3 Top Homebuilders

05/23/2017 2:54 am EST

Focus: STRATEGIES

Marshall Hargrave

Contributing Editor, Wyatt Investment Research

The rising interest rate environment has had some investors worried about the fate of the homebuilding industry, notes Marshall Hargrave, editor of Wyatt Research's Daily Profit.

Jeffrey Gundlach of DoubleLine Capital has been shorting the housing market since 2014 — specifically telling investors to short the SPDR S&P Homebuilders ETF (XHB).

But in fact, housing has remained resilient over the last few years. The XHB ETF has handily outperforming other major industries like biotech and health care since Gundlach’s call.

Grundlach's idea that rising rates equals reduced demand for mortgages appears to be a flawed thesis for the time being, for several reasons. First, the Federal Reserve’s plan to boost interest rates will be very slow and drawn out, meaning rates will remain relatively low for a long, long time.

And some analysts believe, conversely, that the slight increase in interest rates could actually be a catalyst for a segment of homebuyers. That is, some potential buyers are looking to get in before rates go up even more.

D.R. Horton (DHI)

D.R. Horton is the largest homebuilder in the U.S., operating in nearly 30 states. This type of widespread operation gives the company inherent geographical diversification. It pays the largest dividend among major homebuilders; its  yield is 1.2%.

One of D.R. Horton’s biggest advantages in this environment is certainly that it caters more toward first-time homebuyers . . .  millennials, that is. Yes, it’s been challenging for millennials to purchase homes in recent years; that was one of Gundlach’s key bear theses for housing.

But conversely, there’s a lot of pent-up demand here. Some 60% of millennials aged 18 to 35 years old live with parents, relatives or roommates, which is a 115-year high.

Meanwhile, the mortgage market is becoming more favorable for first-time buyers applying for loans. That’s a win-win for D.R. Horton, it appears.

NVR (NVR)

NVR isn’t as cheap as other homebuilders — trading at 13.6 next year’s earnings estimates — but it’s easily one of the best operators in the industry. The company runs a “land-light” business model. That is, it doesn’t buy, invest in, or develop land. As a result, it’s kept a pristine balance sheet.

By buying up already finished lots, NVR has perfected a business model that helps maximize returns for shareholders. Thus, the company’s return on invested capital is nearly 25%. That's one of the industry’s highest.

If you’re looking for a financially conservative company with high margins, you’d be hard-pressed to find a better one than NVR.

Lennar Corp. (LEN)

Lennar pays a modest 0.3% dividend yield. But the real reason investors love the homebuilder is that it owns a massive amount of land. Unlike NVR, Lennar has a decent debt laid that it has amassed by buying land. Lennar is making a bet that land supply will continue to dwindle over the next half-decade.

Lennar is the second-largest homebuilder in the U.S. and expects the land shortage to offer impressive pricing power for the company going forward.

For its part, Lennar management has stated that the company sees a sense of general optimism in the housing market these days.

Concerns about interest rates and homebuilders look overblown, and the turnaround for the starter-home market could be a boost for the top players in the industry.  The three top homebuilding stocks above are positioned to thrive and are the homebuilding stocks to own now.

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