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Are Homebuilders Still a Buy?

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Homebuilder stocks are trading at rock-bottom valuations.

Earnings expectations indicate that these companies are absurdly cheap.

Consider three of the strongest homebuilding companies in this country…

D.R. Horton (NYSE: DHI) is looking at earnings per share (EPS) of $17.43 in 2022, according to a 21-analyst consensus estimate.

With a current share price of $72, that means D.R. Horton is currently trading at a price-to-earnings (P/E) ratio of just 4.15.

Then there’s PulteGroup (NYSE: PHM). According to 16 analysts, it’s looking at an average EPS estimate of $10.95 in 2022.

With PulteGroup’s current share price of $44.98, that puts this company’s P/E ratio at just 4.1.

Then there’s Lennar (NYSE: LEN), which is forecast to bring in EPS of $16.07 in 2022.

With a share price of $78.91, Lennar is valued at a miserly P/E ratio of 4.91. But if you were to buy Lennar’s Class B shares that trade at $67.93, the P/E ratio drops to 4.22.

These are three of the largest homebuilders in the country, and all of them are trading for just over four times earnings.

So in 2022 alone, these companies will have earnings that amount to one-quarter of their entire market valuation.

That means these companies will have an earnings yield of 25% this year.

Is this an incredible opportunity? Or is there more to the story?

Legitimate Concerns

This year has been a rough one for the stock market. It’s been especially brutal for homebuilders.

Year to date, the homebuilding sector is well into bear market territory, currently down 27%.

Chart: The Homebuilding Sector Is Down in 2022 - SPDR S&P Homebuilders ETF

Rising mortgage rates have sparked legitimate concern that there will be a decrease in the demand for new houses.

Rising rates increase the cost of home ownership, which typically means less demand for homes.

Since the outbreak of the COVID-19 pandemic, the demand for housing has been strong, fueled in part by the ultra-low rates that were included in the Fed’s aggressive response to COVID-19.

Mortgage rates have now doubled from the COVID-19 low of 2.65%, with most of that increase coming in 2022 alone.

We started this year with a 30-year mortgage rate of 3% but have quickly added another 2%-plus.

Chart: 30-Year Mortgage Rate

Higher mortgage rates mean higher monthly payments for homebuyers.

That means new homes have gotten much less affordable in 2022.

The first signs of rising mortgage rates impacting demand arrived in April, when new home sales numbers showed a 17% decrease from March and a 27% decline from April 2021.

That’s not bullish for homebuilders.

But Then There’s This…

Despite rising mortgage rates, there’s a more important data point…

Since new home construction peaked at more than 2 million housing starts at the peak of the housing bubble in 2005, there have been only 500,000 new homes built each year on average.

Chart: New Home Construction Recoery Faces a Lag

Over the past 15 years, new home construction has been at its lowest level in 60 years.

From 1960 to 2008, the number of new homes built in the U.S. ranged from 1 to 2 per 100 households.

Since 2008, that number has been just 0.5 new homes per 100 households – roughly half the bottom end of the normal range.

Some 15 years of underbuilding has resulted in a new-home deficit of roughly 3 million homes.

It is going to take years of furious home construction to recover from this deficit – which is a great long-term tailwind for homebuilders.

Yes, mortgage rates are much higher than where they have been during COVID-19, but they’re nowhere close to being high compared with historical norms, as you can see in the chart below.

Chart: 30-Year Mortgage Rate

But we don’t know how much further both interest rates and mortgage rates are going to rise.

The Federal Reserve and other central banks across the globe unleashed an unprecedented easy money policy in response to the pandemic.

Given the “unprecedented” part of this situation, it’s impossible to predict how hard it will be to rein in ongoing decades-high inflation.

Nevertheless, given the 15 years of underbuilding and the tailwind it has created behind the sector, I’m a buyer of homebuilders at current valuations. That said, I’m cautious because I don’t think this sector will bottom until we get some data that shows inflation is relenting to some degree.

Slowing inflation means that the Fed won’t have to use sky-high interest rates to keep inflation under control.

Good investing,

Jody

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