Are Homebuilders Ripe for Investment?

Are Homebuilders Ripe for Investment?

As the economy in the United States continues its gradual recovery from the worst recession since the Great Depression, investors are on the lookout for promising opportunities.

One market in particular that has showed strength is the housing market. As Americans slowly shored up their personal balance sheets, and as mortgage rates sunk to historically low levels, housing activity picked up. This has led to a noticeable improvement in housing-related economic data.

At the same time, talk of the Fed reducing its stimulus and the threat of higher interest rates means the housing market could be at a pivotal inflection point.

Is the future outlook for housing still promising? Or should investors shut the door on homebuilder stocks?

Improving fundamentals built a strong foundation
Recently, we've seen strong improvements in housing data in conjunction with the gradually improving economy.

July housing starts improved nearly 6%, to an annual rate of 896,000 units, which was in line with expectations. Moreover, it appears housing fundamentals may stay strong as evidenced by improving confidence within the home building industry. Home building sentiment remains at a nearly eight-year high.

These numbers were particularly encouraging for home builders including PulteGroup, , Toll Brothers , and Lennar Corp. , and their profits have firmed over the first half of the year.

Pulte reported 25% revenue growth and 19% growth in gross profits over the past six months. Toll Brothers saw first-half revenue jump 35%, and diluted earnings per share more than doubled year over year. Lastly, Lennar's revenue soared 46% over the first six months, and its earnings before income taxes more than tripled in the same period.

Despite such strong growth, home builder valuation multiples remain relatively modest. Each of these stocks trades for multiples in the mid to high teens of their expected 2013 profits per share. In particular, Pulte and Lennar remain very attractively valued at just 12 and 13 times forward earnings.

The future outlook contains some serious question marks
While the road to recovery has been relatively smooth thus far, housing is by no means out of the woods.

Despite noticeable improvement in the unemployment rate over the past few years, hiring remains tepid. Moreover, consumers remain under pressure from the onset of higher taxes and stagnant wages.

And, a new housing headwind has presented itself in the form of higher interest rates.

Long-term rates have spiked in recent weeks and have taken mortgage rates upward in tandem. The 10-Year Treasury Bond yield has spiked from 1.6% in May to 2.75% today. Meanwhile, 30-Year Bond yields have risen all the way to 3.70%, dramatic increases for such a short period of time.

Not surprisingly, mortgage rates have followed suit. According to Bankrate, 30-year mortgage rates sit above 4.5% after declining well below 4% for most of the past few years.

Despite headwinds, housing outlook remains strong
The crimp in housing affordability due to rising home prices and climbing interest rates may indeed slow housing activity over the coming months.

At the same time, those conditions underscore an improving housing market overall, which is clearly a good thing for the homebuilders.

These homebuilder stocks are reporting excellent growth in revenue and profits and are doing an admirable job of improving their balance sheets and buying back stock.

The headwinds facing the housing sector seem to be somewhat reflected in the stock prices of the homebuilders, which have come down significantly over the past several weeks. And valuation multiples remain reasonable.

Plus, investor spirits should be buoyed by the fact that management teams of homebuilders remain entirely optimistic. As Toll CEO Doug Yearley stated earlier this year of his company's positioning, "We are in the early stages of this recovery, and we're raising prices aggressively." Regarding all three of these homebuilder stocks, I tend to agree with that assessment.

As a result, homebuilder stocks still look attractively valued and are poised to capitalize on the clear housing recovery. I think investors should hold them with confidence.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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