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Assessing The Risk And Reward For Homebuilders

By: SeekingAlpha
Posted: 10/7/2013 2:44:00 AM
Referenced Stocks: DHI;KBH;LEN;MDC;MTH
By John Dowdee :

Homebuilders were devastated by the collapse of the housing market during the brutal bear market from 2005 to 2009. Some homebuilders lost more than 80% of their market cap as investors fled. Since 2009, the combination of low interest rates, lower inventory, and rising rental rates has boded well for the housing market. Many of the homebuilders have exhibited excellent performance but the specter of higher interest rates have caused the sector to recently falter. Is the housing sector still a good investment opportunity? To gain insight, I looked at the risk and reward associated with homebuilders over several time frames.

Before analyzing individual companies, it will be useful to review the sector as a whole. There is currently more demand for new homes than supply due partly to the fact that companies have aggressively reduced inventory and scaled down their development. The number of new home sales in 2012 increased 20% over 2011 to an annual pace of 367,000 new homes but this is still well below the 20-year average pace of 760,000 new homes. In addition, the S&P/Case-Shiller 20 City Home Price Index is still below the 2007 top but appears to have stabilized and is continuing to improve.

In summary, the sector is still shell shocked from the bear market and many companies are sitting on large cash positions. The sector is improving but still has a long way to go to match the glory years between 2005 and 2007. To determine which companies may benefit the most from these improving fundamentals, I focused on the largest builders with a market cap over $1 billion. I also required the stocks to be very liquid, trading more than an average of 300,000 shares each day. The stocks that met by criteria are as follows:

As a reference in my analysis, I also included the following ETFs:

To analyze risks and return, I used the Smartfolio 3 program ( over the past 5 years. The results are shown in Figure 1, which plots the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) against the historical volatility.

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Figure 1. Risk versus Reward past 5 years

As is evident from the figure, there was a relatively large range of returns and volatilities. For example, MTH had a high rate of return but also had a high volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio.

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Similarly, I plotted a blue line that represents the Sharpe Ratio associated with iShares Home Construction Index .

Some interesting observations are apparent from Figure 1. Over the past 5 years, homebuilders have exhibited a breathtaking volatility, with some companies being three times more volatile than the S&P 500. Generally, the risk has not been worth the reward since most of the homebuilders are below the red line. However, LEN did have an excellent risk-adjusted return that beat the S&P and MTH had about the same risk-adjusted return as SPY. ITB had a return just slightly better than SPY but had volatility substantially higher than SPY. About half the homebuilders performed better than ITB on a risk-adjusted basis.

I next checked to see how much diversification you obtained from having the homebuilders in your portfolio. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected stocks and funds. The results are provided as a correlation matrix in Figure 2. Generally speaking, the homebuilder provided good diversification with regards to the S&P 500, with correlations ranging from 57% to 65%. As you would expect, the correlation was much higher when compared to ITB, with correlations in the 87% to 89% range. The only exception was SPF which tended to be less correlated than the other homebuilders.

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Figure 2. Correlation Matrix over past 5 years

To check how the performance may have changed over a shorter more-bullish period of time, I reduced the look back period to 3 years and re-ran the analysis. The results are shown in Figure 3.

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Figure 3. Risk versus Reward over 3 years

During the past three years, both the S&P 500 and the homebuilders were in a bull market, with the homebuilders actually generating higher returns (likely because they came from much lower starting points) but with significantly higher volatilities. The only homebuilders that came close to the SPY on a risk-adjusted basis were LEN, with RYL and MTH not far behind. Overall, the homebuilders were still extremely volatile but the absolute value of the volatility was abated over the past three years (ranging from 30% to 60% as versus 40% to 80% during the five-year period). When compared to ITB, all the individual homebuilders were more volatile (as you would expect). The majority of the individual homebuilders had a higher absolute return than ITB but only LEN, RYL, and MTH had as good or better risk-adjusted returns.

The investment landscape became even murkier in the more recent past. Since May of this year, the fear of rising rates has taken a toll on homebuilders, causing them to give back the gains they had achieved during the first quarter. To obtain a more near-term view, I ran the analysis from the beginning of 2012 to the present, a little over 1.5 years. This data is presented in Figure 4.

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Figure 4. Risk versus Reward since January 2012

Some significant changes have occurred over the last 1.5 years. Even over the near term, the sector was still volatile, with volatilities 3 to 5 times the volatility of the S&P 500. Despite the pullback in May, ITB has still outperformed the SPY on an absolute return basis and equaled the SPY on a risk-adjusted basis . The homebuilders have tended to clump together with RYL, PHM, SPF, and KBH providing good risk-adjusted performance and the rest of the sector faltering.

Bottom Line

The recent decision by the Fed to continue asset purchases is a large plus for the homebuilders. At the first sign of potential tapering in May, the sector began to sell off. Mortgages have climbed to the mid-4% range but are still low by historical standards. If you are worried about increased rates in 2014, you may want to focus more on builders that construct "luxury" or "move-up" homes. Purchasers in these higher priced markets tend to be less sensitive to interest rates.

Overall, homebuilders have offered risk tolerant investor excellent absolute returns since the bottom of the bear market in 2009. However, on a risk adjusted basis, they have not done as well as the S&P with a few notable exceptions. The relative performance of the homebuilders varies depending on the period under analysis but in general, RYL, PHM, and SPF have done reasonably well over all periods.

It should be noted that these stocks (with the exception of MDC) pay only small or no dividend, so they are not good candidates for the income investor. However, if you are interested in capital gains, there is a large potential since the stocks are still selling well below the highs of 2005 and 2006. In recent years, the environment has been favorable. If the Fed foregoes tapering and the mortgage rates stay low, this sector could continue to outperform.

In conclusion, homebuilders stocks are not for the faint-hearted. However, if you can withstand the volatility, this sector is worthy of consideration.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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