Buy Builders, If You Dare

To be a truly contrarian investor, you need to buy stuff others are unloading in disgust. And few sectors are more loathed today than homebuilders.

Nobody expects the home-building business to pick up tomorrow. In January, the most recent month for which data is available, housing starts fell to their lowest pace since the government began tracking the numbers in 1959. Analysts forecast that nearly every publicly traded builder will lose money in 2009.

But that's exactly why you might want to add some builders to your portfolio. Builders' profits are highly leveraged to the ups and downs of the economy, and their stocks usually start to recover vigorously well before a recession ends. "It's entirely possible that builders will rally while we're continuing to see declines in home prices," says Jay McCanless, an analyst with FTN Equity Capital Markets. And with the stocks down an average of 88% from their 2005 highs, there's no denying that they're cheap.

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Best of the lot. The most-conservative builders are the best positioned to thrive once the economy rebounds. NVR (symbol NVR) and M.D.C. Holdings (MDC) are unique for their small land inventories. At current building rates, M.D.C.'s inventory would last 1.4 years, compared with the industry average of 3.6 years. And NVR's inventories are nonexistent; it pays third-party owners for the option to buy lots within a certain period of time, but the company can always walk away from a deal and forfeit what it paid for the option. At last report, NVR's outstanding land options were worth just $29 million.

With more cash than debt, both can snatch up cheap land when demand turns around. NVR, whose stock traded in early March at $321, has cash worth $1.15 billion, or $207 per share, on its balance sheet. M.D.C., which traded at $23, holds $1.4 billion, or $29 per share (both figures are before taking debt into account). "There's NVR, there's M.D.C., and then there's everybody else," says Morningstar analyst Eric Landry.

That's all old news to the market. The stocks trade at a premium relative to the sector: NVR shares trade for 1.3 times book value (assets minus liabilities), and M.D.C. trades for 1.0 times book value. NVR also happens to be the only large builder that is expected to turn a profit in 2009. Analysts look for the Reston, Va., company to earn $14.97 per share, giving the stock a price-earnings ratio of 21.

Although luxury is practically a dirty word in light of Americans' newfound penchant for thriftiness, high-end homebuilder Toll Brothers (TOL) is another potential winner. Toll is the only large builder to cater to the luxury market exclusively. Its expertise in that niche gives it extra clout among sellers of land, and the company is adept at choosing locations that appeal to its target audience.

Landry says the Horsham, Pa., company should come out of the recession with a larger share of the luxury market than it had going in. "Many of Toll's competitors are moving out of luxury and into the entry-level market," he says. At $14, the stock trades for 0.7 times book value. Analysts expect Toll to lose $1.34 per share in the year that ends in October but turn profitable toward the end of the next year.

If you find picking individual stocks too onerous or too risky, buy an exchange-traded fund that focuses on the building sector. The best choice is SPDR S&P Homebuilders ETF (XHB), which charges just 0.35% in annual expenses. But remember, the only difference between salad and garbage is timing. Nibble on these shares with caution.