Though the fundamentals are intact, interest rate jitters are enough to lead to iffy performances, especially for low-end builders
Over the last two years, consumers have looked to houses for financial, as well as physical, security. Superlow interest rates made home-buying extra appealing, and the demand kept homebuilders' stocks looking solid. The sector has had several minor pullbacks, but its climb over the past two years has been otherwise steady, rising 45% Yet in the last three months, the homebuilders have dipped close to 10%, and this time it may not be just another bump. Many believe this share-price decline will be steeper and more enduring. As the rate of job growth finally picks up and other data continue to point to economic strength, the market is factoring in higher interest rates sooner rather than later.
That prospect is bad news for homebuilders. "There's limited upside potential in the stocks," says Paul Puryear, analyst at Raymond James. On May 11, he cut his rating to reduce on the eight homebuilders he covers, down from seven strong buys and one buy.
TREND ANALYSIS. A negative call on homebuilding stocks hasn't been an easy one to make, since the housing sector has enjoyed such a stellar run despite all the uncertainties following the start of the nation's economic downturn in 2000. And analysts are quick to point out that earnings growth for the sector should remain healthy for some time.
"From our vantage point, we still see another good year in housing and probably a reasonably strong year next year," says Puryear. However, he still believes that "the market sentiment and impact of interest rates will hold the stocks back."
Recent Standard & Poor's research shows that once the Federal Reserve starts raising rates, homebuilder stocks begin to suffer. Since 1970, the Fed has been on a tightening course for six periods. Looking over those periods, homebuilders fell well short of overall market performance. Six months after rate hikes started, the sector's stocks declined an average of 19%, compared with a 5% decline for the benchmark S&P 500-stock index. Twelve months later, the sector was down 22%, while the S&P 500 was down 6%.
HARDEST HIT. If history is any guide, the stocks will likely fetch lower valuations going forward. As mortgage rates have inched higher over the past year, valuations for the sector have already contracted �- down from 9 times forward earnings to about 7.
"I'm still forecasting earnings improvements for all the big builders I follow through 2005," says S&P analyst Mike Jaffe. But historically, when interest rates start to move up, homebuilder stocks underperform the market. "Investors shrink the multiples they're willing to pay for them," Jaffe says. (He doesn't own shares in the stocks he covers. S&P or an affiliate may have relationships with the companies.)
Some homebuilders will suffer more than others from higher rates. Jaffe slashed his sector view to negative and reduced specific ratings on the stocks he covers. The worst of the downgrades went to KB Home (KBH ) and Centex (CTX ), which were cut to sell, on concerns that their focus on selling homes to the lower end of the market exposes them more to an interest-rate-sensitive customer.
CASH AT HAND. And builders of luxury homes could fare better than the rest. Despite his view that stocks in the sector could struggle over the next two to three years, Puryear still has outperform ratings on builders who cater to the higher end of the market. Of the companies he covers, WCI Communities (WCI ) makes the most expensive houses and is a big player in Florida �- still an attractive market. Toll Brothers (TOL ) builds homes in the $500,000 to $600,000 range. (Raymond James expects to receive fees from Dominion Homes (DHOM ), WCI, and Toll Brothers in the next three months.)
Pulte Homes (PHM ) is diversified across all price points and caters to the so-called active-adult segment �- recent retirees who generally have the means to pay cash for their homes. Puryear rates the stock outperform and figures it can rise to his target of $57, up from a recent trading price of $47.
Jaffe agrees that Pulte, which he cut to hold, along with Lennar (LEN) could fare better than other homebuilders because of their focus on those heading toward retirement. "If rates are sky-high, [these buyers] are able to pay cash. They're less affected by rates."
MINIMAL IMPACT? The long-term bulls still argue that rising rates aren't the blow the market fears they'll be. With baby boomers seeking homes in sunnier climes and first-time home-buying starting at a younger age, demographic trends help make the sector less cyclical, says Duane Roberts, portfolio manager at Dana Investment Advisors, in Brookfield, Wis.
"We think the impact [of higher rates] will be really minimal," Roberts says. His firm still owns D.R. Horton (DHI ) but is staying away from the very low end of the market -- companies like Champion Enterprises (CHB ) and Palm Harbor Homes (PHHM ), makers of pre-fab homes. (Roberts doesn't personally own the stocks. His firm also owns Pulte Homes and MDC Holdings MDC .)
Certainly, strong demand should keep earnings growth on course. But the specter of higher rates alone could move homebuilding stocks out of the star performer ranks and into the so-so group over the next year.
