Despite Prices Being Through The Roof, The Housing Market Still Offers Upside

From my experience, some of the best investment returns come about when you marry the investment philosophies of value investing and contrarian investing. As an example of how this can prove to be a success, we need only look at the housing market. Around a year ago, I found myself bearish on the space but bullish on many of the companies in the industry. I recognize that high-interest rates and inflationary pressures, combined with the possibility of a recession that never came, would prove to be painful for home building demand. But because of a continued housing shortage, combined with the transitory nature of interest rates, I believed that the long-term picture would be very bullish. Demand would be pent-up and, once interest rates declined, the end result would be a surge in orders for houses.

As you will see in what follows, my conclusion was pretty darn accurate. But the one thing that I recognized early on was that I was wrong about the timing. Had you asked me a year ago, I would have made the case that we wouldn’t see any sort of improvement in the industry for at least a year. If you had come to me from the future and told me two years out would be the time that we see some recovery, I would not have been surprised. But by the latter part of 2023, I started seeing signs of a recovery, as I detailed here and here. The market quickly responded, pushing shares of many of the home building companies significantly higher. But even after that move, it looks as though some upside potential for some of the businesses in this space remains.

Interesting Times

The purpose of this article is not to rehash all of the details that I have covered in prior articles. I have already linked to some of those, and I would encourage you to check them out before reading the rest of this. Rather, it’s to provide an update as to where we are. And the best way to start an update, I would argue, is to look at the most recent data available regarding the housing market. In the image below, you can see one data point that is relevant. This data covers new residential construction as of the most recent month for which it is available. That’s January of 2024. According to the Census Bureau, building permits issued in January totaled 1.47 million. Although this is 1.5% lower than what was seen in December, it does represent an 8.6% rise year over year.

This data suggests that while there has been some weakness on a sequential basis, the year over year picture is positive. But from this point on, it would be more beneficial for us to drill down into the homebuilders themselves. The first point to discuss involves overall backlog. As you can see in the table below, backlog for nine of the largest publicly traded home building businesses in the country has largely been negative. This data looks at the most recent quarter provided by each business relative to the same quarter one year earlier. Seven of the nine companies have seen backlog fall year over year.

As a group, backlog is down 9.3% now compared to what it was one year earlier. But not every company has had the same kind of experience. Century Communities (CCS), for instance, has seen the greatest pain, with backlog down 40.9% year over year. On the other side of the spectrum, you have two companies that actually saw a year over year increase in backlog. The first of these is Beazer Homes USA (BZH), with a modest increase of 2.9%. And then you have NVR Inc. (NVR) with a gain of 11.6% year over year.

What’s interesting to point out here is that, while backlog is down an amount that I would consider to be material, the actual number of homes delivered in the space, has dipped a modest 1.9%. Three of the nine companies that I dug up data for showed year over year increases. And one of these is the largest of all nine firms. With this suggests is that, even as the backlog was falling, the home builders were tirelessly working away at the orders that had been built up. The goal here was to continue to generate revenue and attractive cash flows at a time when the near-term picture was looking less and less certain. In theory, if this trend had continued for an extended period of time, a scenario where backlog approached zero would not have been out of the question. Fortunately, demand in the space proved to be far more robust than that.

For the most part, the company specific data we are talking about is rather bearish. The number of homes delivered and the drop in backlog both point to a negative picture for the industry. And yet, the data provided by the Census Bureau illustrates that we are starting to see an increase in activity in the home building market. Fortunately for us, there’s some additional data that corroborates this. In the chart below, you can see the number of net new orders placed at the nine homebuilders that I analyzed. What you can see here is, without exception, a massive increase year over year in orders. In fact, the worst of the nine companies, NVR Inc., reported a 25% rise in net new orders during the most recent quarter compared to the same time last year. The best of the players was none other than KB Home (KBH) with a gain of 175.9%. And if you average out the nine firms, we get a reading of 44.2%.

Frankly, this is shocking. Although inflationary pressures have eased, interest rates still remain at multi-decade highs. You would think that this would mean any sort of surge in net new orders would wait until the market became more acceptable for home buyers. But this is what happens when you have a massive national shortage. At some point, demand pushes through all else. One thing that investors would be right to question is whether these net new orders are coming about because of the homebuilders making major concessions. An example of this would be them cutting their prices on homes just in order to keep work flowing in the door.

This would prove beneficial in the short term but could prove costly in the long term. Fortunately, I don’t think this is what is happening. In fact, if you look at the table above, you can see that four of the nine companies have achieved average sales prices that are higher in the most recent quarter than they were one year earlier. And of the companies that did experience a decline, the worst was only by 5%. We’re not talking about deep discounts in this space. Now, it’s possible that the homebuilders will experience some margin pressure in the future. I say this because lumber prices are currently up 18% year over year. But only time will tell what the truth may ultimately be. We do know that some of the homebuilders are quite bullish right now. For instance, PulteGroup (PHM) announced earlier this year a $1.5 billion increase to its share buyback program. And on Feb. 14, NVR Inc. announced a new $750 million share buyback initiative. These are not the kinds of activities you expect to see of businesses that expect margin compression to be a real issue in the near future.

Another data point that I would like to bring up involves the cancellation rate of orders. It’s one thing to see orders come in. It’s another to see them canceled because of the hardship of those placing the orders or because of other reasons. Over a year ago, cancellation rates were through the roof. Eight of the nine companies that I’m covering in this article provide quarterly cancellation rate data. The worst of them was KB Home with a rate of 68% roughly a year ago. That number has now fallen to 28%. In fact, we have seen meaningful improvements across all eight businesses for which data is available.

I originally got into investing around 2008 during the financial collapse. I have seen a lot transpire in the years since then. One thing I do know is that, while the market is nowhere near efficient, it does eventually catch on to opportunities. At some point in the past year, investors recognized that the long-term outlook for the home building market would be positive. As a result of this, shares of many of the businesses in the industry have skyrocketed. Over the past year, shares of the nine companies that I am covering shot up between 45.6% and 110.1%. By comparison, the S&P 500 is up only 28.3%.

This begs the question of whether there are still some opportunities in the home building market for investors to dive into. My argument would be that, yes, there absolutely are. In the three charts below, you can see how shares of the nine companies are priced on a price to earnings basis, a price to operating cash flow basis and on an EV to EBITDA basis. Many other companies are still trading at levels that I would consider to be very attractive. When you add on top of this the likelihood that the surge in demand for new properties will continue to grow, and I would say it’s highly probable that if anything, conditions will eventually become even more appealing for these businesses.

Takeaway

As matters stand, backlog is still depressed and the pricing for new homes might be a bit on the weak side of things. But outside of that, the situation looks promising. Shares of many of the companies in the industry look attractively priced and it should not be too long before the number of homes in backlog starts to approach or surpass the number that was seen a year ago. When that comes to pass, the recovery will be truly completed. But if you’re bullish about the space, I would caution you about waiting that long to buy in. By that point, all the easy money will have been made instead, getting in now might be the most sensible approach.