How to Profit From the Housing Recovery

The U.S. housing market is finally recovering. But that doesn't mean investors seeking to profit from the recovery should jump into shares of homebuilders, which look pricey today. Instead, consider playing the recovery with home-furnishings and home-improvement companies.

The U.S. housing market is on the mend. According to the S&P/Case-Shiller Home Price Index, the average price of U.S. homes hit bottom in January 2012 and rallied 8% through January of this year, the most recent month for which data is available.

Shares of homebuilders, which were brutalized during the 2007-09 bear market, have soared as the housing outlook has improved. On average, the stocks have climbed 260%, or 38% annualized, since the group hit its bear-market low on March 6, 2009 (prices are through April 19 unless otherwise noted). And some of the largest companies have done much better. For example, Lennar (symbol LEN) surged 551%.

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Housing starts, or the number of new homes starting to be built, jumped 28% in 2012. But Michael Souers, an analyst with S&P Capital IQ, says the main driver of the housing recovery so far has been investor demand, rather than demand from buyers purchasing primary residences (which would indicate a stronger, more sustainable recovery). Moreover, the percentage of mortgage holders who are delinquent on their payments is still high, as is excess inventory of homes in foreclosure or otherwise in line to be sold.

David Goldberg, an analyst for UBS, expects the housing rebound to continue but says the pace of the recovery will slow. "You really need job growth, and to some extent you need wage inflation or underwriting standards to loosen, to keep demand going up," Goldberg says. "There are only so many drivers that increase the pool of buyers."

Souers thinks many homebuilder stocks look expensive. The group's average price to book value (assets minus liabilities) is twice the long-term average. For the shares to continue a long-term rally from these prices, home prices and new construction would need to keep up the kind of breakneck recovery they staged last year, which Souers and Goldberg both agree is unlikely. "Investors in building stocks have gotten ahead of themselves," Souers says.

Shares of home-furnishings companies tend to move with housing, but with a six- to 12-month lag, Souers says. That's because buyers of new homes who have just sunk tens of thousands of dollars into a down payment and closing costs tend to be cash-strapped, so they will buy their furnishings over time.

Souers's top pick for riding the tailwind of the housing recovery is Bed Bath & Beyond (BBBY). The shares have disappointed over the past year, falling 2.1%. Souers says that's largely because of concerns that the Internet is hurting the company. A recent study showed that the company is among the most vulnerable retailers to "showrooming" (customers browsing in its stores but ultimately buying from lower-priced online retailers).

But Souers believes that those risks have been overblown, given that Bed Bath & Beyond tends to charge only 5% to 10% more than online competitors. "As long as the company can continue to drive traffic to its stores, consumers are not likely to be too swayed," he says. At $66.77 per share, the stock trades for 13 times estimated earnings of $5.01 for the fiscal year that ends next March.

Shares of home-improvement companies have surged along with homebuilders, but Home Depot (HD) still looks appealing. The company not only stands to profit from continued improvement in the housing market, it has also benefited from an overhaul in recent years of the way it stocks and prices merchandise. "A couple of years ago, the people there didn't have the technology to say, 'We need to order more snowblowers' " in a store that had run out, says Morningstar analyst Peter Wahlstrom. "Or perhaps they would have sent snowblowers to South Carolina, where they didn't need them, and then wouldn't have discounted them." That is no longer the case, Wahlstrom says, thanks to investments in the way Home Depot manages its inventory. That focus is indicative of a deeper shift in the company's strategy away from opening new stores at a breakneck pace, and toward improving profitability and efficiency within the stores it already operates.

The shares aren't cheap. The stock has advanced 43% in the past year, and at $74 trades for 21 times estimated earnings of $3.53 per share for the fiscal year that ends next January. Wahlstrom says the stock already reflects a healthy recovery in the housing market. Still, given Home Depot's strong competitive advantages, the shares offer a relatively defensive way of gaining exposure to a continuation of the housing rebound.

Stocks of other furnishings and home-improvement retailers look expensive compared with their business prospects, but timber harvester Weyerhaeuser (WY) is enticing. Weyerhaeuser is a real estate investment trust, which means it can avoid paying corporate income taxes as long as it passes along at least 90% of its earnings to shareholders as dividends and meets other requirements. But unlike most REITs, which own developed properties, such as offices or shopping malls, Weyerhaeuser owns timberland. It makes its money harvesting lumber for real estate and producing other wood-derived products, such as stuffing for diapers and packaging board for juice cartons. It also builds homes, a segment that generated 15% of Weyerhaeuser's sales in 2012.

Although Weyerhaeuser has surged along with other housing-related stocks – it has returned 352%, or 44% annualized, since its March 2009 low – it still has room to run. S&P Capital IQ analyst S. Benway thinks the stock, now $29.84, will be worth $35 in a year. But don't count on Weyerhaeuser for a lot of income; the stock yields 2.7% (that figure is based on the $0.20 quarterly dividend rate the company declared on April 11).