Homebuilding – This Time Really Is Different. (Yes, I’ve Gone There.) Buy Pulte Homes (PHM)
Pulte Homes’ stock closed last night at $23.86. Stock analysts polled by Yahoo Finance expect Pulte to earn $3.84 a share next year, so the stock is selling at a 16% earnings yield. That huge yield clearly indicates that investors expect home construction to fall off the cliff in the not-too-distant future. That is an understandable view considering that the US is in its 10th year of an economic expansion, and new home sales in its 8th year. But I argue here that this housing cycle is quite different, and both the economy and homebuilding in particular have at least several good years ahead that will make it worth buying Pulte at its current price.
Saying “this time is different” has proven a graveyard for many investors, so you certainly should be skeptical about my claim. As usual, then, I’ll try to convince you with visual evidence that my contrarian call has some merit. My argument starts with…
Cautious builders? Scientists have established that homebuilders as a group test positive for serious excess testosterone. OK, I made that up, but it’s not a business for shrinking violets (Is that builder in the White House shrinking? We can all agree, both left and right, that the answer is no). Yet check out this chart, which compares housing starts and job growth:
Sources: Census Bureau, Department of Labor
Common sense says that demand for new housing is driven by growth in the number of households, which in turn is cyclically driven by job growth. The picture above corroborates that commonsense theory. But look at this cycle. Home builders have built far fewer housing units relative to job growth than they did in prior cycles. Hmmm.
…Resulted in fewer empty housing units…
The result of this cycle’s recent homebuilder caution is shown here:
Sources: Census Bureau
This picture shows that very low additions to the housing stock, combined with solid job growth, not only soaked up all of the excess housing units erected during the housing bubble, but created a housing shortage that is growing. In fact, the biggest shortage since the 1980s, and still growing despite this being the 8th year of a building expansion. Quite unusual.
…Without the usual debt growth.
A common reason cited by pundits for caution on home construction is too-high home prices, as illustrated here:
“The S&P CoreLogic Case-Shiller 20-city home price index increased 5.9% in July compared with a year earlier, down from a 6.4% annual gain the previous month. Home prices are rising at twice the rate of wages, which has likely contributed to a cooling in the market this year.” (Associated Press, September 25, 2018)
These pundits have history on their side; home price increases that exceed wage gains are a sign of a mortgage debt bubble. So let’s compare home price changes with mortgage debt changes, shall we? We shall:
Sources: Federal Reserve, Federal Housing Finance Board
The correlation between home mortgage debt growth and home prices is clear. But debt growth has always exceeded home price growth…until this cycle! The sharp home price increases over the past five years were not been driven by excessive lending. In fact, home mortgage lending standards are currently quite conservative.
Then what explains the recent sharp home price increases? Good old supply and demand. The first two charts in this post show that growth in demand for housing exceeded supply for the past eight years. The law of supply and demand says excess demand drives price increases. Easy peasy. So instead of today's high home prices being the usual scary sign of excess debt, they are a positive sign that Pulte and its peers need to make more of their product, not less.
What about the recent rise in interest rates?
Clearly, higher mortgage rates increase the cost of buying a home. The rise in the 30-year mortgage rate from 3.95% at the start of this year to today’s 4.71% added 9% to mortgage payments. But other factors drive home construction as well, as this chart shows:
Sources: Freddie Mac, Census Bureau
For example, compare the recession of 1981 with the bigger recession of 2008. During ’81, mortgage rates were over 15%. During ’08, they were 6%, on their way to 4%. Yet ’81 housing starts were higher, and were only exceeded about five years into the post-’08 expansion. More important to housing starts are household demand and access to credit. And the news there is currently good. Demand – jobs – remains strong, and access to credit, while still stringent, has been easing.
Net/net, I don’t see a strong reason for housing starts to materially decline in the next few years, and the decline will only come with the next recession (decline in job growth).
Finally, homebuilder stock prices ≠ housing starts
In other words, market volume doesn’t limit an individual businesses’ opportunity to grow earnings. Also critical are market share, profit margins and changes in a company’s shares outstanding. Good companies figure out ways to outperform their markets. Homebuilders are no exception, as this chart shows. It compares three major builders’ historical stock prices to housing starts:
Sources: Yahoo Finance, Census Bureau
Since 1990, the three stocks grew 3-6 times faster than housing starts.
Which brings me back to my Pulte Homes stock recommendation
For one, Pulte (stock symbol PHM) doubled its market share over the last 20 years. Second, as I discussed in my last post, Pulte has become a believer in the benefit of share repurchases. That is a highly beneficial strategy when its stock has a 16% earnings yield.It is said that stocks have to climb a wall of worry. Investors are certainly worried about homebuilders like Pulte. Hopefully this post has caused you to consider that Pulte might be a wall worth climbing.