Brian Bernard: Euphoric investor sentiment for homebuilder stocks in 2017 turned overwhelmingly negative in 2018 as high home prices, and rising interest rates gave way to softening housing data, including a significant drop in homebuilder sentiment recently. Based on recent data, it's easy to understand why a bullish housing narrative is being met with increasing skepticism. However, our fundamental-based approach to forecasting housing demand tells us that increased demand from millennials could still be a meaningful tailwind. That, along with homebuilders' increased willingness to build smaller, more affordable homes, could support elevated levels of new residential construction over the coming years.
If our housing demand forecast proves to be correct, U.S. homebuilders can look forward to annual housing starts reaching a peak of 1.6 million by 2022 (up from under 1.3 million in 2018) before moderating to a sustainable annual rate of below 1.5 million by 2027. However, we believe that consensus expectations are closer to our bear-case scenario, which assumes that housing starts are already at peak levels and will decline to a 1.1 million pace by 2027.
Four of the five U.S. homebuilders we cover--D.R. Horton, Lennar, PulteGroup, and Toll Brothers--are trading at attractive 4-star valuations. While we believe long-term investors will likely realize above-average returns for each of these four stocks, D.R. Horton is our top pick, and Lennar is a solid second choice. We think D.R. Horton is best positioned to benefit from increased demand from first-time buyers, and we like its conservative balance sheet. Lennar is also well positioned, and we like its emerging multifamily business. While Lennar's balance sheet is not as strong as D.R. Horton's, it has a wider margin of safety.