts, I think the odds of a true rebound in the industry are more likely than not. Strong earnings reports from homebuilders will confirm that something good may be on the horizon. Does that mean you should buy their stocks today?

Actually, I believe the opposite. Valuing homebuilding stocks is simply a matter of looking at book value. Here’s why: Homebuilders aren’t like, say, tech stocks. Investors shouldn’t expect homebuilders to post huge amounts of growth. Therefore, paying a multiple of earnings as you do with growth stocks doesn’t apply. The discipline in homebuilding requires you to buy at book value or less. To the extent shares trade for less than book value, homebuilders should be bought aggressively. Historically, this has been a profitable strategy.

But after a huge rally in October, many homebuilding stocks are trading well above book value. So, now may be a good time to take some money off the table in advance of earnings reports.

While I am optimistic on homebuilding in the long run, stocks are a bit too far out in front for my taste. Home sales in September grew at a weak pace[2], and sentiment among homebuilding companies fell in during that month[3].

Specifically, homebuilding is weighed down by foreclosures that continue to mount. Another troubling sign is the third-quarter increase in mortgage late payments[4]. Throw in the volatility caused by Europe’s debt crisis, and there are plenty of reasons to be nervous in the short run.

None of this should be a surprise to anyone who has followed the boom and bust in homebuilding. The industry experienced a once-in-a-lifetime event. To recover will simply take time. Investors, however, are impatient and ever optimistic. The recent run-up in homebuilding stocks is another in a long line of hopeful rallies.

This one has gone about as far as it can. I would be a seller of homebuilder stocks today. Here are three to consider jettisoning from your portfolio:

DR Horton

If you owned DR Horton over the last three months, you’ve done quite well. Despite the stock being down 5% during Wednesday’s market rout, shares are up a rock-solid 20% over the past three months. Those gains have the stock trading for nearly 1.5 times book value, a hefty premium considering the industry’s headwinds.

From an earnings perspective DR Horton is doing well. The company has exceeded Wall Street estimates in each of the last two quarters and three of the last four. For the full year ending Sept. 30, analysts expect a profit of 26 cents per share. That profit is forecast to grow by 88% in the following year, to 49 cents per share. At current prices, DR Horton trades for a whopping 44 times current-year estimated earnings.

The profits are nice, but they’re small. Book value then is likely to grow only slightly. And because there’s still risk of further declines in homebuilding, those profits aren’t assured. A more reasonable valuation of DR Horton would be 1.2 times book value.

I would look to sell this stock today and buy at a cheaper level.

KB Home

Another homebuilding stock trending positive over the last month is KB Home (NYSE:KBH[5]), but the gains haven’t been easy to come by. The stock has been incredibly volatile during that time. On Thursday it dropped more than 8%. Even so, KB Home shares are up nearly 30% since late September.

The reason for those gains is directly related to its most recent earnings report released on Sept. 23. KB Home posted a loss that was smaller than Wall Street expectations[6]. The results are certainly encouraging, but KB Home is still on the wrong side of the profit track.

Wall Street is looking for it to lose $2.48 per share in the current fiscal year ending Nov. 30. The estimate is for the loss to shrink to 20 cents per share in the following year. Book value is getting smaller. With recent gains in the stock, shares trade for 1.35 times book value.

Earnings performance against estimates has been mixed over the last four quarters. Before the strong last quarter, the company missed Wall Street expectations badly. There’s an equal chance KB Home will miss estimates again.

I would not want to pay more than 1 times book value for this stock. Look for shares to retreat to those levels as investors lock in profits.

Toll Brothers

Supposedly, luxury markets are performing better than the rest of the economy. While the majority of us struggle, the rich and ultra-rich keep spending. And the clear leader in mass luxury homebuilding is Toll Brothers (NYSE:TOL[7]).

But cracks in the luxury world may be showing. A number of stocks in this category have lately slipped, including Harley Davidson (NYSE:HOG[8]) and Ralph Lauren[9] (NYSE:RL[10]), to name a couple.

Over the last year, Toll Brothers shares have actually drifted lower. But since the end of September, when the stock bottomed at just above $13, it has gained more than 40%. That’s a rip-roaring return that envisions a robust housing rebound, which recent statistics suggest may still be elusive.

The stock is ahead of itself. Shares trade for 1.2 times book value — not horribly expensive, but not cheap either. Wall Street expects Toll Brothers to make 20 cents per share in the fiscal year ending Oct. 31. For the following year, profits are seen  improving to 31 cents per share.

After a significant beat in the last quarter ending July 31, look for Toll Brothers to come back to earth when it reports results for the quarter ending Oct. 31. Based on the big gains over the last month, I would sell Toll in advance of results and look to buy shares at a cheaper price later.

  1. DHI: http://studio-5.financialcontent.com/investplace/quote?Symbol=DHI
  2. grew at a weak pace: http://money.cnn.com/2011/10/26/real_estate/new_home_sales/index.htm
  3. fell in during that month: http://www.reuters.com/article/2011/09/19/us-usa-economy-idUSTRE78C33C20110919
  4. the third-quarter increase in mortgage late payments: http://www.npr.org/templates/story/story.php?storyId=142126053
  5. KBH: http://studio-5.financialcontent.com/investplace/quote?Symbol=KBH
  6. posted a loss that was smaller than Wall Street expectations: http://www.bloomberg.com/news/2011-09-23/kb-home-climbs-after-third-quarter-loss-narrower-than-analysts-estimated.html?cmpid=yhoo
  7. TOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=TOL
  8. HOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=HOG
  9. Ralph Lauren: https://investorplace.com/2011/11/macys-ralph-lauren-retail-stocksy/
  10. RL: http://studio-5.financialcontent.com/investplace/quote?Symbol=RL

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