Two Homebuilders for the Recovery Scenario

Almost two years into the housing meltdown, are housing stocks finally worth a closer look? Borrowing a line from fellow contributor Tim Melvin, "if we want to get rich(er), we have to figure out where the destruction lies, and buy."

Successful investing requires anticipation beyond the next quarter or two, and investors who are willing to sit still for a year or two may realize that gems can be found amid the rubble.

As with buying a house, a low stock price does not indicate a cheap asset. In fact, a year ago, many homebuilders were trading at significant discounts to book value (in some cases, 30% of book). Today, most command even lower market valuations. Book value becomes completely insignificant when asset valuations are inflated. And with homebuilders, that's exactly what you got: housing inventory that was being valued at peak levels.

Asset write-downs continue to punish the homebuilders. Homebuilder Hovnanian (HOV - commentary - Cramer's Take) recently booked a third-quarter loss of $202 million, $111 million due to land impairments and predevelopment costs.

The other problem with homebuilders is inventory buildup. Consider that in 2005, at the height of the housing boom, the supply of existing single-family homes was a record low of 3.6 months. According to the National Association of Realtors, the supply equaled about 11 months as of July 2008. In 2005, housing inventory stood at 2.8 million; in July of this year, housing inventory was about 4.7 million homes. It's doesn't take a genius to deduce that if you make more than you sell and continuing do so, you should expect to write off some of that inventory.

All Is Not Lost

Housing may be down (and for a while), but it is certainly not out. The U.S Treasury's bailout of Fannie Mae (FNM - commentary - Cramer's Take) and Freddie Mac (FRE - commentary - Cramer's Take) is a long-shot attempt at stabilizing home prices.

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At the time of publication, Gad had no positions in stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a value investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at [e-mail].