Bloomberg.com featured the relative performance of the Homebuilder stock index versus the S&P 500 index year to date as its Chart of the Day on Monday. Homebuilder stocks as a whole have outperformed the broad market index by 21.5% through last Friday’s close, which spans about 7 weeks. This is not the case of a beaten down sector that has finally reached capitulation on valuation; homebuilders outperformed the broad market for the full year 2009 as well.
“Homebuilders were the year’s third-best performers among 134 industry groups in the S&P 500, according to data compiled by Bloomberg. The groups that did better each had one member: Eastman Kodak Co. for photo products and Harman International Industries Inc. for consumer electronics.” — Bloomberg.com 2/22/2010
We have to agree with Brian Belski, the Oppenheimer & Co. analyst quoted that in the Bloomberg piece who says that it will likely be quite some time before these builders return to profitability. At Ockham, we look for stocks that are showing significant improvement in the fundamental areas of sales, earnings, growth, return on equity, etc and yet the market seems to reject them for one reason or another. That is clearly not the case with homebuilder stocks. Not surprisingly, 15 of the 19 stocks that we cover from the Residential Construction segment receive our Overvalued rating.
If you think of a stock like a house, the fundamentals are the foundation. A strong fundamental foundation will enable a stock to support a higher price with little strain, but the homebuilder stocks have been built up upon extremely weak foundation and could crumble at the slightest sign of trouble. These homebuilder stocks provide no “margin of safety” for value investors to rally around, and in our opinion these stocks are being driven largely by speculation of a housing rebound.
The housing market has certainly shown signs of stabilization as housing prices slowly begin to climb out of the doldrums. There is no doubt that this is a positive development for homebuilders as this will halt or slow the pace of inventory write-downs at the very least. However, most industry analysts would agree that inventory on the housing market remains extremely elevated and there remains a huge uncertainty surrounding the shadow inventory: houses that are often unoccupied that have been held off the market until selling conditions improve. Of course, no one can know how many houses are in this “shadow inventory”, but it may be a significant number which would only add to an already oversupplied housing market.
These companies only thrive when there is demand for new houses, but there is still plenty of supply of existing homes available to buyers. This industry has been sucking wind for some time as they have had to scale down building projects in order to compensate for less demand in a tough economy. There is no doubt that the economy has begun to improve, but we would need to see significant improvement in these businesses in order to say that they justify their stock’s performance.