Three Stocks to Hinge on a Housing Market Recovery

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

To take home a positive return in the second half of 2012, investors must explore all prospects, even in the sluggish American housing market.  Through understanding its collapse and projecting its future, profitable investments can be had in the next 12-18 months.

Collapse

The decline in the health of the United States housing market was one of the earliest triggers of the recent financial crisis.  Centered in the subprime mortgage market, it is estimated that by 2004, a fifth of all outstanding mortgages in the U.S. were below prime in nature, more than twice the historical average.  A few major forces were the cause for ballooning subprime mortgage issuance in the U.S. during the early 2000s.  As economic prosperity blossomed in the developing world after the turn of the century, credit inherently became easier to obtain in all forms.  Known as a “credit boom,” it is during this time that lending institutions lowered their credit standards, specifically those pertaining to subprime borrowers.  Due to the fact that many of these borrowers were inexperienced in matters regarding the mortgage obtainment process, many were subject to predatory lending practices.  The combination of an increase in credit availability and predatory lending practices contributed to an over-issuance of loans to borrowers with the greatest potential for mortgage default and foreclosure.

An additional factor that must be mentioned is the increased popularity of adjustable-rate mortgages (ARMs) in comparison to fixed-rate mortgages. These instruments typically have a primary interest rate that borrowers pay for a small entry period, and a higher variable index rate that is calculated monthly thereafter.  In the hands of either inexperienced or seasoned borrowers, these instruments can be economically detrimental if higher future costs are not accounted for. 

Unfortunately, the possibility of decreasing home prices was not considered by most borrowers during this time period.  Put simply, most believed that a continual appreciation of their home would offset the higher costs of ARMs.  According to a study by the Mortgage Bankers Association, around 20 percent of all mortgages issued in 2003 were adjustable in nature.  By 2005, this figure increased to nearly 50 percent. 

Beginning in May of 2006, the S&P/Case-Shiller Home Price Index began to deflate.  Over the next ten months aggregate home prices fell by 6 percent, while mortgage defaults and foreclosures spiked across the nation.  Firms holding securities tied to these distressed mortgages experienced heavy losses, causing a dramatic decline in stock prices, and subsequently consumer wealth.  As the crisis deepened, unemployment worsened and economic output contracted.  In the battered housing market, measures of new home construction and existing home sales declined.

Future

The next 12-18 months is a crucial time for the recovery of the housing market, which potentially holds the greater fate of the U.S. economy in its grasp.  In 2011, the percentage of mortgages issued that were ARMs rested just under 10 percent.  An amount considerably lower than pre-crisis levels, this statistic signifies two things: that borrowers are demanding the safety of fixed-rate mortgages over more risky ARMs, and lenders are willing to issue fewer ARMs. Perhaps borrowers are also demanding fewer ARMs because most do not believe the future cost of such a mortgage will be offset by home value appreciation.  Looking forward, this can be taken as a positive sign that borrowers have a more realistic expectation of future home prices.

Further signaling a recovery is a slight improvement in the delinquency rate, which is simply the percentage of mortgages that are in default.  Typically measuring homeowners that are 90 days past due on their mortgage payments, this indicator is important to follow because it is a natural gauge of future foreclosure activity. 

Forecasts suggest that a decline in the delinquency rate to around 5 percent should occur by the end of 2012.  Although this is lower than the 6.89 percent seen during the height of the financial crisis, it is still significantly bloated when compared to pre-crisis levels that hovered around 2 percent.  However, any improvement in this rate indicates that foreclosure activity should fall, which would yet be another positive signal of revitalization.  Additionally, improvements in new home construction and existing home sales show genuine improvement in both the current state of housing, but in future prospects as well.

Three Stocks to Hinge on a Recovery

PulteGroup Inc.  (NYSE: PHM)  Although it is one of the largest builders of residential homes in the U.S., this firm has seen its shares lose roughly 70 percent of their value since 2007.  Trudging around $6 per share over the last year, shares of PHM are actually up 47.9 percent since January.  Boasting relatively low price-to-book (1.9X) and price-to-sales (0.8X) ratios, this stock looks undervalued.  The question is how much. 

True upside in PHM exists because demand of housing construction has already started to pick up.  Assuming that this indicator continues to improve through the summer, look for shares to reach above $10 per share in the short-term – a level not seen since early 2010.   In the long-run, a full earnings rebound to pre-crisis levels means that PHM could reach north of $30 per share.

D.R. Horton Inc.  (NYSE: DHI)  Another large builder of homes, D.R. Horton is an attractive investment for reasons similar to those mentioned above.  In the past three months, shares have appreciated almost 25 percent.  A significant characteristic of DHI is that it does not have debt – meaning the firm faces no interest expenses and more importantly, has not needed to finance growth through the issuance of debt.  Typically, companies with little or no debt have greater earnings stability – another good reason to choose DHI. 

In fact, the firm has had a positive earnings per share of 0.23 and 0.77 over the last two years – a period when most industry peers’ EPS were negative.  From a valuation standpoint, shares of DHI look fairly valued at the moment, with P/S and P/B ratios near 10-year historical and industry averages.

Lennar Corp.  (NYSE: LEN)  Lennar Corp. is another firm that specializes in residential homebuilding.  This type of stock has high upside even if a housing recovery is small.  During the crisis, Lennar focused on restructuring its business processes, in order to increase efficiency.  Additionally, overhead costs have been cut in half over the past few years.  These changes allow LEN to be in a better position to benefit from a healthy housing market than most of its industry peers.  The firm has also focused on reducing its debt significantly, and now has a modest debt-equity ratio of 1.2. 

Analyst estimates gathered from a number of sources also prefer this stock over its competitors, due to its history of consistent dividend payments, and its high percentage of insider holding.  If company executives hold over 75 percent of all shares of LEN, it can be reasonably assumed that they have enough incentive to provide shareholders with as much profit as possible.  With a PEG ratio near 1.0, shares of LEN are on the border of being undervalued.

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