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Why Homebuilders Stocks are Still a Buy
Scott Cendrowski / Fortune/CNN Money / September 16, 2013
FORTUNE — What a difference a year makes. Last summer, when Fortune recommended homebuilder stocks, the chorus of dissenters was loud — and to some, persuasive. Their argument went something like this: “Homebuilders are doomed! Foreclosures are flooding the market and besides, no one wants to a buy a new home. They’ll rent forever!”
What happened next? Homebuilder stocks went on a tear. From last July through its peak this May, the S&P homebuilders index rose by 51%, more than doubling the S&P 500’s return. PulteGroup shares, as one example, jumped to $24 from $9. It seemed everyone on Wall Street had piled into the trade.
The case for homebuilders last year boiled down to two key points. First, the supply of new homes was spectacularly thin. A historically low number of new homes existed on the market, so it was clear that builders would have to build more to meet demand, even though demand for new homes was less than half of normal. Second, even though homebuilder shares had already risen, the stocks still traded at huge discounts to what they would be worth in more normal times when demand for new homes returned. Those discounts gave investors a healthy “margin of safety,” which meant that even if you timed the stocks wrongly, you wouldn’t lose boatloads of money because the stocks were cheap to begin with.
Foreclosures and rising mortgage rates and all the other variables in the housing market are important, but their effect on homebuilder stocks is far smaller than these two points. If you have a tight market for new homes and homebuilders stocks’ are cheap, the stocks scream buy.
So after a big run-up, how do they look today?
Here’s where things get interesting. Back in May, investors awakened to the fact that mortgage rates could rise considerably after the Fed talked about ending quantitative easing. Investors acted as if demand for new homes would plummet. Homebuilders’ stocks declined throughout the summer, falling nearly 30% from their peak in mid-May through early September. The good news is that the decline has given investors a possible window. If homebuilders are 30% cheaper than they were a few months ago, and their future success is still probable, then the stocks should be even better buys today.