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At Long Last, Sustained Signs of a Housing Rebound

An ETF for those investors bold enough to take a flier on the exuberant homebuilding sector.

Robert Goldsborough, 09/28/2012

Each new week, it seems, brings more good news to the beleaguered United States housing sector, in the form of a wave of economic reports showing improving housing prices and growing numbers of housing starts. Most recently, the S&P/Case-Shiller 20-City Composite Index showed rising U.S. home prices again during the month of July. For four consecutive months now, home prices broadly have risen, and for three straight months, every one of the 20 cities included in that index registered housing price increases.

At the start of the year, Morningstar's director of economic analysis Bob Johnson, CFA, made the case that the housing market would see "meaningful improvement" in 2012, although he cautioned, "it might be a second-half story." The growing numbers of positive reports on housing suggest that that is precisely how the housing story is playing out. More recently, Bob has stated that "the strength in the housing recovery has been building for most of 2012 but has yet to have much of an impact on overall economic activity. I think that will change in the second half as existing homes purchased in the first half are remodeled and furnished."

Now, a consensus has formed among economists that the housing sector, which previously during the recovery has seen prices rise in fits and starts only to fall back to new lows, is in the midst of a sustained recovery at long last. Economists and analysts have noted a raft of positive data coming in in recent months across all areas of the housing sector, including rising sales of existing homes, fewer house foreclosures, rising sales of existing homes, and improved activity in new home construction, in the form of strong housing start numbers.

As is often the case, investors saw the improving signs in the housing sector well before the numbers were posted, with investors bidding up the shares of all homebuilding stocks far in excess of the broader market. For example, DR Horton DHI has returned 73% since the start of the year, while Lennar Corporation LEN has returned 85%, M.D.C. Holdings MDC has returned a jaw-dropping 129%, and PulteGroup PHM has returned a stupefying 154%.

As homebuilders' shares have surged, investors should review their own margins of safety to determine whether homebuilding companies have more value left in them. For those interested in investing in the homebuilding sector, an exchange-traded fund is an ideal way to hold a broad basket of the U.S.' largest homebuilders. For such investors, iShares Dow Jones U.S. Home Construction ITB likely is the best option. The fund is suitable only as a complementary satellite holding in a diversified portfolio. The average market capitalization of a company in ITB is about $4 billion. Investors should take note that the housing sector is highly cyclical and quite sensitive to economic and credit conditions.

Aside from homebuilders (which account for about 65% of total assets), this fund also holds building-materials and fixtures producers (17%), home-improvement retailers (13%), and furniture companies (5%). This fund contains 27 companies and is fairly top-heavy, with the top-10 holdings accounting for more than 64% of total assets.

Fundamental View
The bursting of the housing bubble, the accompanying credit crisis, and the economic downturn have devastated homebuilders and the broader housing industry. Although all the recent positive data would suggest the sky's the limit for homebuilders, there's always a risk of frothy valuations. Plus, despite all the rosy data and mortgage rates remaining at record lows, there are some danger signs that could hamper homebuilders going forward, such as a huge inventory of foreclosed homes on the market at distressed prices and lending standards much tighter than a few years ago. Given the lousy job market, high housing inventory, and a sea of foreclosures, it's reasonable for an investor to wonder whether homebuilding stocks have gotten ahead of themselves, given their recent rally.

By aggressively reducing inventory and ratcheting back on developments, many of the large homebuilders now are sitting on piles of cash, despite the heavy losses they have taken in recent years. They have also downsized their organizations to better align their cost structures for a lower-demand environment. During the past few years of weakness, many private homebuilding companies have gone bust, and even the stronger publicly traded firms have written off half or more of their book equity since the peak. But the homebuilders that survived are now standing on more-stable financial ground. Thanks to stimulus-related initiatives from 2009, such as the first-time homebuyers credit and longer tax-loss carrybacks for U.S. corporations, homebuilders have been able to improve their businesses and their balance sheets over the past few years.

Robert Goldsborough is an ETF Analyst at Morningstar.
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