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Homebuilding stocks are surprisingly cheap—and analysts say these are the best 4 to buy now

April 14, 2022, 9:00 AM UTC

If you were wondering how residential housing has been doing as an asset class the last few years, just ask any potential buyers. Their despondence will tell you all you need to know.

Annual home-price gains were a scorching 19.2% in January, according to the S&P CoreLogic Case-Shiller Index: the fourth-hottest reading in 35 years.

But funnily enough, you’d never guess at this good fortune from looking at one corner of the market: homebuilders.

Such stocks have been battered and bruised in 2022, placing many names in seemingly deep-value territory. The SPDR S&P Homebuilders ETF (XHB) has sunk over 20% year-to-date, with the forward price/earnings ratios of many individual stocks in the ugly range of four or five.

So what gives? The elephant in the living room, of course, is rising interest rates. Average 30-year fixed mortgages recently crossed 5%, a level not seen since 2011. With the Federal Reserve signaling more rate hikes to help tamp down inflation, this will impact housing affordability—which could put the brakes on red-hot price gains.

“Once we started seeing interest rates go up, we were expecting this,” says Brian Bernard, director of industrials equity research for Chicago-based research shop Morningstar. “Mortgage rates have been increasing in a very short period of time, home prices are the highest they have ever been, and home affordability is becoming a concern.”

Throw in rising materials prices, thanks to supply-chain troubles and society-wide inflationary pressures, and you can see why worry has been baked into stock prices. But as seasoned analysts know, the market often tends to overshoot both on the upside and the downside. Investors have so punished these stocks already that some intriguing values have emerged.

“We have a positive outlook on homebuilder stocks, and actually just upgraded a few of them based on valuations,” says Rafe Jadrosich, senior homebuilders analyst for Bank of America. “Their earnings multiples are very low, and a lot of them are approaching 1x book value or below. This is typically around the level where valuations bottom out.”

For those worried about risk, keep in mind that homebuilders seem to have learned a few lessons from the last housing crisis. Business now often revolves around option contracts: That means these companies have the option of building on tracts, but not the obligation—so they can walk away without too much damage if it’s not cost-feasible, and don’t have to carry all that land on their own balance sheets.

More broadly, the fundamentals of the sector remain positive: an undeniable shortage of supply, combined with the demographic reality that the huge millennial generation is transiting through its prime homebuying years.

“The fact is, there is not enough housing in the U.S.,” says Bernard. “There is a shortage of 3.5 million homes, although I have seen some estimates as high as 5.5 million. Even if interest rates slow demand, we still have a long way to go to deal with population growth and demographic trends like millennials reaching homeowner age. This is a bullish outlook for housing.”

In the near term, of course, homebuilders will likely continue to get punched with every rate increase. But investors with patience and a long enough timeline could be nicely rewarded. A few homebuilders that are a worth a look:

D.R. Horton (DHI). As rising rates affect affordability, more buyers will be nudged toward the entry-level section of the housing market—and that’s where D.R. Horton is especially well-positioned. The nation’s largest homebuilder by volume, it is “my top pick,” says Bernard, with a fair-value estimate of $113. A solid balance sheet, strong presence at lower price points, and an asset-light business model means that it should be able to weather any housing-market turbulence.

PulteGroup (PHM). This $10 billion builder is very familiar to investors, but “across the universe of homebuilders we cover, it has the cheapest price-to-book ratio,” says Jadrosich. No wonder, since it is down around 25% on the year so far. But given its healthy return-on-equity outlook, even a modest valuation of 1.5x book value would boost its shares to $58, from its current level just over $40. Analysts from J.P Morgan are also fans, rating the stock “overweight” thanks to its appetizing “valuation discount.”

Lennar Corp. (LEN). This large-cap name has a higher average selling price than D.R. Horton, and is one of the nation’s top builders by revenue. It also has a presence in some ancillary businesses like multifamily developments, but has been spinning off non-core assets in recent years to focus on being a pure-play builder. It’s ranked four stars by Morningstar, with a fair-value estimate of $124. (You can read Shawn Tully’s feature in Fortune about Lennar here.)

Toll Brothers (TOL). This stock represents the higher end of the homebuilding sector. It’s not as present in the entry-level slice of the market, where much of the group’s growth is expected to take place. But on the plus side, its buyers tend to be more well-heeled—many paying cash for their homes—and so won’t be as rate-sensitive in their buying decisions. Bank of America’s target: $63, up from its current $46. “Two-thirds of the land on their balance sheet was purchased pre-COVID, when prices were much lower,” Jadrosich points out. “I think the book value of that land is understated—and the stock is even cheaper than it looks.”

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