Housing stocks: A money pit?

Despite the steady drumbeat of negative headlines about the U.S. housing industry, a handful of the sector's stocks have sprung to life in recent days. But the lingering housing morass south of the border suggests some of the companies may be traps for the unwary.

This week's gains came after Lennar the fourth-biggest of the publicly traded builders, reported earnings that beat expectations. The company returned to a profit, reported a 14-per-cent year-over-year revenue gain, and said it would be profitable for the year.

Lennar's news boosted all the industry's major players, despite management's message that "it's been a tough summer" and that July and August were "a little less horrible" than June.

Such restrained sentiments pass for optimism in the sector, given the data released so far this week. On Monday, as Lennar was announcing its earnings, the National Association of Home Builders released a sentiment index reading of 13 for September, the worst since March, 2009. (A reading of 50 is the benchmark for optimism).

On Wednesday, the Federal Housing Finance Agency said U.S. home prices fell in July to a six-year low, a rate of decline greater than expected. Even Tuesday's positive news of a 10.5-per-cent gain in housing starts - which helped boost home building stocks - had holes. It was bolstered by the construction of apartment buildings, and the overall rolling average of the numbers has declined since spring, in the period before an $8,000 home buyer tax credit expired.

The expiry of that credit, which stuffed demand for homes into the first half of the year, is in large part responsible for the current gloomy outlook. James Fielding, the primary credit analyst for the sector at Standard & Poor's, estimates that housing starts will come in this year between 600,000 and 650,000, far below the historic average of 1.5 million.

"A potential 'new normal' in housing is beginning to rear its ugly head, nearly three months after the expiration of the home buyer tax credit," said analyst Jack Micenko of Susquehanna Financial Group. "Sales and traffic have continued to drop, new mortgage [applications]have been flat to decreasing, according to the [Mortgage Bankers Association] while incentives appear incrementally sweeter."

Don't Get Too Comfortable

Investors in many home-building stocks have ridden a roller-coaster this year. PulteGroup the nation's biggest home builder by revenue, posted a 40-per-cent gain by mid-April, only to give the increase all back by June, plus another 15-per-cent drop. The story is similar at No. 2 builder D.R. Horton

Lennar, the company that reported Monday, has been an industry standout, notching a gain so far this year. It is Mr. Micenko's top pick in the building industry. Analyst Jade Rahmani of Keefe Bruyette & Woods, who has an "outperform" rating on the stock, believes the company will continue to enjoy modest new-home sales growth, stable pricing, and continued profitability. (The company's year-over-year orders drop of 15 per cent in the recent quarter actually beat expectations.)

At just over 1.1 times book value, Lennar is one of the cheaper players in the sector, according to data from Standard & Poor's Capital IQ. (In a widely unprofitable industry, price/earnings ratio goes out the window because there's no "E" for the P/E.) Price-to-book ratios range from over 2 for NVR Inc. to under one for PulteGroup.

Investors appear to be hoping for a good-news story from KB Home , which reports Friday. Its shares have risen this week and it is now the second-most-expensive stock in the industry by price-to-book ratio, at more than 1.5.

But the high hopes may be dashed. Mr. Micenko believes the company will need to cut its guidance on home sales, or "deliveries," as the industry calls them. He's expecting just over 6,400 deliveries for the company, although KB Home's guidance remains above 8,000.

Special to The Globe and Mail

The major players

Source: Capital IQ; All values in millions of U.S. dollars, except per share data