With the housing market slowing, why bother investing in homebuilding stocks if the group's best days are behind them? Well, the sector is cheap, the bulls say, and even if fundamentals cool down, earnings won't drop off a cliff.

"Our view is that going forward, we're going to see a slowdown in activity, but not enough to derail anything," says Sam Lieber, portfolio manager of the Alpine US Real Estate Equity fund (EUEYX), which has about 50% of its holdings in homebuilders.

Builders' 2006 results are largely in the bag, because the bulk of revenue will come from the companies' backlog of homes already sold but not yet closed upon. The real issue keeping investors nervous relates to the scenario for 2007, and orders in the all-important spring selling season will provide a crucial look at homebuilders' prospects.

Recent order numbers from the group have been mixed. Large builders like D.R. Horton ( DHI) and Pulte Homes ( PHM) posted net order growth of 16% and 10%, respectively, for the fourth quarter. However, smaller builders focused on fewer geographic markets have reported disappointments, such as Standard Pacific's ( SPF) 13% year-to-date order decline and MDC Holdings' ( MDC) 10% fourth-quarter order fall.

"I think the larger builders are showing the benefits of their diversification," says Jack Lake, an analyst for Victory Capital Management, which owns Pulte and Lennar ( LEN).

Toll Brothers ( TOL), which doubled earnings in 2005, has been the recent black sheep of the large builders, as it reported a 29% drop in fiscal first-quarter new orders for its luxury homes. Analysts' average estimate now calls for Toll to see earnings per share drop 4.6% in 2007 from 2006.

It takes roughly seven to nine months for orders to convert into revenue, which means the order numbers that builders report in the coming months will provide more transparency for late 2006 and early 2007.

"I think the spring selling season needs to be good because the investors are expecting the spring selling season to be good," Lake says. But even if results are disappointing, Lake admits the builder stocks might not fall much further in price, because so much bad news is already baked into the share price.

The builders as a group tend to trade at six- to seven-times forward earnings, which is low compared with other industries. "When people find out it is not as bad as they feared, that will bring confidence back to the securities," says Ron Muhlenkamp, portfolio manager of the Muhlenkamp fund (MUHLX), which owns several builders, including Centex, ( CTX), the fund's third-largest holding.

Muhlenkamp started buying the builders in 2000, when the group was at four times earnings. "The market expected earnings would be cut in half (at the time)," he says, but it didn't happen. The economy went south, but not enough so for the bears to be right -- and most builders increased earnings.

Muhlenkamp grants that the overall housing market will slow down over the next few years, but he believes the big builders will continue to gain market share. He expects revenue for the group will be up a "couple percent" over the next few years, accompanied by flat to slightly up earnings growth.

If builders can increase earnings in a slowing national real estate market, then perhaps investors will finally reward the group with higher P/E multiples. It's a theme that several buy-side veterans, such as Robert Marcin, general partner of Defiance Asset Management and a RealMoney.com columnist, have been hammering of late.

History shows that builders can do well financially in a down cycle, though their stocks come under significant pressure. The worst recent period for U.S. housing came in 1989-90, when new-home sales fell 26% on a unit basis and prices for those homes fell 1%. However, during this downturn, the top 10 public builders saw just a 5% revenue decline, according to calculations by Lieber.

Public Homebuilders Grow Through Market Dips
Source: Alpine Woods Investments

There were different issues back then, though, as Lieber points out. The savings-and-loan crisis helped blow up the housing market, along with collapsing GDP, rising unemployment and a 10% rate for 30-year fixed-rate mortgages.

The bear case now is that even though some factors are different today -- for instance, the 30-year fixed rate stands at 6.26% -- new-home sales could still significantly fall.

Ken Rosen, a University of California-Berkeley real estate professor and hedge fund manager, believes a 25% to 30% total drop in new-home sales is possible over the next three years, and that builders will be meaningfully hurt this time around.

"It all depends on how much sales and orders slow and how much earnings are hurt by the margin squeeze we expect in 2007 and 2008," Rosen says. "I don't believe that if housing activity is down 25% to 30% in the next two to three years ... that (builders') earnings can hold up at current levels."

What the bulls don't understand, Rosen says, is that builders "have been borrowing demand from the future over the last few years." Easy credit amid loose lending standards helped fuel much of the boom, he says.

With mortgage rates rising and credit requirements becoming tighter, he expects sales to slow down. Over the last decade, the home-ownership rate in this country rose to 69% from 64%. But Rosen says it is hard to see the rate growing at a similar pace from 69% to 74% over the next few years.

Because of these bearish signs, Rosen predicts the downside risk for builders is another 30% drop in stock price. That's why his $120 million hedge fund, Rosen Real Estate Securities, is currently 30% short homebuilders.

Over the next two weeks, builders will hit the road to sell a much more optimistic version of themselves, beginning with the Wachovia Securities Homebuilder Conference in Las Vegas, which started Tuesday. Next week, several builders will take the stage at the Citigroup Global Industrial Manufacturing Conference in New York.

The companies can expect lots of questions from investors who so far have been skeptical of jumping back into the builders. But most will have to wait for the spring to see whether the fundamentals of the group can hold up.

"The Street will have more visibility as we go from March to June," Lieber says.

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