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This Homebuilder Stock is Firing on All Cylinders

Housing-related stocks can be volatile. The current volatility seems to stem from investor worries over the direction of interest rates—much more than concerns on corporate earnings. Those worries were alleviated again this week, as the Federal Reserve backed away from previous intentions of raising the Fed funds rate three times in 2016. Inflation pressure just doesn’t exist at levels needed to push interest rates higher.

By the way, don’t miss this fascinating chart, which details how many times Fed Chairman Janet Yellen used the words “global,” “China,” and “dollar” in her four most recent economic outlook speeches, dating back to May 2015. She apparently referred to those influences to Fed strategy four, five, seven, and then 21 times.

Personally, I’m wondering if the big recent change in Yellen’s phraseology has to do with embarrassment over the Fed’s confusion, inaction and missteps on dealing with interest rates during that time period, or if it’s an Obama administration set-up to get people to focus on “the global economy” in order to shore up waning support for the Trans-Pacific Partnership trade agreement.

Either way, I’ll continue to put on blinders to peripheral economic data, and focus on actual company-specific earnings results and projections. In that light, my experience shows me that homebuilder earnings trends and quarterly results don’t tend to be volatile at all.

A Homebuilder Stock that’s Firing on All Cylinders

Toll Brothers (TOL) is the leading U.S. luxury homebuilder, with a presence in 20 states throughout the U.S. The company delivered 5,525 homes in 2015, and expects to deliver between 5,600-6,600 homes in 2016.

Here’s a March 2016 MarketWatch article comparing homebuilder stock valuations in 2015 and 2016, showing that these stocks are much cheaper than they were a year ago. Toll Brothers’ stock ranks second-highest in most categories.

Toll Brothers has rising revenues, backlog, gross margins and earnings per share (EPS).

When I analyze stocks, I look for growth and value and bullish charts.

The first thing I look at is Wall Street’s consensus EPS expectations for the coming years. (I ignore quarterly numbers, because they don’t correlate with the stock’s potential success, like full-year numbers do.) I want to see EPS rising 15% or more, this year and next year—the number can be a little lower if the stock pays a dividend.

No Better Predictor of a Stock’s Success

The icing on the cake will be an upward trend in analysts’ earnings revisions. From my experience, there is no better predictor of a stock’s success—its ability to deliver capital gains to investors—than strong annual earnings growth.

Analysts’ 2016 and 17 earnings estimates for Toll Brothers have been steadily inching upwards since the company completed its 2015 fiscal year in October 2015. Consensus EPS estimates now reflect growth of 32.0% and 16.9% in 2016 and 2017.

Those are tremendously attractive earnings growth figures, but the story gets better. The price/earnings ratios (P/E) are very low in comparison to EPS growth. 2016 and 2017 P/Es are currently 11.3 and 9.6.

The two-year P/E range has been 16–22. (The longer-term EPS pattern contains too much fluctuation from which to derive a predictable pattern in the P/Es.)

TOL does not pay a dividend.

Toll Brothers’ 2015 long-term debt-to-capitalization ratio was a little higher than I would prefer, at 47%, but that’s certainly not problematic.

TOL peaked in July 2005 at 57. Fast forward to recent years ... After trading sideways for three years, the stock had an upside breakout last August, and had just begun reaching 10-year highs when the recent round of stock market corrections pulled the price down from a 2015 high of 42.19 to a 2016 low of 23.75. Fortunately, the stock market has experienced a significant turnaround, and TOL is now climbing.

tol chart

Could Deliver a 16% Short-Term Capital Gain

Barring unforeseen bad news, the stock could climb to 34 relatively easily, giving new investors a potential 16% short-term capital gain. After TOL rests a bit, the next upside price resistance is at 38.

I believe homebuilder stocks have immediate growth potential, and I would buy now. However, you never know when a few consecutive down days in the market will appear. Such a scenario could pull TOL down to 27.50, at which point I’d urge investors to buy shares with a very strong expectation that the stock will resume its uptrend in short order.

TOL is an undervalued, mid-cap growth stock. Institutions own 79% of the stock, indicating that TOL is attractive to professional investors.

Toll Brothers shares can appeal to risk-tolerant stock investors who are looking for above-market capital gains. I expect the stock to reward traders with a two-month timeframe, and investors who have a two-year timeframe.

Rating: Buy.

Happy Investing,

crista huff

Crista Huff

Chief Analyst, Smart Investing in Turbulent Times

Crista Huff is the lead analyst of Cabot Undervalued Stocks Advisor, where she combines a strict fundamental methodology with technical analysis, to identify growth and value stocks whose charts are turning bullish.