By
Morningstar
:
By Robert Goldsborough
Each new week, it seems, brings more good news to the
beleaguered United States housing sector, in the form of a wave of
economic reports showing improving housing prices and growing
numbers of housing starts. Most recently, the S&P/Case-Shiller
20-City Composite Index showed rising U.S. home prices again during
the month of July. For four consecutive months now, home prices
broadly have risen, and for three straight months, every one of the
20 cities included in that index registered housing price
increases.
At the start of the year, Morningstar's director of economic
analysis Bob Johnson, CFA,
made the case
that the housing market would see "meaningful improvement" in 2012,
although he cautioned, "it might be a second-half story." The
growing numbers of positive reports on housing suggest that that is
precisely how the housing story is playing out. More recently,
Bob has stated
that "the strength in the housing recovery has been building for
most of 2012 but has yet to have much of an impact on overall
economic activity. I think that will change in the second half as
existing homes purchased in the first half are remodeled and
furnished."
Now, a consensus has formed among economists that the housing
sector, which previously during the recovery has seen prices rise
in fits and starts only to fall back to new lows, is in the midst
of a sustained recovery at long last. Economists and analysts have
noted a raft of positive data coming in in recent months across all
areas of the housing sector, including rising sales of existing
homes, fewer house foreclosures, rising sales of existing homes,
and improved activity in new home construction, in the form of
strong housing start numbers.
As is often the case, investors saw the improving signs in the
housing sector well before the numbers were posted, with investors
bidding up the shares of all homebuilding stocks far in excess of
the broader market. For example, DR Horton (
DHI
) has returned 73% since the start of the year, while Lennar
Corporation (
LEN
) has returned 85%, M.D.C. Holdings (
MDC
) has returned a jaw-dropping 129%, and PulteGroup (
PHM
) has returned a stupefying 154%.
As homebuilders' shares have surged, investors should review
their own margins of safety to determine whether homebuilding
companies have more value left in them. For those interested in
investing in the homebuilding sector, an exchange-traded fund is an
ideal way to hold a broad basket of the U.S.' largest homebuilders.
For such investors, iShares Dow Jones U.S. Home Construction (
ITB
) likely is the best option. The fund is suitable only as a
complementary satellite holding in a diversified portfolio. The
average market capitalization of a company in ITB is about $4
billion. Investors should take note that the housing sector is
highly cyclical and quite sensitive to economic and credit
conditions.
Aside from homebuilders (which account for about 65% of total
assets), this fund also holds building-materials and fixtures
producers (17%), home-improvement retailers (13%), and furniture
companies (5%). This fund contains 27 companies and is fairly
top-heavy, with the top-10 holdings accounting for more than 64% of
total assets.
Fundamental View
The bursting of the housing bubble, the accompanying credit crisis,
and the economic downturn have devastated homebuilders and the
broader housing industry. Although all the recent positive data
would suggest the sky's the limit for homebuilders, there's always
a risk of frothy valuations. Plus, despite all the rosy data and
mortgage rates remaining at record lows, there are some danger
signs that could hamper homebuilders going forward, such as a huge
inventory of foreclosed homes on the market at distressed prices
and lending standards much tighter than a few years ago. Given the
lousy job market, high housing inventory, and a sea of
foreclosures, it's reasonable for an investor to wonder whether
homebuilding stocks have gotten ahead of themselves, given their
recent rally.
By aggressively reducing inventory and ratcheting back on
developments, many of the large homebuilders now are sitting on
piles of cash, despite the heavy losses they have taken in recent
years. They have also downsized their organizations to better align
their cost structures for a lower-demand environment. During the
past few years of weakness, many private homebuilding companies
have gone bust, and even the stronger publicly traded firms have
written off half or more of their book equity since the peak. But
the homebuilders that survived are now standing on more-stable
financial ground. Thanks to stimulus-related initiatives from 2009,
such as the first-time homebuyers credit and longer tax-loss
carrybacks for U.S. corporations, homebuilders have been able to
improve their businesses and their balance sheets over the past few
years.
One possible catalyst for the housing sector involves further
quantitative easing, known as QE3. On Sept. 13, the Fed announced
its plans to purchase $40 billion of agency mortgage-backed
securities per month and extended its pledge to keep short-term
rates pegged at zero until mid-2015. What is unique about QE3 is
that it is open-ended. The Fed plans to keep buying MBS until the
economic recovery is well established. This seems like a no-lose
situation for housing prices. If the Fed's actions are successful
and the labor market improves, it will likely result in improved
consumer confidence and higher home prices. If their actions are
unsuccessful, they will likely spur inflation, which may also
support housing prices. In the wake of the Fed announcement,
30-year mortgage rates hit historic lows of 3.4% and are likely to
continue moving lower as the Fed ramps up its purchases. Low rates
could provide further stimulus for homebuilders.
While Morningstar's equity analysts don't cover enough stocks in
this ETF to form a fair value opinion, we can get some idea about
valuation by looking at the individual stocks they do cover,
including DR Horton, Lennar, Toll Brothers (TOL), and NVR (NVR).
Unfortunately, each of these stocks looks overvalued, particularly
Toll Brothers, which is trading at its Consider Selling price of
$35.70.
Portfolio Construction
This fund aims to replicate the performance of the Dow Jones U.S.
Select Home Construction Index. The index contains 27 companies,
and holdings are float-adjusted and market-cap-weighted. However,
total holdings in non-homebuilding companies are capped at a
maximum of 40% of the portfolio. Out of 27 companies in the fund,
12 are homebuilders. The largest non-homebuilding holdings are
home-improvement retailers Home Depot (HD) (5%) and Lowe's (LOW)
(4%) and building materials manufacturers Sherwin-Williams Co.
(SHW) (3%) and Masco (MAS) (3%). The fund is fairly top-heavy, with
the top-10 holdings accounting for more than 64% in total
assets.
Fees
The fund's 0.47% annual management fee is slightly higher than SPDR
S&P Homebuilders (XHB), which is a similar ETF. XHB charges
0.35%.
Alternatives
The only other homebuilding ETF of any significance is the cheaper
(0.35% expense ratio) SPDR S&P Homebuilders. ITB and XHB both
are focused on the homebuilding industry, but they follow very
different indexes. The index tracked by ITB, the Dow Jones U.S.
Select Home Construction Index, is a float-adjusted
market-capitalization index, and caps total non-homebuilding
holdings to a maximum of 40%. XHB tracks the S&P Homebuilders
Select Industry Index, which is an adjusted equal-weighted index.
Because of these differences, ITB has a much higher exposure to
homebuilders, at more than 65% of the portfolio. XHB, on the other
hand, has only about 28% of its portfolio invested in homebuilding
companies. ITB trades about 1.8 million shares a day and is far
less liquid than the highly liquid XHB, which trades about 6.5
million shares a day. Despite some obvious differences between the
two funds involving the respective sizes of direct investments in
homebuilding companies, the performance of XHB and ITB is 97%
correlated over the past five years.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
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