Financial Jungle

One man’s garbage is another’s treasure. Sometimes it’s quite fruitful to snoop around other people’s dumpsters salvaging disgraced stocks.

Lo and behold, I may be gaping at the rottenest of all: Homebuilder stocks. The S&P Homebuilders index has been nailed and hammered over the past couple of years, and is already plummeting 20% six-months into 2007. Many Homebuilder stocks are teasing their historical low price/book ratios, but who can blame the market when you consider:

• The National Association of Realtors is reporting a nine-month worth of home inventory waiting to burn through. This is a 15-year high.
• The sub-prime fiasco is forcing lenders to tighten their mortgage lending practice, thus reducing housing demand.
• Homebuilders are lowering their prices and enticing buyers with perks in order to clear the excess inventory.
• Homebuilders are expiring and writing off their land options.

I know this may sound counter-intuitive, but bad news is good news for value investors, because the stocks have already absorbed much of these glooming expectations. (For full disclosure, I purchased a half position in DR Horton, which I’ll get to later.)

On Monday, Citigroup slapped nasty downgrades against many Homebuilder stocks:

Analyst Stephen Kim downgraded to “Hold” the shares of D.R. Horton Inc., Hovnanian Enterprises Inc., KB Home, Lennar Corp., Pulte Home Inc., Toll Brothers Inc. and Ryland Homes Inc.

What happened to the DR Horton stock? It dusted off a miniscule 1% over the next 2 sessions. Shareholders are so accustomed to pessimistic forecasts that they barely flinched after the downgrades. When the stock is already priced for disaster, the low expectations along with a higher dividend yield bolster the current price point.

Since homebuilding, by nature, is a cyclical sector, price-to-earning and price-to-sales are deceptive valuation matrices due to the fickle earnings and sales figures. A more reliable valuation matrix for cyclical stocks is the price-to-book ratio, assuming the company can hold its book value steady. Please visit MoneyCentral to appreciate how DR Horton vigorously maintained a modest equity growth even during these difficult times, and then compare what it’s trading now in relation to its historical price-to-book ratios.

Current P/B = 0.96

The question now isn’t if a recovery is looming, but when. Most of the industry experts are projecting a revival of the housing sector within the bottom half of 2008, so securing a HomeBuilder stock at this time may appear premature. However, the market tends to factor in future expectations into today’s price. Accordingly, the stock should rebound ahead of the sector. To quote Brett Arends from TheStreet.com:

[The current valuation] is a fraction of where the stocks usually trade. The last time we saw valuations this low was in late 1990, and that was in the depth of the last real-estate crash. And that time around, the shares quickly rallied — even though the housing market itself took years to get back in the swing.

There are two ways to participate in the Homebuilding sector. The diversified approach is to buy an ETF, such as XHB. The other approach, my preference, is to bypass the MER and snap up a stock directly, since Homebuilders tend to swing in lockstep with each other. DR Horton(DHI) is a reasonable choice because it is the largest US Homebuilder, and the company is buying you beer (3% dividends) while you wait for the inevitable vengeance.

DR Horton traded as high as $42 before tumbling down to $19.75. I haven’t decided when to double-down yet, but I suspect the next cyclical peak will likely surpass the previous high.

Disclaimer: I’m an amateur investor. This is not a recommendation to buy. I welcome any constructive feedback.