Personally, I tend to do more top-down style investing since that suits my preference. But that does lend itself to looking at sectors and I like to look at values while doing that. I noticed today that homebuilders seem surprisingly well positioned after a decent pullback from an earlier upward run.
You can look at the sector here courtesy of Finviz
- Average P/E ratio of the top 20 largest builders is just below 12. That’s absurdly low in today’s expensive markets. By itself however, P/E is not a good thing to look at, but other metrics also support the strong valuations.
- Accounting for past growth, the PEG ratio is also absurdly low, at 1.4
- Debt for these companies is all relatively low. Balance sheets seem in good shape for the most part (but varies company to company)
The Macro Environment
- Homebuilders tend to perform best when inflation growth is slowing, but overall growth is still strong.
- That’s right where we are at right now, and we are pivoting from reflation into more of the goldilocks environment where inflation is falling off a peak, and will be mean reverting for the next 1-2 quarters. I tend to think that some of the recent consolidation is partially a product of fears of margins getting cut into due to rising input costs (lumber, construction materials, labor, etc)
- Obviously, demand is quite strong and supply is super limited in homes right now as most people are already aware. This will eventually work its way out, but part of the solution is literally building more homes. I honestly would have thought that these companies would have been priced higher given how well-known the housing shortage is.
- Millenials moving to homes & starting families is a secular trend that will likely be a component of the next 5-10 years. Maybe not an immediate catalyst, but should be good as a sector tailwind for quite some time.
- The items that are causing a lot of the inflation right now are a product of supply shocks caused by Covid lockdowns. These items such as lumber will not stay high since lumber mills and timber companies have every incentive in the world to ramp up production given the high prices they can get from selling their goods. Same is true for most other sectors.
- Zooming out over a long time frame, please look at the chart of New Privately-Owned Housing Units Started from the Federal Reserve. Note how low this has been over the last 10 years, and the fact that we’re only now back at where we were in 1998. In short, we’ve been seeing a significant buildup of housing shortages over the last 10 years, and are only now getting back to producing in any meaningful way. So long as we have a shortage, prices will be high, and so long as prices are high, margins will be great for homebuilders and they will be encouraged to keep building.
Mispricing Cyclical Risk?
While there is never any way to prove these things, I tend to believe that the consensus view on homebuilders right now is that they’re priced as if the cycle will turn for them. After all, cyclicals are usually the most expensive when their P/E ratios are cheap.
Inflation has surged over the last year, and home prices have gotten quite expensive. Higher prices have led to a relative softening of demand, although nothing outrageous. Furthermore, the stock price on homebuilders has already surged since the Covid bottom.
That being said, I don’t think think the rise is over yet. Thing is, mortgage rates have not meaningfully risen, and even been falling in the last few months – see chart here. And I think the inflation view is going to lose steam in the next 3-4 months, which will act as a tailwind for homebuying until it starts to kick back in.
Also, while stimulus isn’t going to be reaching consumers going forward, we should see that offset by a reduction in supply chain associated inflation costs.
In short, I think that the cyclical view of homebuilders is linked to the cyclical view on inflation, which is a linear extrapolation that I think is incorrect.
Obviously there are some risks, some more on an individual company level, which vary.
- I would say that there could be some issues if and when eviction moratoriums start to rise and homeowners are allowed to default on their loans. IE, when the government protection backstopping credit in this industry finally rolls off, there may be some negativity.
- Homebuilders do tend to be somewhat cyclical, although I don’t really think we’re at the point that there would be risks here. Typically the cyclical risk from homebuilders can come from rising interest rates, which I don’t think is something to really think about for another 2-3 years, and even then, builders don’t always respond negatively to rising rates.
- As many in this thread have pointed out, Homebuilders are somewhat cyclical, and cheap p/e’s are often cheap because the cycle is about to turn. With that said, I think this is where the consensus view is quite wrong as they’re just extrapolating the recent inflation moves into the future at the same rate. I’m rather confident this won’t be the case (of course you can never be sure however).
- Stimulus programs + covid lifestyle changes likely did fuel some demand for purchasing new homes, which obviously won’t be a part of things looking forward.
- Rising home prices *could* cool demand, which would cut into profits due to lower housing starts even if margins keep rising due to increased prices.
With that said, homeowner balance sheets have completely reversed since the GFC and that goes for really the industry as a whole. I blame this on PTSD from the financial crisis causing people to focus on de-risking anything relating to homebuilding, mortgages, and real estate.
- Great current valuation by almost every metric you would use to value a company
- Great growth prospects on both a short term and long term basis (helps to avoid value traps)
- Strong balance sheets reduce risk
- Favorable macro tailwinds on both a short term and long term basis
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.