Home Sweet Homebuilders

Some prosperous fund managers continue to embrace the group, even as bubble talk swirls.
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A fortunate group of mutual fund managers has discovered there's no place like homebuilders. But after a phenomenal two-year rally, how much longer will the housing sector's welcome mat stay out?

Homebuilding stocks, as measured by the Philadelphia Housing Sector Index, have nearly doubled over the past two years. Some members of the homebuilding community, like high-end developer

Toll Brothers

(TOL) - Get Report

, have even seen the price of their shares more than triple as the demand for new homes continues to soar.

Most recently, March new-home sales were reported at a 1.43 million annual rate, up 13% from last year and 12% from February. Analysts' consensus estimate for March was 1.19 million units, so new home performance dusted the experts' best guess as well.

The rally in homebuilder shares began four years ago, just as the

Federal Reserve

started chipping away at interest rates. And the journey upward has been especially unkind to the many short-sellers betting against the so-called housing bubble.

The naysayers remain steadfast in their predictions that higher interest rates and increased supply will inevitably knock homebuilders shares down. Meanwhile, mutual fund managers who are long shares of homebuilding stocks have been prospering. Most remain unconvinced the end is near.

"When the housing slowdown arrives, it will be less than the consensus thinks," says David Jordan, portfolio manager for the $79 million

(FOGRX) - Get Report

First Focus Growth Opportunities fund. "Intermediate-term interest rates won't rise as much as expected, and the homebuilders have factored in higher rates to their earnings projections."

Jordan identifies himself as a growth-at-a-reasonable-price manager. Two of his fund's largest positions are Toll Brothers and

Hovnanian Enterprises

(HOV) - Get Report

. He likes Toll due to its big backlog of building projects, plus the fact that it has enough undeveloped land in inventory to keep it busy for the next five to 10 years. He says Hovnanian is still reasonably priced at just over six times next year's earnings.

Both companies have been big growers for Jordan, but what about the price? Still reasonable?

"The

S&P 500

is trading at 17 to 18 times current earnings and the homebuilders still trade at a multiple less than half of that," says Jordan, whose fund has beaten the S&P index by 9 percentage points in each of the past five years. "Our outlook is that they are near peak cyclical earnings, but normalized earnings are higher than the current outlook."

So much for valuation, but what about the doomsday scenario involving rising interest rates?

The Fed has raised short-term lending rates seven times since last summer, undoing much of the post-9/11 rate cuts meant to spur the economy. Although longer-term interest rates have not risen in tandem with short term -- much to Fed Chief Alan Greenspan's consternation -- the bear camp anticipates that inflation will inevitably force them higher. And when they do, the housing sector will crumble as it did in 1994 when the Fed also ramped up rates.

The average large-cap builder fell 10% in 1995 after a 284-basis-point rise in the 10-year Treasury the previous year, according to Lehman Brothers.

But don't let the bears tempt you into thinking we will see a reprise of 1994, says Sam Lieber, fund manager for the $527 million

(EUEYX)

Alpine U.S. Real Estate Equity fund.

"Greenspan is aware of what happened then and he won't repeat his mistakes," says Lieber. "The rise in rates has been, and will continue to be, orderly."

Lieber posits that even if 30-year fixed mortgage rates hit 7%, up from their current level near 6%, the market won't be rattled. Only if long-term fixed lending rates pass 8% will the foundation of the housing market start to rattle, says Lieber. Not that he is expecting rates to hit that milestone any time soon.

Lieber also discounts the notion that demand for new homes will drop off if prices continue to skyrocket, especially in hot real estate markets like Las Vegas and Florida. And if the demand remains strong, so too does the prospect for the homebuilders.

"Clearly some markets are overheated like in Las Vegas and Florida, but those were underpriced before. And people are still moving into those areas," says Lieber, whose homebuilder-heavy fund has been up an astounding 32.3% annually over the past five years.

"When people get priced out of the market, they'll stop moving in or be forced out," says Lieber, who has recently added to already heavy stakes in names like Toll,

KB Home

(KBH) - Get Report

,

Pulte Homes

(PHM) - Get Report

,

Lennar

(LEN) - Get Report

and

Ryland Group

(RYL)

. "But you are not seeing a mass exodus in Los Angeles or New York City even with new supply coming online."