It may seem like the worst time to invest in homebuilder stocks. Demand for new houses is slumping as elevated home prices, high interest rates and a slowing economy make affordability the worst in nearly 40 years. New single-family housing starts, a primary indicator of future demand, have tumbled by 20% from a year ago. And, with most forecasters calling for a recession in 2023, demand appears poised to weaken further.
And, many homebuilders’ shares don’t appear to fully reflect the darkening outlook. The SPDR S&P Homebuilders ETF (XHB) has slipped only about 28% from its late-2021 peak yet remains 25% above its pre-pandemic level. It would seem that the shares have a long way to slide as conditions weaken.
But, homebuilders’ shares offer considerable appeal to value investors. First, the fate of housing is by no means assured. Predicting the future path of the economy is a low-success-rate endeavor – and investing based on economic forecasts, especially when so many investors share the same worries, holds little merit.
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Second, while year-over-year statistics suggest that demand for new homes is evaporating, it is being compared to the surge in demand following the pandemic. Current demand is actually in line with the typical level of demand in the three years prior to the pandemic – hardly the collapse that is commonly cited. And, as the population continues to grow, new families will continue to move to new houses. While the direction of near-term demand is uncertain, the longer-term underlying demand for new homes would seem to have a floor roughly around the current level.
Critically, current valuations of many homebuilder stocks are attractive, as they trade at or below tangible book value (P/TBV), our primary homebuilder valuation tool. As homebuilder profits are highly cyclical, earnings-based valuations are less reliable. The P/TBV metric takes advantage of the clarity provided by these companies’ balance sheets. Most of their assets are cash, homes inventory (homes under construction) and land inventory (for future homebuilding). These are recorded at cost, and given the relatively rapid turnover, are closely linked to market values. We ignore intangible assets as these can have murkier value. Netting out the liabilities, this tangible book value approximates liquidation value and provides a useful gauge of a company’s underlying value. We consider a price/tangible book value of less than 1.0x to be a discounted valuation.
One risk comes from falling new home prices. But investors have two sources of protection that reduce this risk. First, home prices are declining following increases of as much as 25-50% over the past two years. And, homebuilder book values have a natural cushion against falling home prices. The home inventory goes on the books at cost, but the house is sold at mark-ups of 25% or more, leaving the post-sale book value at worst unchanged. Helping support future mark-ups is the rapidly declining cost of lumber, now down 73% from the pandemic surge and back to its long-term average.
While large-cap homebuilder stocks like Lennar (LEN) and D.R. Horton (DHI) trade at premiums to tangible book value, many mid-cap and small-cap homebuilders trade at sizeable discounts. One of our recommended stocks is a mid-cap homebuilder that has a solid management team, diversified geographic operations and a reputation for building houses in desirable neighborhoods and towns. Its small market cap keeps it off the radar of major investors (helping provide the bargain valuation of about 0.6x tangible book value) yet may make it attractive as a target of larger homebuilders if the industry sees another wave of consolidation.
The shares offer a sizeable fundamental and valuation margin for safety along with the opportunity for appreciation over the long term. Check out our two value investor publications to learn more about this and other attractive value stocks.
At Cabot Undervalued Stocks Advisor and the Cabot Turnaround Letter, we help investors navigate the equity markets using a common-sense value-oriented approach that emphasizes out-of-favor stocks of companies with real value. Let us help you sort through the market to find them.
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