How to add homebuilders to your portfolio

06/27/2012 6:30 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Shares of homebuilders were among the market leaders this today. Lennar (LEN) closed up 4.8% today. DR Horton (DHI) was up 2.3%. Toll Brothers (TOL) was up 3.9%.

And no wonder. We’ve had quite a run of good news from the housing market this week. Today the news was that in May the index of pending home sales had jumped 5.9% to match a two-year high reached in March. (Economists surveyed by Briefing.com had expected a 0.5% increase.) That follows on news that new home sales had climbed to an annual rate of 369,000 in May, up from 343,000 in April and above the 350,000 consensus from economists. And that followed on data from the Case-Shiller 20-City Index showing that housing prices had declined by 1.9% in April. That’s better than the 2.6% decline in March and the 2.5% decline predicted by economists.

Shares of home builders are up strongly in the last year—shares of Lennar, for example, are up 57.4% in the last 12-months—but we are still in the early stages of any housing rebound. And I think any drop in these shares in the next few months either on volatility in the general stock market or on bad news from the housing market (if, say, more homes in foreclosure go up for sale depressing housing prices) would be a good time to pick up a stock or two in this sector.

But which one? The decision is actually easier than it looks because home building companies are very different one from each other with concentrations in different parts of the market and different strengths and weaknesses. Here’s my take on the three home building stocks that I find most attractive for the next year or so.

Lennar (LEN) has rebuilt its finances and operations during the bust. Good thing since the company expanded aggressively in the years before the collapse. In late 2001, for example, Lennar expanded into North and South Carolina and added to its business in Colorado and Arizona. Other acquisitions in 2002 expanded the company’s business in California. In 2005 Lennar entered the New York, Boston and Reno markets. That year the company also added to its business in Jacksonville. More recently the company has focused on cleaning up its balance sheet. In fiscal 2009 (the company’s fiscal year ends in November) Lennar retired $281 million in notes due in March 2009 and issued $400 million in notes due in 2017. In fiscal 2010 the company issued new debt and retired debt due in 2010, 2011, and 2012. In addition the company has exited 235 of the 270 off-balance sheet joint ventures it showed in 2006.  The company has also turned around its return on equity, which had been negative, according to Standard & Poor’s in the three years following fiscal 2006. Lennar’s return on equity, according to Morningstar, was 2.97% for the last 12 months. That’s a big improvement from negative territory but still a long way from the 29.1% return on equity in fiscal 2005. The Wall Street consensus projects earnings growth at 71% in fiscal 2012 and 63% in fiscal 2013.

Toll Brothers (TOL) targets upper-income homebuyers in what is frequently described as the near-luxury segment. In May the company forecast fiscal 2012 selling prices for its homes of $560,000 to $580,000. Toll Brothers’ concentration on the upper-income buyer has led the company to sell a broader range of housing formats—high-rise condominiums, townhomes, traditional houses, and resort communities—and to build both in suburban and urban areas. That wide distribution of types of housing and property locations gives Toll Brothers a wider geographic spread—19 states--than the average home builder that is focused on the South or the West. Before the housing bust, Toll would often buy land well in advance of construction since the upper-income buyer demanded premier locations. That inventory hurt the company in the early stages of the bust, but more recently the company has been able to use its land acquisition expertise to acquire distressed land at bargain prices. Standard & Poor’s estimates that revenue will climb by 16% in fiscal 2012 and by 21% in fiscal 2013. (The company’s fiscal year ends in October.) The Wall Street consensus sees earnings climbing to 43 cents a share in fiscal 2012 and to 88 cents a share in fiscal 2013.

DR Horton (DHI) is the most volume oriented of these three homebuilders. (It was the first company to sell 50,000 houses in a single year in fiscal 2005.) The company focuses upon entry-level and first-time move up buyers so it will be a leading beneficiary of a pickup in industry sales volumes (and from the eventual easing of credit quality restrictions on mortgages.) The company closed on 16,695 homes in fiscal 2011 so there’s still plenty of headroom to pre-bust run rates. During fiscal 2010 DH Horton repurchased or redeemed $1 billion in long-term debt and it finished the year with $1 billion in cash and cash equivalents. The Wall Street consensus sees earnings growth of 462% in fiscal 20121 and 29% in fiscal 2013. (The company’s fiscal year ends in September.)

If you’re just starting to build a position in the home building sector, I’d suggest prioritizing your buys in the order that I’ve listed these three stocks—Lennar, Toll Brothers, and DR Horton. I think that gives you gradual exposure to a slow recovery in the housing market with a low but gradually increasing level of risk.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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