With Rates on the Rise, Is It Time To Flip Housing Stocks?

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Mortgage rates increased more than 1/2% this week to 4.46%, the largest weekly increase in more than a quarter-century and the highest rate in 2 years. This is on top of revised economic data showing that the US economy grew at a much slower rate during the first quarter than previously thought, and what appears to be a slowing of hiring, and a stagnation in unemployment claims that had been consistently dropping for over a year.

The question is what should investors do?

Time to flip?

<img alt="" src="http://media.ycharts.com/charts/72c288784029121cd6dfa72028b11d60.png" />

KBH data by YCharts

If you've invested in homebuilders like KB Homes (NYSE: KBH), PulteGroup (NYSE: PHM), or Meritage Homes (NYSE: MTH) in the past year, you've probably done well, and are tempted to take your money and run. Even the nearly 25% increase for high-end homebuilder Toll Brothers (NYSE: TOL) may seem tempting to cash in. 

But the key to investing is not letting past results cloud our assessment of the future. KB Home announced earnings on June 27 that exceeded expectations, both on the top- and bottom-lines. And at a price near $20, down from its 52-week high, there is plenty of reason to see future growth with this builder. However, my concern with KB Home is easy to sum up: debt.

<img alt="" src="http://media.ycharts.com/charts/7c5e5d529d623191f1ea3b1fa8f3715d.png" />

KBH Debt to Equity Ratio data by YCharts

The housing market (and the constant cash flow it generates) must continue to perform, or KB Home could find itself in a crunch, as it carries a very high level of debt versus its peers. With the market potentially slowing, I'd consider stepping back and looking for more data to support whether this is just a speed-bump, or a prolonged slowdown, before making a call to sell.  

Toll Brothers, which carries the lowest debt to equity of this group is also protected from a protracted shift in the housing market in another way. Its average home selling price is nearly $570,000, more than double that of KB Home, and per its most recent earnings report in May, the average price of a home in its backlog is $693,000. If the softening of the housing market is driven by rising interest rates, it could be reasonable to assume that focusing on the higher end of the market, and carrying less debt, makes Toll Brothers an attractive long-term investment. 

PulteGroup and Meritage also carry much more reasonable debt loads than KB Home, so they may be worth exploring a little further:

<img alt="" src="http://media.ycharts.com/charts/40a4cf21952b7aa7d512aec92b91f26d.png" />

KBH Forward PE Ratio data by YCharts

I'm a fan of the forward PE ratio when looking at businesses that are (or should) be generating profits. While sometimes a company may be an anomaly, this is a good metric to compare a company to both its peers, and to its own past. With that context, we are more likely to glean useful information. To me, it's pretty clear that Mister Market is expecting KB Home to keep delivering, and I'm not convinced that it will live up to these very high expectations.

Toll Brothers is also carrying a high forward PE, but it's a strong performer in a good segment of the market, and has a solid balance sheet. It's a little rich for my blood, but seems to be a better bet today than KB Home is.

Buy a starter homebuilder

From a future-looking earnings valuation like forward PE, PulteGroup and Meritage, as with their debt-to-equity ratios, seem to have something in common. Both seem to have reasonable balance sheets; and at nearly 20, Meritage's forward PE is very reasonable compared to the two prior discussed companies. At 14.9, PulteGroup's forward earnings valuation is very conservative, especially when compared to the others above. 

But what it really comes down to, as all things with investing, is the future opportunity: At nearly 4 times the size of Meritage, PulteGroup just doesn't offer the same kind of growth. And since none of the companies discussed offer a substantial dividend today, there isn't an income stream for investors to count on.

Foolish bottom line

Even with the recent interest rate hikes, they are still near record lows. Factor in that new home construction (even with the recent expansion) is still well below historical averages, and I think that even if there is a slowdown, it will be little more than a temporary speedbump in the road to a recovering housing market. As to the companies discussed, I'd put my money in Meritage (I have) first, and Toll Brothers next. PulteGroup just doesn't excite me, and KB Home seems overvalued by most metrics.

What do you think? Tell me in the comments below.

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Jason Hall owns shares of Meritage Homes. The Motley Fool recommends Meritage Homes. 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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