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Are Builders Really a Bargain? + Vic Wisemann’s Thoughts on WB, BAC, WFC, KBH, TOL, DHI, MDC and more…

Vic Wisemann
InvestorsObserver
Featured Contributor

The generational progression on real property has long been at the heart of many fortunes in America. Many of us have heard stories about someone's distant relative or a friend of a friend who bought some land for a few dollars and held onto it for decades then sold it for millions. Then there are the stories about the interstate going through and the shopping mall paying Grandpa a truckload of cash for the family farm.

My favorite is the story about a man who purchased 21 acres on Hilton Head Island for $225 in the 1880's. The property is now worth literally millions. His heirs have been discussing if they should sell it outright or possibly get tens of millions if they take the time and expense to have the property developed.

Think there aren't any bargains in homebuilders? Read on to see where they are.

I think most of us would love to have had an ancestor who bought land and passed it down through the generations. Unfortunately, most of our ancestors, much like ourselves, couldn't really afford to speculate on a land purchase in the hopes there would be a huge return decades or 150 years later.

As a matter of fact, in quite a few cases, the property bringing this generation such profits resulted from a failed enterprise in the past, resulting in a loss for said ancestor. Like them, our time horizon for profits is a bit closer than generations from now.

With our shorter time frame we can still, however, profit on real estate. We don’t need to invest in the land. We can trade in the stocks of companies that build on the land. I'm talking about the homebuilders here, not the diverse conglomerate heavy construction companies; residential construction companies like KB Home (KBH), Toll Brothers (TOL), Ryland Group (RYL), DR Horton Inc. (DHI) and Beazer Homes (BZH), to name a few.

This market has been battered over the last year or more. Wall Street has been waiting for one or more of the homebuilders to go bankrupt. It’s odd that, as banks like Washington Mutual and Wachovia (WB) go out of business or are bought by the likes of JPMorgan (JPM), Bank of America (BAC) and Wells Fargo (WFC), these homebuilders are still around.

That is simply because the banks, Fannie Mae (FNM) and Freddie Mac (FRE), were taking all the risk. What has driven those big financial companies out of business from losses just means a business slowdown for these homebuilders.

Most of the homebuilders have seen their stock prices moving up from 52-week lows in the early part of this year, after plummeting from historic highs. Many have moved up, heading out of the summer building season. In fact, the S&P 1500 Homebuilding Sub-industry Index shows homebuilding’s trailing 52-week price performance was in the top 10% of all sub-industries in the S&P Composite 1500 Index (consisting of the S&P 500, MidCap 400 and SmallCap 600 Indices).

Why are homebuilder stocks showing such promise?

There are three basic reasons that I see:

Mortgage availability could be increasing soon.
When Congress gets around to actually passing some form of financial relief plan, the lending institutions that remain will get back to lending money. It won't be nearly as easy to get credit as it was even a year ago, but it will be available. The difficulty in obtaining a mortgage has even increased over the past couple months, making it more challenging for creditworthy borrowers to find financing.

The availability of credit will, in turn, help buyers with adequate resources to move through the glut of existing homes on the market. As the level of supply decreases, the need for new construction will increase. Since there are substantial barriers to entry, the big national builders will pick up most of the new construction as the housing market perks up.

The need for housing continues to grow.
The Census Bureau estimates a birth every seven seconds, one death every 13 seconds, and a new immigrant every 31 seconds. The result is an increase of one person every 11 seconds. The population of the United States officially hit the historic 300 million milestone in October 2006, according to U.S. Census Bureau estimates. All of these people need to live somewhere and most of the people I know enjoy owning their own homes rather than renting. This will drive the housing sector as much as any other single factor in the coming years.

The markets see these stocks as more fairly valued.
Looking at the charts for the publicly-traded homebuilders, you see that almost all have leveled off from their ski slope falls. These companies have been writing down the value of land they own and reducing the sales price of already-completed homes, as well as cutting staff and other expenses to bare bones levels. What you have left are companies trading at or below their book value with lean staff and a motivated work force.

So, it looks like housing stocks may be at a place where we might look for some bargains as we move into the end of the year. Spread trades are available for most of the homebuilders on both the call side and the put side.

There are a few things that make me cautious about these stocks, however.

Existing home sales continue to disappoint.
US existing home sales fell an unexpected 2.2 percent in August after two months of gains, signaling no end in sight to the country's worst housing slump in decades. The National Association of Realtors (NAR) said sales of existing homes and apartments fell to a seasonally adjusted annual rate of 4.91 million units. The August number underperformed market expectations at a pace of 4.93 million units.

Prices continued to drop.
A closely-watched index shows home prices tumbling by the sharpest annual rate ever in July, but the rate of decline is slowing. The Standard & Poor's/Case-Shiller 20-city Housing Index fell a record 16.3% in July from the year-ago period -- the largest drop since its inception in 2000. The 10-city Index plunged 17.5% -- its biggest decline in its 21-year history. Home values in all 20 cities fell year-over-year, with Las Vegas prices plunging the most at nearly 30%.

However, the pace of declines has slowed over the last three months, but there is still no sign of a bottom. Lower prices for existing homes will also put pressure on new home starts. Most people figure that if they can get a home that’s close to what they want for substantially less by buying an existing home rather than building, they will give it serious consideration.

If you want to try your hand with the homebuilders, you might consider the December 30/25 Bull Put Spread on MDC for an 85 cent credit. That's a 20.5% return, and the stock has to fall 17% to cause a problem.

Be cautious when investing in homebuilders. There are some good trades out there but the volatility is a monster. Be sure all trades fit into your personal risk tolerance and reward profile and try to have some fun.