The U.S. economy entered a recession in the first quarter this year, and many investors assumed it would be 2008 all over again. In other words, the consensus estimate back in March was for housing starts to decline, home sales to reach new lows and homebuilder stocks to shed billions of dollars in market value. None of these expectations, however, materialized.
The economic stimulus packages introduced by the government, the emergency rate cut delivered by the Federal Reserve and the return of the quantitative easing program have all contributed to the strong performance of the housing market over the last few months. October housing data suggests the bull run will continue for longer, and growth investors are not too late to benefit from this booming sector.
The numbers tell the story
According to data from the Census Bureau and the Department of Housing and Urban Development, seasonally adjusted housing starts hit a 13-year high in October.
What is noteworthy is that housing starts have fallen in almost all the previous recessions, which are illustrated by the white columns in the above chart. This time around, the fortunes have changed for the industry. National Association of Home Builders chief economist Robert Dietz wrote in a blog post:
"The October reading of starts was consistent with surging builder confidence, as single-family construction rises to meet strong buyer traffic, supported by low interest rates, a changing geography of demand, and a growing number of sales that have not started construction."
According to data compiled by Spanish bank Banco Bilbao (XMAD:BBVA), there is a massive imbalance between the demand and supply in the U.S. housing market as new properties are hitting the market at a considerably lower rate than the increase in demand. If this persists, homebuilders will be in a strong position to generate economic profits as house prices will inevitably continue to increase.
Best bets in the industry
Many investors might be inclined to buy into the largest homebuilder stocks in the country, such as D.R. Horton Inc. (DHI, Financial), Lennar Corp. (LEN, Financial) and NVR Inc. (NVR, Financial). There is nothing wrong with betting on these big players as their scale will help them improve the return on capital, leading to an expansion in earnings multiples.
A lesser-known yet profitable company to consider is Green Brick Partners Inc. (GRBK, Financial). The majority shareholder of this small homebuilder is David Einhorn (Trades, Portfolio)'s Greenlight Capital. In addition, Green Brick is the firm's largest holding. Almost a year ago, I discussed why the stock was significantly undervalued. Since then, the stock has appreciated more than 100%.
Despite the recent gains, Green Brick is still trading at cheap multiples compared to the leading players in this space. Even though the company is valued at a discount to the industry and its rivals, Green Brick has consistently achieved above-average growth rates in many of the most important profitability metrics, which is illustrated below.
Investing in small-cap stocks is a tried-and-tested strategy of generating alpha returns, and Green Brick ticks many boxes an investor would want to see in a high-growth company.
The macroeconomic outlook
There are many tailwinds pushing homebuilders higher. First, the ultra-low interest rate environment is projected to remain the same through the end of 2022. Redfin chief economist Daryl Fairweather told Mansion Global:
"Affording mortgage is as inexpensive as it's ever been due to record-low interest rates, making a home purchase very appealing to people who are lucky enough to be securely employed."
Homebuilder stocks are negatively correlated to mortgage rates because low borrowing costs lead to more activity in the housing market. Assuming this relationship will hold in the coming year, homebuilder stocks can be expected to build on the current momentum and deliver double-digit returns.
Second, the expected recovery of the global economy will also be a growth driver for the sector. The unemployment rate has risen sharply over the last few months, but the demand for houses did not dry up, which indicates the strength of the U.S. housing market. When economic growth returns, the demand will only head higher as more consumers will be able to afford buying houses. Even now, the market is under-supplied and housing prices are continuing to skyrocket. As illustrated below, total active listings are down 39% on a year-over-year basis for the week ended Nov. 7. Because of this supply scarcity, median listing prices have soared 12.9% in the same period, and this trend has persisted for several months.
Source: Norada Real Estate Investments
Considering the expected income boost in the country, it's reasonable to conclude that this trend is unlikely to reverse in the foreseeable future, which is good news for the homebuilding sector.
Third, the economic stimulus packages introduced by the government is likely to trigger a wave of new home purchases. Under the $2.2 trillion fiscal stimulus package passed in March, households were sent checks worth up to $1,200. The primary idea behind these payments was to help struggling families cope with the new reality as thousands of Americans lost their income. A survey conducted by The Economist, however, found that nearly a third of these disbursements have gone directly into savings.
Source: The Economist.
As borrowing costs are at historic lows, consumers who have yet to purchase their first homes are likely to use up the stimulus checks to fund the initial equity required to obtain a mortgage facility. There is every chance that another round of similar checks would follow in the coming year. The House of Representatives has already approved a $2.2 trillion economic relief package, but the Senate has yet to vote on it. In any case, the Senate previously proposed a $1.8 trillion package. There is no doubt that another fiscal boost is in the cards for the American economy within the next few months, which is good news for the housing industry.
Takeaway
Homebuilding stocks have outperformed the broad market so far this year. The S&P 500 Index is up about 9.5% in 2020 in comparison to the massive 24% gain reported by the S&P Homebuilders Select Industry index. This trend is set to continue in the foreseeable future. The macroeconomic outlook is promising, and homebuilders of every size and scale are poised to deliver attractive returns to investors. A prudent investor, however, might want to focus on the lesser-known names in the industry as many small-cap stocks have yet to be discovered by the investing public.
Disclosure: The author owns shares of Green Brick Partners.
Read more here:
- Tudor Investment Boosts Its Disney Stake
- Seth Klarman Bets on Micron Technology
- George Soros Divests Banks and Bets on the Tech Sector
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
