A sharp drop in prices makes their shares look ridiculously cheap. By J. Alex Tarquinio January 31, 2006 Once upon a time, we lived in caves. Then one of the more innovative among us built a house -- with a view of the tar pits no less. Shortly thereafter a fellow tribesman offered the builder a pile of clamshells in exchange for the house. With clamshells in hand, the entrepreneurial caveman constructed ten more houses. And thus the homebuilding industry was born, and soon thereafter the first housing bubble.For the past six years, homebuilders have amassed a huge pile of clamshells -- er, profits -- amidst one of the strongest housing booms in history. Their stocks reflected the profit explosion -- Standard Poor's Homebuilding index soared 675% from the start of 2000 through July 2005. But with talk of a bubble about to burst, the stocks have struggled since last summer, falling 18%. A chill shot through the industry in November when Toll Brothers, a leading builder of luxury homes, lowered its sales forecast for 2006. Investors now wonder whether the correction represents merely the cooling of a red-hot sector or the arrival of a new ice age. Before we tackle the stocks, here's our take on the big housing picture. We don't see a collapse of housing prices (see What's Your House Worth?). We agree with Frank Nothaft, chief economist for Freddie Mac, who expects a "soft landing," meaning that home prices won't fall, but they'll grow at a much slower pace. He predicts 5% a year on average, rather than the torrid 15% annual growth that some regions have experienced during the past five years. If prices continue to rise, builders' profits will probably hold up. But investors are treating their stocks like lepers. On average, they trade at about six times estimated 2006 earnings (versus 16 for the overall market). That's low even for homebuilding stocks, which traditionally are accorded single-digit price-earnings ratios because of the boom-and-bust nature of the industry. Investors often sell stocks of cyclical companies when their P/Es are so low because they think earnings are at a peak and more likely to fall than rise. Advertisement Ways to play Assuming that the glaciers aren't closing in, you can play builders in two ways. First, as Goldman Sachs suggests, hope that investors overreact and drive the stocks down to the point where they sell for five times earnings, and then swoop in. Or decide that the market isn't giving builders the credit they're due and that now is a fine time to buy. The argument in favor of buying now is that the publicly traded players are much stronger than they were when the industry was last tested by a severe downturn, in the late '80s and early '90s, and that earnings will hold up even if the overall housing market slumps. The key difference between then and now is consolidation. The big publicly traded builders today account for 25% of new-home construction in the U.S., which is more than double their share of the market in 1993. This promotes efficiency. Also, a real estate slump will probably benefit the big builders by making it easier for them to gobble up the small fry. One proponent of this rosy scenario is Sam Lieber, manager of Alpine U.S. Real Estate Equity fund. His fund soared an annualized 31% over the past five years to December 1, in large part because of a huge position in builders. Lieber, who still has 60% of his fund in builder stocks, says the number of new homes sold in 2006 could drop by 3% to 7% nationwide. But he insists that the stocks are too cheap and predicts that the group's average P/E will rise and approach 10 over the next few years. If he's right -- and even if earnings are flat over, say, the next three years -- that still suggests 67% appreciation, on average. Three to buy You can build a good portfolio with these stocks. Advertisement Hovnanian Enterprises, which operates in 17 states, is on a buying binge, having acquired four builders in 2005 alone. "We're among the most acquisitive companies in the business," chief financial officer Larry Sorsby recently told analysts. The largest of those acquisitions, First Home Builders of Florida, boosted Hovnanian's backlog (the number of homes sold but not yet delivered) by 45%. The stock (symbol HOV) traded at $73 last summer, but was down to $49 in mid December, or less than six times the $8.39 per share that analysts expect the Red Bank, N.J., company to earn in the fiscal year ending next October. Another of Lieber's picks is Lennar, based in Miami, which builds homes in 15 widely dispersed states. Lieber likes the company's large land portfolio and its strong balance sheet, which will allow it to buy more land, especially if prices drop. At $58 (down from $69 last July), the stock (LEN) trades at a bit more than six times profit estimates of $9.30 a share for the year ending next November 30. Lieber also likes Standard Pacific, which is based in Irvine, Cal., but focuses on the West, the Carolinas and Florida. With average selling prices of $375,000, its products are more upscale than those of Lennar or Hovnanian. Because some investors worry that pricier homes might suffer more in a real estate downturn, Standard Pacific's stock (SPF) is cheaper than the other two. At $37, down about 25% from its August high, it sells at just 5.5 times estimated '06 profits of $6.78 a share. Advertisement There are a few funds with big stakes in homebuilders. Beside Lieber's Alpine fund (EUEYX; 888-785-5578), there's Fidelity Select Construction Housing (FSHOX; 800-544-6666), which at last report had nearly half of its assets in the group. The fund returned an annualized 20% over the past five years. An exchange-traded fund, PowerShares Dynamic Building Construction (PKB), has about 30% of assets in homebuilders. The fund is less than one year old.