Home Builders Are Hurting. Their Stocks Are Good Buys.

The housing market has been a rollercoaster ride in recent years, with home prices soaring and then cooling off. As a result, home builder stocks have taken a beating, with the SPDR S&P Homebuilders ETF (XHB) down 28% in 2022. However, despite the recent market downturn, there are several reasons why home builder stocks may be attractive for long-term investment.



First, many home builder stocks are currently trading at or below their tangible book value (P/TBV), which is a primary valuation tool for these companies. A P/TBV of less than 1.0x is considered a discounted valuation. For example, lennar (LEN) and D.R. Horton (DHI) are trading at premiums to tangible book value, but many mid-cap and small-cap homebuilders are trading at sizeable discounts. This indicates that these stocks may be undervalued and offer a margin of safety for investors.

Second, home builder profits are highly cyclical, making earnings-based valuations less reliable. However, the P/TBV metric takes advantage of the clarity provided by these companies' balance sheets. Most of their assets are cash, homes inventory, and land inventory, which are recorded at cost and closely linked to market values. This provides a useful gauge of a company's underlying value.

Third, home builder book values have a natural cushion against falling home prices. The home inventory goes on the books at cost, but the house is sold at mark-ups of 25% or more, leaving the post-sale book value at worst unchanged. Helping support future mark-ups is the rapidly declining cost of lumber, now down 73% from the pandemic surge and back to its long-term average.

Fourth, despite the recent downturn, the housing market has long-term growth potential. The U.S. has a massive undersupply of housing stock, and it will take years of building to match millennial new household formation and demand. Additionally, low mortgage rates, rising home ownership demand, and increased time spent at home are long-term trends that should enable the industry to continue growing.

Fifth, some home builders, like the recommended mid-cap homebuilder, have diversified geographic operations and a reputation for building houses in desirable neighborhoods and towns. This diversification helps mitigate risks associated with regional market fluctuations.

However, there are also risks associated with investing in home builder stocks at this time. High home prices and interest rates make affordability the worst in nearly 40 years, which could lead to a decrease in demand for new homes. Additionally, a slowing economy and potential recession could further weaken demand for new homes. Lastly, falling new home prices could lead to lower profits for homebuilders, as their book values are based on the sale price of homes.

To mitigate these risks, investors can consider the following strategies:

1. Focus on homebuilder stocks that are trading at or below tangible book value (P/TBV), as these companies may be undervalued and offer a margin of safety.
2. Diversify your portfolio by investing in a mix of homebuilder stocks with different market capitalizations, geographic operations, and product offerings. This can help reduce the impact of any single company's underperformance.
3. Consider the long-term trends that should enable the housing market to continue growing, such as low mortgage rates, rising home ownership demand, and increased time spent at home. These trends could help offset short-term challenges.
4. Monitor fundamentals and valuations, keeping an eye on the companies' profit margins, order volumes, and mortgage rate buydown programs to assess their ability to navigate a challenging market.
5. Stay informed about the latest news and developments in the housing market, as well as the broader economy, to make informed investment decisions.

In conclusion, while the recent market downturn has taken a toll on home builder stocks, there are several fundamentals that make these stocks attractive for long-term investment. However, investors must also be aware of the risks and consider strategies to mitigate them. By doing so, they can position themselves to benefit from the long-term growth potential of the housing market.