Why Pigs Will Get Slaughtered in Homebuilder Stocks

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Cyclical stocks are the toughest to call, since they rely on multiyear cycles of upturns and downturns. Rising employment, home prices, and low rates are fueling a rebound in American home prices. In some areas, real estate is so supply-constrained that bidding wars are back. Look at Phoenix, for example.

What's good for homeowners might not be so good for investors. Companies like Toll Brothers, D.R. Horton, Ryland Group, and Lennar have surged since the start of 2012, but for long-term investors, the industry presents little opportunity.

<img src="http://media.ycharts.com/charts/1dd1dee50b5f4fb16b402ca0bc00d6c6.png" />

TOL data by YCharts

Why shy on home building

Much like airlines, homebuilding stocks offer short-term opportunity when supply is constrained, but below-average return on invested capital over the long haul.

Take, for example, Toll Brothers (NYSE: TOL), which builds and markets homes. Underlying conditions have improved, driving the stock higher by 57% since 2011. On average, however, the company generates a poor return on its investment capital. Since 2004, Toll Brothers maintained an average returns on invested capital of 3.6%. One should expect those low returns to continue.

Part of the problem is the business model of homebuilding. In the most recent annual report, Toll Brothers indicated that it had more than $1 billion in inventory, consisting of land it intended to develop in the future. Land is one of the worst investments, given that it is cash flow-negative and difficult to sell, dragging down Toll Brothers' ability to compound your money.

Investors should be sure to note that Toll Brothers isn't the only low-return laggard. D.R. Horton (NYSE: DHI) managed only 1.4% returns on invested capital over the past 10years, while competitor Ryland Group (NYSE: RYL) scored relatively high (but still horribly low) returns on invested capital of 3% per year. Those who believe stock prices should be reflective of the fundamentals would expect homebuilders to trade well below book value given their low asset returns. They don't.

Hide from the pork cycle

The below-average returns on capital for home builders can be explained with a very simple economic concept called the pork cycle. Economist Mordecai Ezekiel observed multi-year trends in pork production, resulting from cyclical shifts in supply in response to prices. Every few years, pork would be in tight supply, resulting in higher prices. The next year, farmers would raise more pigs after noticing the previous years' undersupply and high prices.

Predictably, so many farmers would rush to fix and profit from an undersupply of pigs that the result would be an oversupply, leading to rapidly falling prices.

The same effect can apply to housing, which is a relative commodity. In the boom years, homebuilders enjoy above-average returns on capital as they fail to keep up with demand and high prices. When boom turns to bust, however, homebuilders are caught holding the bag from too much supply and too-low prices.

Over time, homebuilders only earn normal economic profits, and deliver very low returns for investors. Those who wish to speculate on a short-term bump in housing should look for companies that are not entirely exposed to homebuilding.

Home Depot (NYSE: HD) is correlated to housing, but its year isn't made or broken entirely by new construction. The company sports a reasonable forward earnings multiple of 15, and an impressive ability to generate economic returns on capital. The company earned an average of 14.1% on every dollar invested in its business over the last ten years.

Similarly, Bed Bath & Beyond (NASDAQ: BBBY) trades at 11 times forward earnings, and has a decade of earnings more than 20% on its invested capital, having dropped below 20% in only two years in the past 10, 2008 and 2009. This debt-free retailer doesn't need to risk itself with leverage to generate high returns for its shareholders.

Invest more intelligently. While Home Depot and Bed Bath & Beyond will rise on any boost in homebuilding, both stocks have a track record of excellent profits even when housing isn't so hot. Take the safe bet with best-in-class returns on capital, you'll thank yourself when another housing bust shows up to bite overly aggressive investors.

valuemagnet has no position in any stocks mentioned. The Motley Fool recommends Bed Bath & Beyond and Home Depot. 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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