Two Stocks To Buy For A Housing Recovery

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

'CoreLogic recently reported U.S. home prices in November gained 7.4% year-over-year, the largest gain on 6.5 years. Rising prices is seen as a key factor in the U.S. housing market's recovery, and CoreLogic forecasts prices to continue to rise in 2013 by 6%.'

'The usual drop in supply at this time of year and a pickup in demand spurred by historically low mortgage rates, a firming job market, and growing households risk keeping inventories lean, pushing prices even higher. The median price of an existing house climbed 6.3 percent in 2012, the most since 2005.'

Source: Bloomberg

So, where do you invest to play the housing recovery?

Despite the large number of choices out there I have whittled the group down to 3 choice stocks - 2 home builders and a supplier. Even though I having two home builders in the article I only consider one to be  to be the best investment despite the strengths of the other. The first house builder is Lennar: 

Lennar (NYSE: LEN)

Lennar is the third largest home builder in the country and builds affordable, move-up, and retirement homes. Lennar recently reported that for 2012 home sales rose 33% YoY, while the average selling price also moved up nearly 10%. Lennar also managed to push up selling margins to 12% on higher prices and fewer buyer incentives.

Like most of the homebuilders Lennar recently announced a huge rise in profits, Q4 EPS came in at $0.56 vs. $0.16 a year earlier.  The company also had an order backlog of $1.2 billion at the end of the year.

The other home builder I believe could be a great recovery play is the higher end Toll brothers.

Toll Brothers (NYSE: TOL)

Toll Brothers, is right at the other end of the market. The company designs, builds, markets and arranges financing for single-family detached and attached homes in luxury residential communities. This gives the group a much higher margin and average selling price.

Unfortunately, these home builders have been through a really rough period over the past few years and the ones that are left are bound to be best of breed. Even though they survived how much damage did the housing crash do?

$US Billion Toll Lennar
Current Assets 5.2 6

Current Liabilities

0.9 1.1
Inventories 3.8 4.4
Cash & Short Term Assets 1.3 1.4
Long Term Debt 2.2 4
Current Portion Of Long Term Debt 0.1 0.6
Market Cap. 6 7.5
Gearing Ratio 0.2 0.4
Quick Ratio 1.6 1.5
Current Ratio 5.8 5.5

Financially both of these companies look sound. One of the problems with homebuilders is the huge amount of unsold inventory they have that clouds the balance sheet. This can be seen in both of these stocks. Although, when I strip out the inventory to calculate a quick ratio both of the companies look to have solid balance sheets with liabilities well covered. Both Lennar and Toll have low levels of gearing and cash on their balance sheets - so financially they look ok, if they can sell their inventory (houses)! 

Financial Fundamentals P/E (TTM) Profit Margin Return On Equity Performance-Year
Toll 12.5 26% 17% 53%
Lennar 15.8 15% 19% 85% 

Toll is the cheaper stock on a lower than average P/E of 12.5, compared to the rest of the sector this leaves significant upside for the company. Lennar has a slightly higher P/E of nearly 16, although this is significantly below some of its competitors.  The luxury aspect of Toll shows through when looking at the profit margins of the two groups. Toll’s higher profit margin is produced through much higher prices.

Based on the lower than average multiples and the higher profit margins I think Toll Brothers could be the best investment right now. In addition, the company has also had the smallest share price gain over the last year - this leads me to believe there is more upside in the stock. Lennar one the other hand is up 85% over the past year and the rally looks to me to be overheating.

The final stock choice is significantly more speculative. Of course if you are worried about investing within the sector the best bet would be Berkshire Hathaway – for a position without direct exposure.

USG (NYSE: USG)

USG manufactures and distributes building materials. It produces a wide range of products for use in new residential, new non-residential, and residential and non-residential repair and remodel construction, as well as products used in certain industrial processes.

This is more of a general building play as the company has operations in all building segments. I was first attracted to this company when I discovered Buffett had brought a chunk and decided it was worth a closer look.

Like most building suppliers, the stock has not made a profit since 2007 – although current losses are falling. The biggest loss the company saw was in 2009 and amounted to nearly $800 million. This loss has since fallen to $400 million in 2010 and 390 million in 2011 despite revenues remaining constant over the period – indicating improving efficiencies.

Analysts expect EPS to further improve for the full year 2012 to -$1 (up from -$3 in 2011) and another improvement is expected into profit in 2013 up to an average of $0.5 EPS. The company's balance sheet looks strong with a current ratio of 2.4 and a quick ratio of around 2.  USG has a cash pile of $500 million and debt of $2.3 Billion resulting in a net debt position of $1.8 billion; a gearing level of roughly 58%.

Conclusion

Overall there are many ways to play the housing recovery but in my opinion the best way is to cherry pick a combination of home builders and building supply stocks. Toll Brothers and USG present two very good opportunities, one high end home builder that looks to be going cheap and one building supplier, which is significantly more speculative but presents a much better all-round investment. Of course as I have already said an investment in Berkshire Hathaway would be the boring but significantly more secure investment. 

Data Source: Finviz,YCHARTS


RupertHargreav has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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