Bargains in Homebuilders

There's nothing like yet another dismal report on the sorry state of the nation's housing market to dampen investors' enthusiasm.

Stocks retreated from record territory on October 2 as traders digested news that pending home sales -- deals under contract but not yet closed -- fell to record lows in August, presaging at least another couple of months of disappointing home-sales figures. The Dow Jones industrial average fell 40 points, or 0.3%, to close at 14,047.

The incessant drumbeat of negative housing news begs a question -- especially for straw-hat-in-winter types who love to sniff out bargains at times when the demand should seem to be lowest: Is it time to invest in the stocks of beleaguered homebuilders?

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Clearly, the answer for some investors is, "You betcha." Builder stocks rose on October 2 for the second-straight day -- first running with the bulls, then bucking the overall downtrend.

Citigroup provided a catalyst for the rally, upgrading the homebuilding group on October 1. Analyst Stephen Kim said he was under no illusions about an imminent turnaround in housing per se but reminded investors that "it is precisely when things have gotten this bad that the stocks start looking good."

Among the sector's big gainers on October 2: Beazer Homes (symbol BZH) soared 12%, gaining $1.04 to close at $9.44; Meritage Homes (MTH) advanced $1.50, or 10%, to $16.19; Ryland Group (RYL) logged 8%, up $1.88; to $24.44. Toll Brothers (TOL) jumped $1.57, or 8%, to $22.22; Hovnanian Enterprises (HOV) added 89 cents, or 8%, to $12.50; D.R. Horton (DHI) climbed 88 cents, or 6.5%, to $14.34; Standard Pacific (SPF) rose 34 cents, or 6%, to $5.87 and Lennar Corp. (LEN) gained $1.45, or 6 %, to close at $24.72.

Flash back just a couple of days, however, and there's no arguing that things had gotten pretty bad. Since peaking in the summer of 2005, the stocks have been in virtual free fall, declining 71%, on average. Within the group, NVR, which focuses on Maryland and other eastern states, is down "just" 50%, while Standard Pacific, with a heavy concentration in hard-hit Florida and California, is down 90%.

Before the recent bounce, homebuilders as a group had dropped 40% just since late June. "You should smell opportunity with that kind of pessimism," says Doug Ramsey, a senior researcher at the Leuthold Group. He doesn't -- at least not yet -- and we'll tell you why later.

But Citigroup's Kim makes a persuasive case that the dawn must be approaching for homebuilders simply because it's hard to see how things could get much darker. In fact, he sees a lot of similarities between this market and the housing collapse that ran from 1987 through 1990.

Housing starts, existing home sales and new-home sales have all now declined by roughly the same amount that they had in late 1990, when homebuilding stocks bottomed. The stocks themselves have declined by similar amounts -- roughly 70% -- although it took nearly four years for stocks to bottom after the 1987 housing peak, while this time around they've achieved a similar loss in just two years.

Moreover, says Kim, over the past 30 years, homebuilders have never traded at a lower ratio of stock price to book value (assets minus liabilities). That's more than enough to compensate for the further write-down of assets that Kim says is coming.

Says analyst Josh Spencer at T. Rowe Price, whose mutual funds own a "fair amount" of homebuilders and are adding to positions now: "If people want to give 'em to me at this price, I'll take 'em."

But Leuthold Group's Ramsey isn't tempted by the seeming bargains. The "valuation mirage" will disappear as struggling home builders end up writing down unsold assets -- mostly land -- to the tune of 25% to 30% of book value industrywide, he predicts. No doubt, "sometime in the next six to 18 months, homebuilders will be the best contrarian bet in the market," says Ramsey. "I just don't think this is the bottom yet."

The problem, of course, is that no one announces when the bottom has been reached. And you can't tell by looking at the health of the housing market because the stocks will turn up well in advance -- if history is a guide, some three to five months in advance of an upturn in housing starts. When the turn comes, it comes fast, and the rallies are powerful.

Consider: new-home sales, housing starts and existing home sales all bottomed in January of 1991. By the time those reports came out in March, the homebuilding group had already doubled.

The surest sign of a bottom? Not lower interest rates, or political proposals to circumvent foreclosures. Instead, look for a convincing decline in the inventory of unsold homes -- now at some 4.6 million homes and condos, at a ten-month supply. Getting back to a more normal four-month supply will simply take time.

Meanwhile, what can you do if you're afraid of getting hammered by further losses on the one hand and afraid of missing the beginning of the comeback on the other? The better part of valor in this case is to look for building companies that can withstand the current storm and emerge in a better position than their peers. Avoid small-cap builders with a taste for leverage in favor of their larger, more diversified brethren with the strongest balance sheets.

Citi says only speculators should dabble in the stocks of Beazer Homes, Hovnanian and Standard Pacific because of lingering concerns about debt levels and concentrations in hot (make that formerly hot) markets. But while Standard Pacific still rates a "buy" from Citi, it gets a "sell" from UBS analyst David Goldberg, who says the company faces higher land-related charges than its peers on account of a major geographic expansion over the last decade.

Fact is, even among analysts who agree that it's time to venture into this risky area, there is little agreement on which homebuilder to buy. Centex, which gained a mere 3.8%, to $28.98, on October 2, is among the few candidates with something of a bullish consensus behind it, rating "buys" from both Citi and UBS. Through June, the total lot count at Centex was down 49% from the peak, while the group's average inventory reduction was just 37%. And Centex is addressing affordability constraints with smaller, less amenity-packed houses.

Investors who measure their stock holding periods in years may well find some great bargains in homebuilders now. Ditto those who measure their holdings in months, as the group is surely due for a bounce over the coming months. But whether that's a bounce on the way to even lower lows, or new highs, is anyone's guess. For those with holding periods in between, beware.