Editor's Pick: Homebuilders and Housing Confab

The state and future outlook of both the housing market and homebuilding stocks has captured the attention of RealMoney columnists and readers in the last day or so.

Thursday brought the release of new-home sales figures for June, and Tony Crescenzi examined the data, noting in a blog entry that homebuilders appear to be controlling the housing glut.

But the real debate got rolling after Richard Suttmeier wrote a profile of the homebuilders in which he advised not to abandon the sector, saying, "I certainly don't see a reason to buy stocks in this sector now, but investors who can wait out a painful healing period should be rewarded."

Nicholas Yulico, who covers the real estate industry for TheStreet.com, took immediate issue with Suttmeier's argument. Yulico -- who that very day had written Homebuilder Pain Spreads in response to the latest two homebuilders to slash guidance -- questioned the worthiness of the ValuEngine service Suttmeier cites in determining homebuilder valuations.

In response, Suttmeier explained his use of ValuEngine ratings and weekly chart profiles in his overall approach. The next columnist to weigh in was Dan Fitzpatrick, who offered his own bearish observations on the sector.

Suttmeier responded with further clarification on his valuation modeling technique, and that prompted Fitzpatrick to reread the article and to offer more insight.

The housing-sector subject proved compelling enough to carry into Friday, albeit on a slightly different bent. Jim Cramer offered his take on the homebuilders in his first blog entry of the day, but it was an interesting Census Bureau statistic posted in Columnist Conversation by David Merkel that got folks really talking. Cody Willard and Dave Baker asked for more information, so Merkel fleshed out the data in a subsequent post about the homeowner housing vacancy rate.

Cody Willard offered his reaction to the statistic and Michael Comeau his own anecdote. That's where the conversation stands thus far. Catch up to the commentary by reading their comments below.

Builders Are Controlling the Housing Glut

Tony Crescenzi
7/27/2006 11:02 AM EDT

New-home sales were weaker than expected in June, running at a pace of 1.131million compared with forecasts for a pace of 1.150 million. In addition,data for the previous month were revised sharply downward, with sales nowreported at a 1.166 million pace instead of the 1.234 million pace that waspreviously reported (large revisions to the new-home sales data are common).

I have noted since February that mortgage applications have fallen about 15%from the peak, suggesting that sales would fall similarly. Today's figure puts sales roughly in line with what should be expected, based onmortgage applications -- with sales down about 17% from the peak in the latestmonth and 15% when looking at the average sales pace of the past threemonths. The data, therefore, are hardly a surprise.

A highlight of the home-sales report is the fact that the inventory-to-salesfigure, although up in June, has stabilized. The ratio now stands at 6.1months of supply, up from 5.9 months in May but below the peak of 6.4 monthsset in February. This is in contrast to the I/S ratio for existing-homesales, which reached a nine-year high in June.

A key feature of the housingmarket is likely to be improved inventory control as compared to the lasthousing downturn in the early 1990s. With a greater share of the housingmarket controlled by larger, more capital-rich homebuilders than was thecase in 1990, inventory control is likely to be better this time around,which should reduce the amount of forced liquidations and help to containprice declines.

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Homebuilders Are Lousy but Not Worse

Richard Suttmeier
7/27/2006 3:40 PM EDT

You know it's bad when not getting worse is good. That's exactly where the homebuilders are now, and that's better than it seems at first glance. I certainly don't see a reason to buy stocks in this sector now, but investors who can wait out a painful healing period should be rewarded. I definitely wouldn't panic out of the group at this point.

Homebuilders Centex ( CTX), Pulte ( PHM) and Beazer Homes ( BZH) reported disappointing earnings this week. The companies all lowered full-year guidance, as none see conditions improving anytime soon.

The good news is that shares may have bottomed on July 21, before this week's wave of bad housing news.

The PHLX Residential Housing Index (HGX) provides a sign of stability for the group. It has closed two weeks in a row below its 200-week simple moving average (SMA). A close this week above the 200-week SMA of 197.10 would be a sign that the bad news is being built into the homebuilders as a group.

When I first started to profile the homebuilders between June and August 2005, all were overvalued, with price-to-earnings ratios between 9% and 15%. It was tough to identify risky levels as shares continued to trade to new all-time highs. The weekly chart profiles became overbought, and returning to the 200-week simple moving averages was not considered a possibility. In those earlier columns I suggested that investors consider reducing exposure to the homebuilders.

Today the homebuilders trade like the damaged goods they are, with P/E ratios between 5 and 8. All are below their 200-week SMAs and have traded cheaper than annual value levels, which should have held as the worst-case scenario on weakness. ValuEngine rates the seven homebuilders in the table below buys, but fair values for all have declined in recent months, so none of the stocks are more than 20% undervalued.

Investors who reduced holdings in the homebuilders at risky levels over the past year and subsequently added to positions on weakness to annual value levels (now shown as pivots) should monitor my model for guidelines for the next suggested investment strategies. Your exposure to the homebuilders should be much lower than it was a year ago, but given the undervalued and oversold nature of the group, it's best to sit tight on this portfolio allocation at this time. Can't take the pain in the meantime? A strategy of paring shares on rebounds to pivots or even strength to risky levels (those former value levels) should make the wait for an improved environment go more quickly. (See a definition key for the terms I use at the bottom of the table below.)

The Homebuilders
Jul 26 Close Rating (-UV) / OV By Fair Value MOM 5-Week MMA 52-Wk Low 200- WK SMAs Value Levels Pivots Risky Levels
Beazer Homes (BZH) $40.51 BUY -11.90% $45.98 OS $45.22 $36.27 $41.09 none 45.32 A 56.68 S
Centex (CTX) $47.57 BUY -15.50% $56.28 OS $49.14 $42.90 $49.06 none 52.95 A 61.24 A
DR Horton (DHI) $21.22 BUY -13.70% $24.59 OS $23.84 $19.52 $23.80 none 25.29 A 30.83 A
KB Homes (KBH) $42.36 BUY -13.40% $48.91 OS $45.99 $37.89 $44.99 none 49.83 A 59.59 A
Lennar (LEN) $45.20 BUY -18.70% $55.59 OS $45.12 $38.66 $46.08 none 43.51 A 57.35 A
Pulte Homes (PHM) $30.05 BUY -7.20% $32.39 OS $29.43 $26.02 $27.49 none 28.60 A 34.88 A
Toll Brothers (TOL) $24.79 BUY -4.50% $25.96 OS $26.02 $22.22 $25.79 19.78 M 25.59 A 29.99 A
Key: MOM, momentum; OB, overbought; DM, declining momentum; RM, rising momentum; OS, oversold; F, flat; M, monthly; Q, quarterly; S, semiannual; A, annual. A value level is a price at which my models project that buyers will emerge; a risky level is a price at which investors are likely to reduce holdings, according to my models. A pivot is a value or risky level that has been breached in its particular time horizon; the stock will likely trade around this pivot.
Source: Global Market Consultants

No positions in stocks mentioned

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Valuing Homebuilders

Nicholas Yulico
7/27/2006 4:37 PM EDT

Richard, I'm really starting to question the worthiness of this ValuEngine service you continually cite when determining homebuilder valuations. Back in March, you said investors should hold onto Beazer (BZH); that it was 7.5% undervalued and had fair value at $71.50. Today, you're telling investors to hold (or buy) it again at $39.65.

D.R. Horton (DHI) was the most undervalued homebuilder back in March, according to your story; it has since dropped 36% to $21.01, and you're still recommending it.

Amid all this, I still don't understand how you can conclude that things aren't getting any worse from this point forward. You concluded roughly the same back in March when future fundamentals for the group looked less dim than today. I guess if the stocks were cheap back in March, they must be even cheaper now. Or will they be even cheaper in October?

No positions in stocks mentioned

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ValuEngine and Homebuilders

Richard Suttmeier
7/22/2005 10:51 AM EDT

Nicholas, you have to review all the columns I have written on the homebuilders going back to June 21, 2005. There are 12 of them. If you follow the overall theme, investors reduced holdings near the highs and bought back at the Value Levels and at the worst case they own the same number of shares with a significant amount of cash in the bank.

ValuEngine ratings are not a signal to buy, sell or hold, they are a ranking of more than 4,000 stocks, where only 2% can be a strong buy and 15% can be a buy. These are based upon 21 data points from Thomson/First Call and Capital IQ.

The second component of my three-pronged approach is the weekly chart profile, which includes a momentum reading and close relative to the five-week modified moving average.

The third component is to buy weakness to a value level and sell strength to a risky level.

The overall approach allows investors to stay with a core position and trade around that core.

In March investors would have added to Beazer (BZH) only if it weakened to the Value Level shown. Or, investors would have reduced positions on strength to the risky level. There is nothing in today's column that says buy Beazer. There is no value level at which to buy, and there is a risky level at which to sell. The same is true for D.R. Horton (DHI).

Today's column does not include any recommendations to buy at this time. Conditions in the housing market are lousy, but the fact that share prices are above last week's lows is a sign that even worse conditions may have been anticipated.

I will post my detailed guidelines tomorrow to give readers a better understanding.

No positions in stocks mentioned

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Weighing In on the Homebuilders

Dan Fitzpatrick
7/27/2006 6:08 PM EDT

Richard & Nicholas, I can't help myself. I have to weigh in on this.

First, I'm having a tough time understanding how any software based on various data points can put anything except an arbitrary value on the homebuilding companies. Do we really know when they bought their land, and at what price? How long have they been holding it? Certain companies like MDC Holdings (MDC) and D.R. Horton (DHI) have business models that only permit land purchasesd that enable them to get in and out within two years -- the "stick and move" strategy. Others like Lennar (LEN) will buy land and sit on it for years as they take it through the entitlement process -- the "buy and hold" strategy.

The problem with the stick and move strategy is that, by definition, the land was all bought at the top of the market. How good is this business model? Does it provide some safety from a downturn in real estate? Doesn't seem that way to me.

The buy and hold strategy doesn't work too well either. Builders don't start writing down the land cost until houses built on that land close escrow. With slow absorptions and sales prices that all but the most casual observer will acknowledge are still declining with no sign firming up, how can you credibly value these companies?

I've been in the building business for more than 20 years and I can tell you this -- the homebuilding sector is always the first to feel an economic downturn, and the last to recover.

Some "experts" are saying that absorption rates are bottoming out, but price cuts are still accelerating. Hmmm. I wonder why absorption rates are bottoming out.

Here on the Left Coast, subdivisions are rife with "For Sale" signs stuck in front yards with grass over a foot high. The builders still have later phases to sell. When will this end? I don't know. But I do know that nobody on Wall Street -- including the guys who enter those numbers into the database -- knows either. Execs that I know on the East Coast (specifically, Florida) tell me the same thing is happening. Same thing in Las Vegas.

How can we really know when such an illiquid market will turn around, or when the worst is behind us? Some tool from a major firm (discretion prevents me from mentioning which one -- though the firm is bullish on America) emailed me $20 ago that I didn't know what I was talking about when I said KB Home (KBH) could fall as far as $35. He mentioned some concept used by the IRS that land values keep the same basis as their purchase price. Tell that to the VPs of finance in each division that have to explain to "corporate" why they aren't making any profit on sales. And options mark-ups don't exactly make up for a stagnant market. There are only so many Sub-Zeros and can lights that people will buy.

This is far from over. Obviously, these stocks aren't going to zero. It's silly to be too confident about stock prices falling much further, but I assure you that this is dead money for the foreseeable future. Any scan based on fundamentals will find all the homebuilding stocks. There is too much squishiness in the earnings estimates to provide much value. Also, it's a lot easier for the Average Joe to understand how the real estate and homebuilding market is than it is to learn whether DRAM prices are dropping.

Want to know when the bottom in the homebuilding sector will occur? Just watch for land sales to start picking up. As of today, builders continue to wisely walk away from seven-figure deposits because the deals don't work. Builders are very savvy when it comes to their local markets. When they start buying land again, it's time to move back into this sector.

Position: Short MDC.

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Models Provide Guidelines

Richard Suttmeier
7/27/2006 6:35 PM EDT

Dan, thanks for chiming in. I cover more than 4,000 stocks with my model, and ValuEngine is the fundamental screening I use as a guide to valuations. To my eyes, the values are not arbitrary, as I can interpret the patterns evolving. But, keep in mind I do not use it as a black box. You obviously know more than I when it comes to traditional bottoms-up fundamental analysis. I enjoy learning nuances from pros like you.

The ValuEngine Stock Valuation Model was derived from the research and findings of Dr. Zhiwu Chen, professor of finance at Yale University, and his co-authors. The model is more sophisticated than traditional valuation models and outperforms its peers by employing a three-factor approach to stock valuation. Fundamental variables such as a company's trailing 12-month earnings per share (EPS), the analyst consensus estimate of the company's future 12-month EPS, and the 30-year Treasury yield are all used to create a more accurate reflection of a company's fair value.

My column today was not a recommendation to buy the homebuilders, nor was it a prediction that they have bottomed.

I hope you have read my concerns about the regional banks, which are set-up like dominoes should construction loans start to go into default.

No positions in stocks mentioned

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Bulls, Bears and Homebuilders...

Dan Fitzpatrick
7/27/2006 6:59 PM EDT

Richard, thanks for replying (I thought all you East Coasters were out to dinner by now). Yes, I read your excellent article and it would be a mistake to interpret anything you wrote as a buy recommendation.

In fact, as I read your article again, I think you're really making a very compelling case that the bears who are still growling so loudly have likely seen their better days -- even though we don't hear the sound of stampeding bulls yet.

Also, I believe you make an excellent point about your ability to "interpret the patterns evolving." That's gotta be a function of your experience in the business -- experience breeds insight. I believe the same is true for any kind of analysis. Experience will take us far beyond the raw data.

I'm just not sure that these are even stocks for the patient investor. I think these stocks are likely to be trading at these same prices a year from now. But then, as I type this I am realizing that I am exhibiting the same tendency that I've just written about -- taking current data and looking too far out into the future.

You know, I admit that I did not read your piece on regional banks -- I'll do that tonight. I'm not really tuned into the construction loan situation other than in Southern California. I'm not hearing of any defaults yet. I think a version of those "creative financing" vehicles that have been bailing out the highly-leveraged homeowners is still in play on the construction-lending side. Sooner or later, Paul will be unable to rob Peter any longer because Peter will have nothing left to steal.

Thanks for the dialogue, Richard. (Looking forward to reading your thoughts on the regional banks).

No positions in stocks mentioned

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Housing's Return to Rationality

Jim Cramer
7/28/2006 8:34 AM EDT

If you read every article about housing you would think that your house is worth 30%-40%, maybe even 50%, less than it was last year. And then, when you go to your house, you'd find that, if priced right, it sells in a nanosecond.

I know the housing companies are all predictably bearish now. I heard Richard Dugas last night on CNBC talking about how bad things were and how expansion has to be curtailed dramatically. All I can tell you is that when housing was cresting, when it was about to go over the cliff we all recognize, Mr. Dugas was bullish as all get out.

No, I am not trying to call an ironic bottom. I am simply saying that rationality has returned to housing. Pricing's not going up any more. We have the overextended speculators, who used cheap money, getting hammered. That's an important cohort, and that's who is doing the cancelling.

But there is still massive housing demand in this country from the plain old growth we've had and that's not changing. Which is why, if you offer your house at a price that is lower than you wanted, but still respectable, it will get sold. The much ballyhooed inventory, I believe, is simply from people who refuse to recognize that housing is no longer going up in value, not that it is plummeting.

This misconception of plummeting values explains why people are fleeing Countrywide Financial ( CFC) as well as some of the other more mortgage-related banking institutions. I believe that's an overreaction.

Bottom line: I don't want to own the homebuilders. I don't particularly care to own stocks where the estimates are too high. I have my hands filled with companies that beat the estimates but go down anyway. But the bears have to be a little more realistic, too. Housing's not collapsing. It is simply not going up in price.

At the time of publication, Cramer had no positions in stocks mentioned.

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Housing Anecdote

David Merkel
7/28/2006 11:03 AM EDT

From the Census Bureau, the homeowner housing vacancy rate hit 2.2% for the second quarter of 2006. According to Bloomberg, this is the highest rate since the Census Bureau began keeping records in 1956.

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May Not Be As Bad As It Seems

David Merkel
7/28/2006 12:26 PM EDT

Cody and Dave, I can only check the statistics back to 1964. Here's what I know: between 1964 and the third quarter of 2005, the statistic varied between 0.9% and 1.9%. It hit the lows in 1971, 1972, 1973, and 1978. It hit the high end of the range in 1985, 1989, 2001, 2003, and 2005. We're now above that old range.

What does the statistic mean? According to Bloomberg, "The homeowner vacancy rate is the proportion of the homeowner inventory which is vacant for sale." From the Census Bureau website, they define a vacant housing unit as:

A housing unit is vacant if no one is living in it at the time of the interview, unless its occupants are only temporarily absent. In addition, a vacant unit may be one which is entirely occupied by persons who have a usual residence elsewhere. New units not yet occupied are classified as vacant housing units if construction has reached a point where all exterior windows and doors are installed and final usable floors are in place. Vacant units are excluded if they are exposed to the elements, that is, if the roof, walls, windows, or doors no longer protect the interior from the elements, or if there is positive evidence (such as a sign on the house or block) that the unit is to be demolished or is condemned. Also excluded are quarters being used entirely for nonresidential purposes, such as a store or an office, or quarters used for the storage of business supplies or inventory, machinery, or agricultural products. Vacant sleeping rooms in lodging houses, transient accommodations, barracks, and other quarters not defined as housing units are not included in the statistics in this report. (See section on "Housing Unit."

Ugh. I know your feelings about bureaucrats, Cody, so I'll spare readers the rest of the definitions. Wonks can find them here.

My interpretation is that some people are moving to new homes before they sell their old homes. Secondarily, the increase in foreclosures is leading to more vacant homes as well. We have at least one vacant home on my street now; it's only a block long. Not a big sample, but it is an example of moving without selling, not foreclosure. That said, it's been vacant for a year. Some people wait in selling for a given price, and then the property doesn't sell. That's a reason why transaction volumes have slowed as well. To make a sale, one has to have a reasonable price.

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Telling Stats

Cody Willard
7/28/2006 12:38 PM EDT

Thanks, David. I am a pretty vocal bear on housing, but I figured that stat might not be a total "doomsday" data point. Note too that the homeowner vacancy rate hit the high end in 2003 -- price points from that year being still quite a bit lower in general than they are today. That is, 2003's high homeowner vacancy rates weren't exactly a great tell for a pending collapse. Regardless, fascinating discussion all around. Thanks all.

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Housing Anecdote

Michael Comeau
7/28/2006 12:40 PM EDT

I've heard from a few private homebuilders for months now that the market has clearly been slowing down. Pricing is tougher, sales are taking longer, and buyers have gotten very disciplined in their bidding. Also, it's becoming common for builders to start throwing in sweeteners like plasma tv's to help move inventory.

Also, I'm actually hoping to see a slowly weakening housing market because the nicer (and even some of the not-so-nice) parts of Brooklyn are absurdly expensive, and one day I hope to be a homeowner.

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