Can Housing-Related Shares Keep Rallying?

by Daniel Putnam | December 26, 2012 7:00 am

The recovery in the housing market was one of the most important stories of 2012. In addition to shoring up homeowners’ balance sheets and keeping the economy on a positive track, it has boosted financial stocks and propelled homebuilding stocks[1] to a gain of over 80%.

While these beneficiaries generally receive the most attention, the housing rebound has also fueled excellent performance for companies that produce materials and furnishings for new homes. Now, with most names in this group already having delivered triple-digit performance since the lows of October 2011, the opportunities are much harder to come by than they were last year at this time.

The strong performance for stocks in the home “supply chain” stems from the same factors that have propelled homebuilders in the past year-plus: The housing market is on the road to recovery, new-home construction has resumed and demand for furnishings and building materials has picked up.

Just how strong have returns been? This table tells the story:

Home Depot HD Retail 102.1%
Lowe’s LOW Retail 91.7%
Lumber Liquidators LL Retail 257.8%
USG USG Building Materials 363.8%
Owens Corning OC Building Materials 80.3%
Mohawk Industries MHK Flooring Products 113.6%
Masco MAS Home Improvement Products 149.3%
Armstrong World Industries AWI Ceiling & Flooring 77.1%
Quanex Building Products NX Window, Door, & Building Products 119.1%
Lennox International LII HVAC Products 113.8%
Leggett & Platt LEG Residential Furnishings 57.0%
A.O. Smith AOS Water Heaters 113.2%
Whirlpool WHR Appliances 118.8%
Fortune Brands Home & Security FBHS Security & Home Improvement Products 146.6%
Sherwin Williams SHW Paint 109.9%

The question now is whether any buys are left in this group. Keep in mind that each of these companies offers its own fundamental story — and that many, such as Whirlpool (NYSE:WHR[2]), have significant international business lines. Still, some general statements apply across the entire group.

First, these housing supply-chain stocks are on track for growth that’s much better than the overall market next year. The vast majority of these companies are estimated to generate earnings growth north of 15% in 2013, more than triple the 5% growth analysts see for the S&P 500.

At a time in which U.S. GDP is expected to expand by only about 2%, this type of growth — and continued headlines about the strengthening housing market — will continue to attract buyers in the months ahead.

That’s the good news. Unfortunately, another similarity is that valuations are no longer cheap based on forward price-earnings ratios. Trailing P/Es don’t carry much weight here because many of these suppliers are coming off periods of depressed earnings. However, with the exception of Quanex Building Products (NYSE:NX[3]) and Whirlpool, are all trading with forward multiples that are at premium to the  S&P 500’s P/E of 13.9.

COMPANY 2013 EPS GROWTH (EST.) 2013 ESTIMATES (90 Days) P/E Trailing P/E 2013 (EST.)
Home Depot 14.1% Rising 21.8 17.7
Lowe’s 20.9% Rising 21.1 16.9
Lumber Liquidators 25.5% Rising 34.3 25.1
USG n/a Rising n/a 56.4
Owens Corning 84.2% Falling 51.5 17.6
Mohawk Industries 24.5% Rising 26.6 18.1
Masco 100.0% Flat n/a 29.5
Armstrong World Industries 16.5% Falling 22.8 17.4
Quanex Building Products 342.9% Flat 37.2 10.4
Lennox International 24.4% Rising 32.5 15.9
Leggett & Platt 8.7% Flat 21.9 16.9
A.O. Smith 17.0% Rising 19.4 18.5
Whirlpool 31.0% Rising 16.6 11.1
Fortune Brands Home & Security 30.7% Flat 164.0 25.9
Sherwin Williams 19.6% Flat 27.5 19.4

Bulls will argue that these stocks deserve such a premium multiple given that they’re in the midst of a recovery, and that’s true to some extent. But as is the case with the homebuilders[4], investors need to be careful here because much of these companies’ stock prices already reflect the good news. These are no longer beaten-down, contrarian plays that investors can pick up on the cheap.

As a result, there’s much less room for continued good news from the housing market to propel further gains as there is for a disappointment to lead to meaningful downside. Also, any combination of fiscal-cliff disruptions, renewed problems in Europe, slowing U.S. growth or — especially — rising interest rates, and the housing supply-chain stocks are almost certain to underperform.

Investors, therefore, need to pick their spots. While one more upleg is likely in store for both the homebuilding and housing supply-chain sectors, it’s going to take good old-fashioned stock-picking, rather than a broad-based sector bet in an fund such as the SPDR S&P Homebuilders ETF (NYSE:XHB[5]), to make money from here on out.

A good starting point for ideas is to look for opportunities in stocks that have lagged the broader group, offer fairly reasonable valuations, have flat to rising earnings estimates and that are trading near breakout levels rather than being hugely overextended such as SherwinWilliams (NYSE:SHW[6]) or Lumber Liquidators (NYSE:LL[7]).

Among the names that warrant consideration are Lowe’s (NYSE:LOW[8]), Quanex Building Products, Lennox International (NYSE:LII[9]), and Leggett & Platt (NYSE:LEG[10]).

Still, even these stocks will be vulnerable if the broader market encounters rougher sledding. For now, investors will be better served by waiting to buy a dip rather than expecting the home suppliers to deliver much more upside from here.

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

  1. homebuilding stocks:
  2. WHR:
  3. NX:
  4. as is the case with the homebuilders:
  5. XHB:
  6. SHW:
  7. LL:
  8. LOW:
  9. LII:
  10. LEG:

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