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Housing Stocks Look Set to Build on Gains

Betting against homebuilding stocks could be foolish, analysts say.

Listening to a housing-stock analyst today is kind of like listening to an Internet analyst during the tech boom. The only difference is, housing analysts have reason on their side.

It hasn't been prudent to bet against homebuilding stocks over the past few years, and betting against them today could be equally foolish, analysts say.

What makes them all so bullish? For starters, pundits claim that valuations in the group remain low. Sure, the stocks have skyrocketed, but so too have earnings. That means price-to-earnings ratios have remained below their long-term averages.

"They're still cheap from a historical perspective," said Lawrence Horan, an analyst at Parker Hunter. Parker Hunter has no investment banking relationship with these companies, although Horan does own a number of stocks in the group.

Over the last decade, housing issues have traded at around 10 to 12 times future earnings estimates, whereas today, they trade at just eight times profit estimates. What's more, forward numbers continue to be revised higher. On Wednesday,

Lennar

(LEN) - Get Lennar Corporation Class A Report

beat second-quarter earnings estimates by a wide margin and said it expects to earn $8.50 a share this year and $9.50 a share next year, ahead of analysts' projections, which called for earnings of $8.01 and $8.18 in 2003 and 2004, respectively.

Lennar is up almost 100% from where it was trading this time two years ago, but it sports a P/E ratio of around 9 and a price-to-sales ratio of just 0.7.

Reasons to Say, 'Hmmmmmmmm'

To be sure, the big run-up in the group might give investors pause, and some analysts have expressed concern recently about a possible rise in mortgage rates if a

Securities and Exchange Commission

investigation into

Freddie Mac

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uncovers more issues. Still, analysts' arguments for a continued rise in housing stocks are compelling.

James Wilson, an analyst at JMP Securities, said he likes the group because demand continues to outstrip supply. Despite the terrorist attacks on Sept. 11, immigration into the U.S. has shown no signs of slowing down, he said. In addition, the population is aging and home-ownership rates are going up. These factors have sent land prices higher in recent years, making it more difficult for smaller players to stay in business.

"This is a capital-intensive business, and the cost of doing business is going up because of the short supply of land in many parts of the country; so there's been a lot of consolidation," he said.

Wilson likes

D.R. Horton

(DHI) - Get D.R. Horton, Inc. Report

, in part because it derives 70% of its earnings from the Southwest -- a region that Wilson feels is poised to do well. His firm has no investment banking relationship with the company, although he does own shares.

Horan of Parker Hunter is equally enthusiastic. He believes earnings will accelerate as the economy strengthens and more jobs are created. He also noted that home builders should benefit from a change in their business model.

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Easy Money?

In the 1980s, the savings and loan industry rushed to finance high-interest land acquisition and development, and land speculation was rampant. Without this easy money today, Horan said the industry is much less volatile. Earnings are also more stable today, because all builders keep unsold inventory very low. The "'build and they will come' operational model is dead," he said. "Thus, when demand weakens, unsold inventory is not a major problem."

While some might worry about the possibility of higher interest rates down the road, analysts generally aren't concerned. "Mortgage rates are a factor, but demographics have a lot to do with it," said Wilson. "Lower rates allow you to buy a bigger house, but they generally don't make you buy or sell your house."

Although an increase in rates could have a psychological impact on investors, Wilson said home builders should continue to grow.

Parker noted that he is looking for interest rates to stay muted for some time, citing the

Federal Reserve's

recent concerns about deflation. But even if rates were to climb from historically low levels, he doesn't believe it would be enough to derail the recent rally in housing stocks.

"If rates do go back up, the rate of increase in housing prices would slow, but I don't think we would see a strong adverse reaction, because demand will remain strong," he said.

So just how much further can these stocks climb? On Wednesday, Wilson raised his price target on Lennar to $93 from $85. He has a $36 price target on D.R. Horton. Meanwhile, Lehman Brothers analyst Steven Fockens recently lifted his price target on

Centex

(CTX)

to $92 from $75,

KB Homes

(KBH) - Get KB Home Report

to $74 from $60,

Pulte Homes

(PHM) - Get PulteGroup, Inc. Report

to $83 from $73 and

Toll Brothers

(TOL) - Get Toll Brothers, Inc. Report

to $35 from $31.

After a huge surge Wednesday, investors were taking a few profits Thursday morning, with Lennar down 2% at $73.85, D.R. Horton down around 4% at $29.99, and Centex and KB Homes down 3% at $83.05 and $64.91, respectively. Toll Brothers was down 4% at $30.37, and Pulte Homes was down 2% at $68.61.

"Typically, in the early stages of an economic recovery, these stocks trade more in a 12 to 15 multiple range," Wilson said. "That would suggest they have quite a bit further to go."