These 2012 Top Performers Will Repeat In 2013

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Rule #1 in Sam Stovall’s book The Seven Rules of Wall Street is to “Let your winners ride.” Stovall believes in finding the best performing sectors and industries from the previous year, and investing in them for the next. While past results do not indicate future performance, this strategy of buying high and selling higher has performed very well over the last 20 years.

2012’s Best Performer

One of the best performing sectors in 2012 so far has been the U.S. home construction sector. The iShares Dow Jones U.S. Home Construction ETF (NYSEMKT: ITB) is up 72.4% year-to-date. The year has seen fantastic results for homebuilders as we’ve seemingly reached a bottom in housing. Home prices have risen every month (compared to the same period a year ago) for 12 consecutive months dating back to November 2011.

While housing starts fell last month, the three-month period through November represents the strongest three months in housing starts since June – August 2008. Moreover, housing starts have improved about 25% year-to-date.

2013 Outlook

There are plenty of promising signs that the homebuilding industry will continue its momentum in 2013. Chief among them is the shrinking number of foreclosures and mortgage defaults. In October, the number of homes that were in foreclosure or 90 days past due fell to about 3 million. That’s down 430,000 this year, and over 1.3 million from the peak in 2010. With fewer homes being foreclosed upon, the supply of housing will go down, and average home prices will go up. Homebuilders will make up the supply deficit and generate higher margins with higher prices.

Second, rising home and relatively high rent prices may encourage homeowners to sell and renters to buy. There is an increasing sense of urgency for potential home buyers. Housing prices are expected to continue to rise through 2013, and potential buyers want to buy at the lowest price they can get. With record low mortgage rates, it’s not going to get much more inexpensive to buy a home. More people buying houses implies a greater demand. Homebuilders will fill that demand in 2013.

Third, the number of building applications issued in November rose to a four-year high. Permits climbed 3.6% in November to an 899,000 annual rate, well above economists’ average forecast of 875,000. Permit issues are a great indicator of future home starts, as construction usually doesn’t get underway for another 9 to 12 months after issuance.

Finally, homebuilders confidence is at a 6-year high. On Tuesday, the National Association of Home Builders/Wells Fargo Housing Market Index, which reflects builder confidence for new single-family homes, rose to 47. This marks the index’s highest point since May 2006. While anything below 50 represents weak builder confidence, the index is definitely moving in the right direction. Last December, the index reported a mark of just 21. Perhaps next month, after some economic issues (read fiscal cliff) are settled, the index will break 50.

The Best of the Best

Stovall recommends not only buying sector funds, but also finding the best companies to invest in the best performing industries. “Best” is quite subjective, and what’s best for one investor could be different from what’s best for another.

If one is evaluating stocks based solely on momentum, PulteGroup (NYSE: PHM) takes the cake with a 177% increase in price year-to-date. Lennar Corp (NYSE: LEN) still posted outstanding growth of 92% so far this year. Competitor Toll Brothers (NYSE: TOL) grew about 49% year-to-date.

However, with its huge increase in stock price this year, PulteGroup is now trading at a price more than 25 times next year’s earnings estimate and a very high ratio of 42.7 times earnings from the trailing 12 months. Comparatively, Lennar trades at just 12.5 times forward earnings and is even expected to grow earnings slightly faster in the next five years at a rate of 6% compared to Pulte’s 5% anticipated rate. Better growth at half the price, sounds like a good investment to me.

Another reason I consider Lennar a better investment is its margins. Lennar leads the sector with a homebuilding margin of 23.2%. It keeps its margins high by focusing its efforts in areas where high demand drives home sales and not low pricing. As more metropolitan areas see increase home buyer demand in 2013, Lennar’s strategy should result in good growth on the top and bottom lines.

For someone looking for more growth prospects in housing, Toll Brothers makes an interesting case. In its most recent quarter, Toll reported a 75% increase in the number of newly signed contracts to build homes worth more than $684 million total. The number of units increased 70% to 1,098. Most importantly, profits grew from just $15 million in 2011 to $411.4 million in 2012 for the quarter ended October 31. While the company trades near 33 times forward earnings, the company’s profit growth ought to justify the high price. 

As I mentioned earlier, there are some "economic issues" that may cause investors in home builders concern. If you buy in now, you may want to have some downside protection if things don't work out in Washington. Alternatively, investors may just want to wait until January for a clearer picture.

adamlevy has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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