Housing Industry Stock Outlook - June 2018

It has been tough going for the U.S. homebuilding space this year, thanks to rising rates, higher input costs and lack of supply. Offsetting these headwinds is solid builders' confidence in the market along with robust economic growth and a consistent job market. This mixed backdrop has left investors uncertain about making positions in homebuilder stocks.

As a result, the Zacks Homebuilding Industry has slipped 16.8% so far this year versus the 1.6% gain of the S&P 500. Limited land availability, higher material costs and a constrained mortgage environment are indeed restricting homebuilders to respond to the growing demand to some extent

However, the industry looks attractive this year given solid economic growth. Consistent job growth, growing interest from first-time homebuyers as well as seemingly high homebuilder confidence are adding to the momentum.

Mixed Bag for Homebuilding So Far

Although recent housing sales data were not impressive, the larger picture is not that bad. The most recent data from the National Association of Realtors (NARs) shows that existing-home sales decreased 2.5% in April to a 5.46 million sales pace from March. With last month's decline, sales are now 1.4% below a year ago and have fallen year over year for two straight months.

Meanwhile, sales of new homes in the United States dropped in April after gaining in March. In fact, new home sales faltered in three of the last four months this year, suggesting the struggles of the housing market in winning back momentum. Housing starts and building permits also fell 3.7% and 1.8%, respectively, in the month.

Additionally, new home sales data for the prior three months was also revised down. The revisions revealed that sales in the first three months of the year were not as strong as reported earlier.

It is to be noted that although sales are trending down for both existing and new homes, the housing market performed remarkably well in 2017, with substantial wealth gains for homeowners and historically low distressed property sales.

The only bright side in the April report was inventory of new homes. Based on current-month sales, there were 300,000 new homes on the market in April, the highest in nine years and up 0.7% from March and 12.4% from a year ago. This is expected to bring some relief in the beginning of the spring selling season.

For existing homes, supply shortage is still prevalent, as total housing inventory at the end of April fell 6.3% year over year to 1.80 million existing homes available for sale, but is up 9.8% from the March figure, according to NAR's report. Housing inventory has now fallen year over year for 35 consecutive months.

Inventory shortage prevailing in the U.S. real estate market has been pushing up average home prices, with 5.3% gains nationwide in April for existing homes. The median sales price of new homes sold in the month was $312,400, 0.4% higher than the year-ago period.

Reaffirming a Positive Outlook for 2018

Despite the month-to-month hiccups, new home sales were up 11.6% year over year in April. Additionally, although April starts and permits tumbled from the March level, housing starts were up 10.5% year over year on a 7.2% increase in single-family homes, and a 19.1% surge in apartments. Permits were 7.7% above the April 2017 rate of 1.26 million units prompted by a 7.9% surge in single-family homes and 6.4% growth in buildings with five units or more.

Although inventory constraints have been consistently pulling the housing market down, robust demand is keeping the industry alive. This is primarily because of a solid labor market that is near full employment.

On the other hand, builder confidence increased two points to 70 in May from a downward revision of 68 in April, reinstating builders' confidence in the current housing market. Importantly, the reading was above the 50 mark, in the first five months of 2018, indicating a favorable outlook. Moreover, this is the fourth time in 2018 that the index has reached 70. Builders are particularly optimistic on growing consumer demand for single-family homes.

We cannot ignore the fact that rising mortgage rates and high prices of homes from inventory squeeze are indeed creating hurdles for buyers (mostly first-time). Nonetheless, robust demand from a solid economy and a cheerful job market is keeping the industry alive.

Although U.S. economic growth cooled down in the first quarter to an annualized pace of 2.3% after averaging higher than 3% in the previous three quarters, the economy is likely to rebound in the coming quarters as the labor market is near full employment, and both business and consumer confidence levels are strong. The U.S. economy is expected to expand at a 4% annualized rate in the second quarter, as per the latest Atlanta Federal Reserve's GDPNow forecast.

Growth is expected to accelerate in the second quarter as the industry starts to feel the impact of the Trump administration's $1.5 trillion income tax package on their paychecks.

Will Less Supply, Rising Input Costs & Hawkish Fed Stall Housing Momentum?

Limited supply of homes for sale has been the biggest issue facing the market and the problem will continue, particularly at the entry-level market. Inventory constraints are already pushing prices higher, thereby affecting affordability. As per the latest report from National Association of Realtors or NAR, housing affordability declined from a year ago in March, pushing the index down 7% to 150.4 from 161.7.

Apart from supply constraints, higher mortgage rates appear to be weighing on home sales, since buyers are facing higher borrowing costs. Mortgage rates are surging in proportion to U.S. government bond yields in anticipation of higher rates of inflation and further monetary tightening by the Federal Reserve.

The rise in interest rates comes at a time when values of homes are marching up with higher demand and lesser supply. The situation could be detrimental for first-time buyers, again raising affordability issues.

Adding to the woes, increased lumber prices are denting builders' earnings growth. Labor and material costs have already been increasing year over year. Now, with the recent imposition of a 25% tariff on imported steel and 10% on imported aluminum, raw material cost for homebuilders will further escalate.

Let's take a look at why it's worth paying more premium for the stocks in the industry.

Homebuilding Industry Offers More Upside

Because of homebuilders' asset-driven nature, it makes sense to value these based on price-to-book ratio. The valuation of the industry looks attractive at present. The industry currently has a trailing 12-month P/B ratio of 1.43. This is quite cheap compared with the market at large, as the current P/B for the S&P 500 is 3.85. Its lower-than-market positioning calls for upside in the quarters ahead.

What the Zacks Industry Rank Indicates

Within the Zacks Industry classification, homebuilding companies are broadly grouped in the Construction sector (one of 16 Zacks sectors).

We rank 256 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Our back-testing shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1. (Click here to know more: About Zacks Industry Rank. )

The Zacks Industry Rank for homebuilding is currently #37 (top 14%).

Sector Level Earnings Trend: Positive

The Q1 earnings season has heated up with 100% of construction companies having already released their numbers. And the showing has been good for these players with an earnings and revenue beat ratio of 69.2% and 84.6%, respectively.

Per the latest Earnings Outlook , the construction sector's earnings increased 47.3% in the first quarter, marking a sharp rise from the 20.6% earnings growth registered in the preceding quarter. The sector also registered top-line growth of 20.3% (13.3% growth in Q4).

For 2018, total earnings for the sector in the S&P 500 cohort are expected to increase 39.6% (compared with 15.5% earnings growth registered in 2017) on the back of 17.9% revenue growth (versus 10.65% in 2017), which looks quite compelling.

U.S. homebuilding companies have been riding high in recent years and the March quarter was no exception. Most of the notable homebuilders reported stellar results despite headwinds, beating on both top and bottom lines.

The positive momentum is likely to continue through 2018 given the solid earnings outlook and favorable economic fundamentals. The industry has been registering solid revenues over the past five years after having slumped during the 2009-2011 time frame.

How to Play Housing Stocks

Overall a favorable ranking, earnings growth expectation instils optimism for the industry. Investors can consider the following homebuilding stocks that are backed by a solid Zacks Rank and healthy growth projections.

Century Communities, Inc. (CCS) currently has a Zacks Rank #1 (Strong Buy) and has a solid earnings track, having surpassed expectations in three of the last four quarters, with an average surprise of 46.36%. Earnings estimates for 2018 and 2019 moved up 9.9% and 2.8%, respectively, over the past 60 days. Estimated earnings growth is 47% for 2018 and 14.2% for 2019.

M.D.C. Holdings, Inc. (MDC) has a decent track of positive earnings surprise, beating expectations in three of the last four quarters, with an average surprise of 31.45%. Meanwhile, the Zacks Consensus Estimate for 2018 and 2019 earnings has moved north by 10.7% and 9.7%, respectively, over the past 60 days. This Zacks Rank #1 stock has an expected earnings growth rate of 27.9% for 2018 and 13.2% for 2019. You can see the complete list of today's Zacks #1 Rank stocks here .

Beazer Homes USA, Inc. (BZH), a Zacks Rank #2 (Buy) stock, has surpassed earnings expectations in each of the last four quarters, with an average positive surprise of 177.21%. Earnings estimates for the current quarter and 2019 have moved north by 7.9% and 5.6%, respectively, over the past 60 days. The Zacks Consensus Estimate projects EPS growth of 78.3% for the second quarter.

William Lyon Homes ' (WLH) solid backlog and a favorable market environment bode well for this Zacks Rank #2 stock. Although the earnings estimate for 2018 has declined over the past 60 days, it has moved 5.6% up for 2019. Estimated earnings growth is 40.7% for the current year and 22.2% for 2019.

Meritage Homes Corp. (MTH) has also surpassed earnings expectations in each of the last four quarters with an average surprise of 23.04%. Earnings estimates have moved 6.3% higher for 2018 and 1.2% for 2019, over the past 60 days. The company has expected earnings growth rate of 38.7% for 2018 and 8.1% for 2019.

KB Home (KBH) has a Zacks Rank #2 and an expected EPS growth rate of 16% for the next 3-5 years. Earnings estimates for 2018 and 2019 have moved north by 2.5% and 0.6%, respectively, over the past 60 days. The Zacks Consensus Estimate projects EPS growth of 48.5% for the second quarter.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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