Homebuilding Stocks: Be Greedy When Others Are Fearful

Homebuilding stocks have fallen by more than 40% in the past 12 months. Major housing indicators are down and trending lower; the Commerce Department reported that July housing starts and building permits were down 13% and 20% from a year ago. Even homebuilding executives, a cheery lot just a year ago, have suddenly become gloomy. According to the National Association of Homebuilders (NAHB), a survey of homebuilder sentiment reached its lowest level since February 1991 this August.

So why are we pounding the table for homebuilding stocks? In short, some homebuilders are well positioned to survive this housing downturn, and current share prices reflect a doomsday scenario that's unlikely to happen.

Our Approach
We don't spend much time trying to predict the direction of the housing market. For starters, there's no such thing as a national housing market; the market can be divided into distinct geographic regions, each moving in different directions. For instance, even as some homeowners in California and Florida saw their homes appreciate by double-digit rates in the last few years, price appreciation for homes in the Midwest in general barely beat inflation. Thus,  M/I Homes (MHO), with a strong Midwestern presence, earned an average 23% gross margin the last five years, while  Centex Homes , with operations in more than 90 markets in 26 states, earned more than 26% in the same period.

Then there are the customer segments catering to the different demographics--entry-level, first move-up, second move-up, active adult, and luxury. Predicting how key economic drivers affect the different demographics is an inexact science; rising mortgage rates may shut out some entry-level customers, but higher-end customers may not be equally affected by the cost of financing, as they can afford to pay for their homes in cash or put down higher deposits. Not surprisingly,  Toll Brothers (TOL), which caters exclusively to high-end customers, has enjoyed the fattest gross margins in the industry in the past five years.

Even if we could accurately predict demand, we would be lost trying to gauge supply. By some estimates, about 75,000 builders are actively involved in the trade, and the top 20 account for nearly 30% of total single-family home sales. When the housing market slows, it's every builder for itself, and even earnest money deposits are no deterrent for opportunistic homebuyers. No wonder  WCI Communities'  cancellations have doubled to more than 30% in the past year, as potential homebuyers gave up their 5% deposits for, presumably, the 20% discounts around the corner.

We think all you need to know about market-timing can be found in this excerpt from Warren Buffett's 2004 letter to  Berkshire Hathaway's (BRK.B) shareholders: "Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

Key Criteria
Here's what we look for before buying a homebuilding stock. First, the balance sheet has to be pristine. We look at both the amount and type of debt: a high proportion of fixed debt and a low debt/total capital ratio (a measure of leverage) is a winning combination. We'd avoid homebuilders with too much variable debt, particularly when short-term interest rates are rising.

Second, we run through the land inventory account. Because the land approval process is becoming more difficult--thanks to stricter zoning laws and NIMBY (not in my back yard) movements--homebuilders have prudently invested in land for future development. Many own or option enough land to meet two to six years of future demand. We prefer builders with a higher proportion of optioned to owned land; options are cheaper and easier to walk away from or renegotiate. By contrast, creditors may force a fire sale on owned land.

Third, we favor builders operating in multiple geographic regions and serving multiple demographics. We believe such builders enjoy a natural hedge against regional economic downturns and trends within the different demographic segments.

Finally, we scrutinize management biographies; among other things, we want to know whether they've survived a past housing downturn, and if they own a big chunk of the company.

Our Picks
We like the prospects for luxury homebuilder Toll Brothers. The company is the only large builder operating exclusively in the high-end market and is poised to profit from the growing ranks of the affluent and the estimated 76 million baby boomers. The number of wealthy households--those earning more than $100,000--is rising 3 times faster than households overall, and boomers are in their peak earning years. Additionally, Toll Brothers has operated for years in the affluent, land-restricted communities where land entitlement is toughest; few have the legal and political savvy to challenge it on this turf.

At the other end of the customer spectrum is  DR Horton (DHI), which fancies itself the  Wal-Mart (WMT) of homebuilding. DR Horton has grown into the largest homebuilder by units by catering to value-conscious entry-level and first move-up buyers. In the process, the company has gained unmatched economies of scale in operations and materials procurement. After establishing itself in a major market, DR Horton fans out into smaller satellite markets using its established infrastructure at the regional hub. Even as the overall market slows, DR Horton can keep growing by taking market share from smaller regional builders.

Success in homebuilding depends largely on the ability to procure land in fast-growing regions. Few homebuilders match  Lennar Homes'  (LEN) expertise in land development. The company keeps land procurement separate from construction, and managers are measured by returns on capital invested in each activity. Moreover, Lennar can take on bigger projects than rivals by tapping into the deep pockets of its long-term joint-venture partners. For example, in 2003 the company contributed just 20% of the $1 billion investment to buy the 34,000-acre Newhall Ranch in the potentially lucrative north Los Angeles market.

Centex Homes and  Pulte Homes (PHM) not only operate in multiple regions, they hedge their bets further by serving different customer segments. As a result, Centex and Pulte have the flexibility to allocate their capital where it earns its highest return.

Stocks to Avoid
Not all homebuilders are created equal, though. Even though it's the sixth-largest builder in the nation,  Beazer Homes' (BZH) returns on capital (about 15% on average the last five years) are significantly lower than peers. The company is regionally diversified but doesn't have a dominant presence in its markets, reducing any potential leverage from spreading costs over more units.

  NVR's (NVR) narrow geographic focus counts against it; the Washington and Baltimore metro areas account for 40% of unit home sales. Additionally, we are not fans of the company's egregious stock options plan--NVR's stock options have accounted for nearly 20% of total diluted shares outstanding in the recent past.

We think WCI's rising cancellations are a looming threat to the balance sheet. The company finances its tower homes with a line of credit and pays down debt as homes close. Even though buyers give up their 5%-20% deposits when they cancel their orders, WCI is stuck with the balance of the purchase price and unsold units.