Markets

Time to Buy Homebuilder Stocks?

The battered shares of two companies look promising for the long term.

Each month brings fresh data that the housing market is in the dumps. The latest: Home prices in June were down 15.9% from the year-earlier period, according to the Standard & Poor's/Case-Schiller 20-city index of home prices. That was the biggest decline since the index was introduced in 2000.

So it doesn't seem to be the most auspicious time to invest in homebuilder stocks. Or is it?

Consider this: On August 13, Citigroup initiated coverage on eight homebuilders, assigning "buy" ratings to two of them, Toll Brothers (symbol TOL) and Pulte Homes (PHM). Citi isn't the only one to think it may be a good time to invest in the battered builders, even if it may be months or longer before home prices turn around. "The only way we won't make money in these stocks is if the companies don't make it through this cycle," says Josh Spencer, homebuilding analyst with T. Rowe Price. "It's hard to think the housing market won't recover eventually and that homebuilding stocks won't get back to profitability."

The argument for buying building stocks now isn't that home prices are about to stabilize. The case for the stocks is that they have fallen so much -- more than 70% -- since peaking in 2005, additional home-price declines are already reflected in the share prices. If the patterns of previous investing bubbles hold this time, the potential is huge. Justin Walker, co-founder of Bespoke Investment Research, notes that after the Nasdaq Composite Index imploded during the 2000-02 bear market, the index rebounded strongly in 2003, gaining 50% and outpacing all domestic indexes.

Of course, you shouldn't invest in homebuilders (or hold on to existing positions) expecting them to return to their old highs. "They have a long way to go before they can even put a dent in their decline," Walker says.

There's also the matter of timing. "If you look at them on a long-term basis, the homebuilders are great values," says analyst Rashid Dahod, of Argus Research. "Near-term is a different matter." Dahod gives "hold" ratings for the short term on several of the builders he covers, but "buy" ratings for the long term.

Dahod recommends looking for builders "with sufficient access to capital and plenty of cash on the balance sheet." Toll Brothers, which builds luxury homes, is one that he says fits the bill. It has $900 million in cash on its balance sheet and access to $1.2 billion in unsecured revolving credit. "Toll Brothers has strengthened its balance sheet so much that the market knows it's clearly a survivor," says Spencer of T. Rowe Price.

Still, you need a strong stomach to pull the trigger now. Toll Brothers is saddled with more land than it can profitably sell. It reported that homebuilding revenues for the quarter that ended July 31 fell 34%, to $796.5 million, from the same period a year earlier. Analysts expect the company to have lost 19 cents a share in the quarter, and they see a loss of $1.55 per share for the fiscal year that ends this October. But they see a profit of 56 cents a share in the October '09 fiscal year.

The stock, which closed at $22.33 on August 25, is 62% below its July 2005 record high of $58.25. The stock trades at 1.1 times Toll's book value (assets minus liabilities) of $21 per share.

Pulte's shares, which closed at $12.75, are 73% below their July 2005 high of $46.82. The stock trades at slightly less than 1 times book value of $13.48 per share. The company holds $998 million in cash, although it carries more debt than Toll. Analysts expect Pulte to lose $4.15 per share this year and to lose 23 cents a share in '09.

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