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How to Build a House of Stocks

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

Less than a decade ago far too many individuals purchased homes – or more realistically rented homes from the bank – as if they were objects and this in part caused the housing bubble that triggered the worst recession we have ever seen.  Subsequently, home prices declined anywhere from 30%-60%.

Fortunately investors that take advantage of home building stocks before the train leaves the station will be rewarded over the next several years.  In this discussion we will take a look at specific home building stocks in order to determine which will outperform and which will go bust as the housing market continues to strengthen.

Let’s lay the foundation

Many possible homeowners and investors are still pessimistic regarding the housing market.  This is understandable considering the average home price is down about $75,000 from their pre-recession highs.  On the other hand, the data is beginning to indicate that the housing market is at the early stages of a long term recovery.  As you can see below, home prices have somewhat stabilized in 2012 and if this trend continues then we will see home building pick up as well.  And as you can imagine, if home building picks up then the big winners will be home building stocks.

<img src="/media/images/user_13467/case-shiller-aug-12_large.png" />

As we have already insinuated, we are expecting the demand for homes to increase and due to the lack of building over the past two years there is not enough supply to meet any increase in demand; thus home prices will increase.  As home prices increase we will see homebuilding firms increase production in order to take advantage of the higher prices.

Naysayers will quickly point out that there are thousands of homes up for foreclosure and if not for new regulations these homes would be on the market.  This is a great point, but we believe that as the unemployment rate decreases more home buyers will resume searching for their dream home as they get back to work.  In other words, we believe that the demand for homes will not only surpass the supply of new homes, but also the extra demand will surpass the amount of possible foreclosed homes as well.

Now to add walls

There is no shortage of home building stocks to choose from.  But the question is which stocks will outperform the market based upon new orders, backlog, and future deliveries.  It may be simple to assume that all home building stocks will be successful, but this is not the case.  The first time around we saw most home building stocks soar, but investors and traders have become cautious and will avoid falling into a greed trap.  The reason new orders are an important metric is simple; new orders are a forward looking measurement that can be used to estimate future revenues and income.  Similarly, backlog is important because a firm with a greater backlog (but not too large) indicates that homes are ready to be bought and will more quickly be recorded as revenue and income.

The first stock that deserves attention is Toll Brothers (NYSE: TOL).  No matter which way you slice the pie, Toll Brothers has bounced off the bottom and will head higher.  Many investors and market spectators have watched the stock rally 48% over the past 12 months.  This is mainly due to impressive improvement in operations on a year over year basis.

<img src="/media/images/user_13467/toll-b_large.png" />

As you can see above Toll Brothers’ backlog, deliveries, and new orders slumped after the housing bubble popped and are now recovering.  Obviously the slide from 2005-2010 is of concern, but we are expecting to see all three metrics increase year over year for at least the next three years.  On the other hand, it is important to note that we do not expect to see the same growth rate that we witnessed during the first half of the 2000s.

Another homebuilding stock that investors should take a serious look at for long term growth is PulteGroup (NYSE: PHM).  PulteGroup is very similar to Toll Brothers operational wise, however PulteGroup’s stock is up about 160% over the past 12 months.  The reason for this is that PulteGroup did not have a stellar 2011.  Therefore the stock did not begin to perform well until 2012.  Even after the first three quarters of PulteGroup’s fiscal year, new orders are about equal to all of 2011.  Also, PulteGroup’s backlog is about 100% higher than the end of 2011.  This indicates that PulteGroup is not only taking new orders, but building new homes as well.

We are also expecting PulteGroup to produce about $300 million on $5 billion of revenue in 2012.  This will be the first profitable year for PulteGroup since 2006.  On the other hand, revenue will end up lower than over a decade ago; which further indicates that home prices are still low and demand has not reached critical levels.

A third and possibly the most intriguing stock of the bunch is Hovnanian (NYSE: HOV).  The reason for this intrigue is the fact that in 2005 the stock price sat at the $70 per share level.  And after you compare this to the current $5 per share level then it is easy to daydream of a once in a decade rally.  Even six years ago the stock was seven times higher than its current level.

Hovnanian’s recent 230% rally over the past 12 months is due to similar reasons as PulteGroup.  In 2011 the firm did not perform up to par with other home building stocks such as Lennar (NYSE: LEN) and Toll Brothers, but in 2012 everything has clicked.  We are expecting to see Hovnanian report earnings of $18 million on $1.4-$1.5 billion of revenue for the fiscal year 2012.  More importantly, Hovnanian’s backlog and deliveries will or already have surpassed 2011 levels.

If you are looking for a steadier home building stock then Lennar is the stock to buy.  Lennar’s strength is consistent with that of a company that is beginning a new growth phase.  Also, Lennar’s lower volatility risk makes the stock a less risky investment when compared to Hovnanian.  The reason for this is simple.  Since Hovnanian is a smaller firm any slight weakness is magnified as opposed to a very large firm that can hide weakness if one small portion of business is weak.

Lennar’s growth is a near mirror image when compared to Toll Brothers.  Therefore there is no need to go into an incredible amount of detail.  However, it is important to note that new orders through the first nine months of Lennar’s fiscal year are the highest since 2008.  We are expecting to see new orders eclipse that of 2008 but fall well short of years 2002-2007.  We are excited to see new orders building up because this indicates that the demand for new homes is increasing which will help home prices recover and allow current homeowners to sell at some point in their life.

<img src="/media/images/user_13467/len-new-order_large.png" />

But what if it rains?

While we are bullish about homebuilding stocks, there are plenty of concerns that need to be addressed.  While it is a fact that housing starts and home prices are up, home prices are lower than two years ago.  As you can see from the table below, home prices bounced off the 2009 lows and were unable to sustain those gains.  More importantly, the longer term trend for home prices is negative and we have not seen the necessary support to make us feel 100% confident that we are in the midst of a long term uptrend.

<img src="/media/images/user_13467/sp-case-shiller-aug-12-2_large.png" />

If in fact home prices are unable to hold the current gains then most home building stocks will take a beating.  We believe that the rally in the home building sector is due mostly in part to the increase in home prices and new orders.  The truth is we will just have to wait and see.  But the good news is that many real estate professionals are reporting to us that they have received more business recently and this is a good indication that the housing market is improving at the retail level.   

sbeefyk1 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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