3 Great Ways to Play the Housing Recovery

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

Home prices have stabilized in the United States. In some regions they have seen a broad increase. Investors seem excited by this recovery and are considering online real estate search stocks Zillow (NASDAQ: Z) or Trulia (NYSE: TRLA) as potential ways to play housing.

Unfortunately, Trulia and Zillow are overpriced relative to (1) homebuilders and (2) companies that enable securities markets. Instead of Trulia and Zillow, investors should consider traditional homebuilders or stocks which facilitate trading in other markets.

Trulia’s $100 Million IPO

Trulia operates the popular real estate website Trulia.com which lists residential properties. Trulia has been gaining more users and generating income by selling smartphone and tablet app subscriptions. The company has stated that its website and mobile applications are currently being used by over 20 million visitors per month. Its recent IPO raised over $100 million, the proceeds from which are expected to be used to boost its working capital.

Conceptually, online search is a much better business than building homes. There is no inventory, so there should be a higher return on assets. Moreover, housing is largely a commodity market in which homebuilders have to compete on price. Search websites are network goods which can avoid price competition for advertisers and content providers. They don’t have to compete on price as long as they are among the more popular platforms. In addition to not requiring an expensive inventory, this avoidance of price competition is a big plus for online real estate search sites.

Unfortunately, excitement over the Trulia IPO seems to be driving shares beyond reasonable valuations. The IPO valued total debt and equity of Trulia over $400 million, which is about 8.8-times last year’s sales of over $50 million.

The success of the IPO has been attributed to how the U.S. housing market is showing broad evidence of a recovery. Thus, investors are thinking of Trulia as though it is in the residential real estate business.

Its growing operations are exciting. Unfortunately, Trulia appears even more overvalued than it was at its IPO at its current market price of $22. Equity in this company is rich on a price-to-sales basis since shares trade at a 11.51 multiple, 9 times higher than the 1.29 S&P 500  average. Trulia shares are trading at an incalculable price-to-earnings ratio because it doesn’t have a net profit over the last twelve months.

Zillow is another online real estate research tool whose stock is too expensive. At a price of roughly $38 this stock is rich on a price-to-sales basis since shares trade at a 12.42 multiple, 10 times higher than the 1.29 the S&P 500 average. Zillow shares are trading at an indefensibly high 345 price-to-earnings ratio. As was the case for Trulia, these multiples cannot be reasonably justified. Worse yet, Zillow’s business model and valuations were recently reviewed under the scrutiny of Citron Research.

Same Industry, Different Business Model

Investors must consider multiple factors when evaluating established businesses and their newer tech entrants as ways to play industries. They must consider whether the newer company’s business model represents a real improvement over incumbent businesses.

If the newer business model is more attractive, then investors should be willing to pay higher valuations for the newer companies. However, if the new business model is not more attractive, then investors should require a discount. There are no ties here: a new business model should be considered more risky, so if it is not an improvement over more seasoned business models, then investors should wait for a discount before taking on the risk of a new business concept.

These online real estate stocks are overpriced when compared with traditional homebuilder Lennar (NYSE: LEN) whose stock is trading around $38 per share. The firm's 1.94 price-to-sales ratio is in line with today's prevailing market multiples. LEN shares are trading at a fair 14.26 price-to-earnings ratio, again in line with the S&P 500 average. Shares trade at a 2.65 price-to-book ratio which is a little above the 2.05 S&P 500 average. Unlike the web search real estate stocks, Lennar is fairly valued.

Better Market Making Companies

The big picture idea is that Trulia and Zillow are getting closer to becoming market makers in residential real estate. That’s the 800 pound gorilla in the room. They introduce clients to homes that are on sale, to real estate agents, and to mortgage brokers. If there are fees this starts to sound a lot like market making.

I suggest that investors should look to other securities markets to find companies that already successfully provide support for traders. Many of these companies are cheap!

The best investment among these firms is Nasdaq OMX Group (NASDAQ: NDAQ) at approximately $24 per share. The firm's 1.15 price-to-sales ratio is in line with today's prevailing market multiples. NDAQ shares are trading at an attractive 11.37 price-to-earnings ratio, lower than the 14.1 average of the S&P 500 index. The 0.79 price-to-book multiple of this stock is very attractive, much cheaper than the 2.05 S&P 500 average.

This stock is great for income, too! The 2.21% dividend yield of the stock is comparable to the 1.74% 10-year treasury yield. Future dividend payments are likely because the company pays out less than 10% of earnings as dividends, so earnings could drop considerably before dividends must be cut.

Shares of NYSE Euronext (NYSE: NYX) are almost as good at prices near $25 per share. NYSE Euronext shares are trading at an attractive 12.41 price-to-earnings ratio, 0.98 price-to-book multiple, and 1.44 price-to-sales ratio. However, income investors should not rely on the stock’s hefty 4.81% dividend yield because its 0.60 payout ratio is the cut-off rule of thumb for maximum sustainable dividend payouts.

Conclusion

Investors looking to profit from a recovering in housing should consider Lennar and wait for a collapse in the price multiples of online real estate search companies prior to investing. They can also find lower valuations in stock market enabling firms rather than hope that Trulia and Zillow can assume larger roles in real estate transactions.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Zillow. Motley Fool newsletter services recommend NYSE Euronext and Zillow. 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure