TCS Daily

Bring Your Money Home

By James K. Glassman - October 22, 2002 12:00 AM

Here's a stock that might interest you...

The company, exceptionally well managed, is in an industry that has boomed this year despite the economic slowdown. The firm's revenue has doubled in the past four years and quadrupled in the past 10. Earnings have risen in what I call a "Beautiful Line," from 73 cents a share in 1995 to an estimated $6.80 in the fiscal year that ends next month - up each year at an annual average of more than 30 percent.

The Value Line Investment Survey ranks the company "A" (near the top) for financial strength and "1" (among the 100 best stocks) for timeliness.

Yet the stock carries a price-to-earnings (P/E) ratio of just 8. In other words, you can buy a dollar's worth of this company's annual profits for eight bucks. The average P/E of the Dow Jones industrials is 21; of the 500 stocks of the benchmark Standard & Poor's index, it's 31.

When you do the math, you find that the ratio of the company's earnings growth rate to its P/E - a valuation measure that goes by the acronym PEG - is about 0.3. Anything under 1.0 is pretty spectacular. In addition, the ratio of the company's price to its book value (that is, net worth on the balance sheet) is less than 2, while the average for the benchmark S&P 500 index is about 5.

What is this gem? It's Los Angeles-based KB Home Corp. (symbol: KBH), formerly known as Kaufman & Broad, which builds medium-priced (average: $178,000) houses in seven states and France.

KB is not alone. The entire home-building industry is flush with highly profitable companies trading at P/E ratios that seem to be lacking an initial digit like 1 or 2 or even 3.

Consider Centex Corp. (CTX), the largest publicly traded home builder. Like KB, it has notched seven straight years of powerful earnings increases. It was trading Friday at a P/E of about 7. So was Toll Brothers (TOL), a builder of upscale detached houses, townhouses and condos, with profits that have risen every year since 1991, from 6 cents to nearly $3 a share. So were Ryland Group Inc. (RYL), with operations in 295 communities, mainly in the South, and M.D.C. Holdings Inc. (MDC), which builds more-expensive houses, averaging $250,000. Beazer Homes USA Inc. (BZH) is even cheaper, trading at a P/E of merely 6.30.

With few exceptions, home-building stocks have been hammered since spring. Ryland, Toll Brothers and D.R. Horton Inc. (DHI), for example, have each fallen by about one-third.

Meanwhile, sales of single-family homes keep soaring - up 14 percent compared with last year. The National Association of Home Builders expects a new record this year. And the pace does not seem to be slowing. On Thursday, it was announced that housing starts had increased 13.3 percent in September.

In short, these stocks represent sparkling businesses in a wonderful sector, and, by any conventional standard, they are absurdly cheap. So what's wrong with this picture? Or, more precisely, how can such good companies carry such low prices?

First, many investors are worried about a "bubble" in real estate, like the bubble in technology stock prices in the late 1990s. The term "bubble" is sadly abused. (Kevin A. Hassett, my colleague at the American Enterprise Institute, has just published an excellent book, "Bubbleology," which clarifies the mysteries.) Briefly, rising prices alone do not constitute a bubble. A bubble occurs when prices get out of touch with reality - when people buy things, knowing that they are overpaying but figuring they can find a buyer who will overpay even more: the "greater fool" theory.

Certainly, house prices have risen sharply - but the increases have been localized. One study found booming, and possibly overvalued, markets in Boston; San Diego; Fort Lauderdale, Fla.; San Francisco; Miami; Denver; and Charleston, S.C. The latest figures show home prices increasing at an annual rate of more than 20 percent in New York City, the D.C. area, and Nassau and Suffolk counties on Long Island, N.Y. But nationally, writes Celia Chen of, "the pace of house price appreciation is abating slightly, giving hope that house prices are heading toward a slower, more sustainable rate of growth." Still, she warns that more and more metropolitan areas "are looking frothy, with house prices appreciating wildly."

Overall, however, house prices nationally are up at a pace of 7 percent this year, or about 5 percent after inflation, after an increase of more than 6 percent last year - the biggest jump in a quarter-century. During the 1980s and '90s, house prices stayed only a percentage point or so ahead of inflation, so 5 percent is a big jump. But does it constitute a bubble?

That's doubtful. House prices are rising for good reason. In many areas, new regulations to protect the environment and discourage sprawl have made it difficult to get building permits, thus restricting supply. Meanwhile, demand is rising. A Harvard study estimates that immigration alone will create 1.2 million new households annually for the next 20 years. Add growth in the native U.S. population and you get close to 2 million new households annually. To put that number into perspective, understand that this year fewer than 1 million new houses will be sold.

Demand is also strong because mortgage rates are so low - an average of just 6.2 percent for a 30-year fixed-rate home loan. And, while the economy is far from robust, unemployment remains below 6 percent and personal incomes are growing at a decent pace.

As a result, the NAHB's "housing opportunity index" is close to an all-time high. The index measures the percentage of houses sold in the United States that would have been affordable to a family making the median income. The latest reading is 65 percent, the highest since mid-1999, an indication that lower interest rates and higher incomes have overcome rising prices (the median home now costs $160,000, up from $140,000 three years ago).

Robert C. Carlson, editor of the Retirement Watch newsletter and chairman of the board of trustees of the Fairfax County Employees' Retirement System, recently looked at real estate data and sensibly concluded: "Over the long term, housing prices nationwide rise at the inflation rate, plus one or two percentage points. Clearly, it is unlikely that housing price increases of the last couple of years can be maintained. That isn't the same as saying that housing prices are a bubble that is about to deflate."

But, if there's no bubble, why are home-building stocks so cheap? The main reason is that they are viewed as "cyclicals," and investors bestow significant discounts on such stocks.

A cyclical company is one whose earnings are at the mercy of the ups and downs - the cycles - of the economy. A good example is the auto industry. During the late 1980s, Ford Motor Co. (F) was earning more than $4 per share, but earnings dropped to less than a dollar in 1990 and then turned to losses in the recession year 1991 and again in 1992. Earnings recovered as the 1990s progressed, hitting a record $5.86 in 1999, but losses set in again with last year's recession. Over the past decade, Ford's P/E ratio was consistently about half that of the market as a whole.

By contrast, consider a firm like Gillette Co. (G), whose sales of razors and toiletries grow largely unaffected by economic cycles. Consumers can put off buying a new car for a year or two, but they keep on shaving no matter what happens to the GDP. Despite marketing and cost-control problems in the late 1990s, Gillette's P/E has averaged about 11/2 times that of the market as a whole for the past decade.

Since investors are wary of cyclical stocks, knowing that a downturn in the economy will depress or even obliterate their profits, the valuations of those stocks tend actually to decline in times of high earnings. Which brings us back to home building. Traditionally, it has been a cyclical enterprise demanding a cyclical P/E ratio. But is it really?

At random, I pulled up the page of research Value Line provides for Lennar Corp. (LEN), a home builder founded in 1954 and based in Miami. Since 1986 (the earliest date on the Value Line data sheet), Lennar has increased its earnings from 48 cents a share to $6.01. Earnings rose in 13 of those 16 years, declining in 1990 and 1997 and remaining flat in 1989. For KB Home, the figures are about the same - only one year of declining earnings out of the past 11. Just to be sure, I looked at earnings over the past 10 years for the 13 largest publicly traded home builders. There were only two losses out of 130 "earnings years."

Certainly, the supply-demand environment has been delightful over the past decade, with restrictions on building and available land, lower interest rates and higher incomes. The decade could be a pleasant fluke. But management has also improved. Home building has traditionally been a fragmented industry, with thousands of small firms spread across the country. That's changing (though the top 10 home builders still account for only 17 percent of the entire market), and it is bringing smarter financing practices and tighter cost controls to a seat-of-the-pants business.

Just look at a company like NVR, which is based in McLean and builds houses under the trade names Ryan NV and Fox Ridge. Since it went public in 1994, NVR has increased its earnings per share every year, from 53 cents to an estimated $35.40 for 2002. Over the past five years, earnings growth has averaged 72 percent annually, though Value Line (which says "NVR continues to amaze") projects a decline to merely 31 percent for the next five years.

NVR's stock rose sharply on Thursday after it announced that profits rose 52 percent in the third quarter. It closed Friday at $323 (that's not a misprint), up from less than $10 just six years ago. Sounds like another high-tech bubble stock, right? Not at all. NVR this year will earn more than $300 million on $3 billion in revenue, and its A-rated balance sheet has only minimal debt and $100 million in cash. Interest payments run about $20 million a year.

Yes, NVR carries a higher valuation than KB and Lennar, but not by much. Its P/E is 10.

Such a combination of high growth and low price seems almost too good to be true, and it's important to recognize the risks. Almost certainly, interest rates will rise in the next few years as the economy recovers. The question is whether higher incomes - and a more optimistic outlook - will trump higher mortgage payments. Another risk is that competition among home builders will get tougher as consolidation increases. With profit margins at lofty levels, the urge to build and build will increase, and an oversupply of homes could depress prices.

Still, some of the smartest bargain hunters in the business remain excited about home-building stocks. John Buckingham, editor of the Prudent Speculator, which the Hulbert Financial Digest ranks the top newsletter for returns over the past 20 years, is recommending Beazer, Centex and Horton, stocks that, unlike KB and NVR, have fallen in the past year. Each trades at close to book value.

Unfortunately, I can find no mutual fund that concentrates on home-building stocks, though that's hardly a surprise, given that the total market capitalization of the top 10 firms in the industry is only about $20 billion. Most Americans already have residential real estate in their investment portfolios - they own their own homes. But, if you recognize the risks, the home-building sector could be a fine addition to your stock holdings. At these prices, stocks such as NVR, Centex and KB are hard to resist.



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