Best ETFs for 2019: A Contrarian Play in iShares US Home Construction ETF

An ugly 2018 has priced the worst-case scenario into housing stocks

Heading into 2019, there are few bets more contrarian than U.S. housing. Since January, investors have been selling off anything construction-related. Homebuilder stocks have been halved in many cases. Building products suppliers and distributors have performed just as poorly — if not worse. Even Home Depot (NYSE:HD), one of the best large-cap stocks in the market since the financial crisis, and one of the best companies in America period, has dropped 20% in a matter of months. As a result, the iShares US Home Construction ETF (BATS:ITB) has declined sharply. ITB shares are down nearly 30% so far this year – and by more than one-third from late January highs.

There are some reasons for the selloff, admittedly. ITB is homebuilder-heavy, and rising interest rates appear to have caused new home demand to soften. Inflation, labor shortages and tariffs are driving expenses higher. Homebuilders, and their suppliers, look pressured in terms of both revenue and costs.

But at this point, the bad news looks priced in … or close. Yet there are multiple catalysts to send the group higher. Any resolution of the trade war with China would help the sector. Earnings can stay strong, as they’ve been for much of 2018. Housing starts can re-accelerate from post-crisis levels that remain well below historical trends.

Investors clearly are nervous about the 2019 and 2020 results for the industry and, again, there are reasons for caution. But a still-strong economy and still-growing demand for housing, along with modest exposure to renovation and replacement demand, should keep the industry at least close to stable. With ITB down 30% from its highs, and near a 21-month low, that’s enough to place a contrarian bet heading into 2019.

The ITB ETF

ITB tracks the Dow Jones U.S. Select Home Construction Index, and as the name suggests, the exchange-traded fund focuses on residential construction. The top five holdings all are homebuilders, led by D.R. Horton (NYSE:DHI) and Lennar (NYSE:LEN). DHI and LEN each account for over 13% of the fund, with the five largest positions driving nearly half of the ETF. The homebuilders group on the whole accounts for roughly two-thirds of ITB’s portfolio.

Another 14% comes from building products plays, both suppliers and distributors. Home Depot and Lowe’s (NYSE:LOW) are another 7.5%. So while this is mostly a new construction play, there is some exposure to steadier repair and renovation spend.

The Case for ITB

The argument for ITB, at this point, is almost purely contrarian. Again, homebuilders, in particular, have had a brutal year. LEN is down 43% from its highs, DHI 33% and high-end Toll Brothers (NYSE:TOL) 39%. Most of the stocks in the sector are selling at single-digit earnings multiples — valuations that suggest a reasonably sharp collapse in earnings in the not-too-distant future.

Yet performance has remained relatively strong. Both D.R. Horton and Lennar, No. 1 and No. 2 in the U.S., respectively, have posted three straight earnings beats this year. Last month, smaller KB Home (NYSE:KBH) did cut guidance for its fiscal fourth quarter, but for the most part, business is holding up.

And so are the stocks in the sector. ITB itself bottomed in late October. KBH regained most of its post-Q4 losses in a matter of sessions. Even as the broad market has seen declines — driven by cyclical worries — homebuilders have traded sideways. That’s not bullish news, necessarily, but it is a possible sign that the bottom is in. Cyclical fears are hitting other sectors, but the market over the past six weeks seems to have decided that those fears are baked into a group trading at 6x to 8x earnings.

Looking to 2019

So from here, the risk/reward for ITB looks reasonably attractive. Should broad markets rebound, the fund has a lot of room to the upside. A return to past highs would imply 40%+ gains next year. Those types of returns likely are too much to ask, given higher input costs and potentially weaker demand. But it shows the type of upside possible if sentiment improves even modestly from current levels, and ITB recovers, say, half of its losses.

And if cyclical fears play out, there’s some slack in the valuation to limit declines. Homebuilder stocks in theory (if not always in practice) should see their multiples expand heading into the bottom of the cycle. With the group trading at single-digit multiples, even reduced 2019 earnings expectations don’t necessarily lead to further declines in ITB shares.

To be sure, this isn’t a “riskless” trade by any means. Construction stocks are notoriously cyclical and notoriously volatile. Investors could have made, and no doubt did make, a similar argument about ITB back in 2006, when the fund had dropped by a similar 30% within its first five months of trading. A subsequent bounce proved to be false optimism: at crisis-era lows, the ETF had lost well over 80% of its value in less than three years.

But the point here is that it isn’t 2009 or close to it. The economy still is strong, and still recovering. Housing starts have been slow since the crisis; even with concerns about the debt owed by younger potential customers, supply hasn’t kept up with demand. New home construction activity isn’t likely to soar next year, but at these prices, it doesn’t have to for ITB to gain nicely. And if the industry somehow can drive a significant rebound, ITB will have enormous upside.

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


Article printed from InvestorPlace Media, https://investorplace.com/2018/12/best-etfs-for-2019-ishares-us-home-construction-etf-itb/.

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