This Could be a Surprise Sector for Stocks Next Year

There are so many reasons to dislike housing stocks. Foreclosures continue at an alarming rate, and with a rising tide of empty existing homes, who needs to buy a newly-built home? Yet while the gloomy headlines rule the day, the Philadelphia Housing Sector Index (HGX), which was stuck in a tight trading range for the past three months, is suddenly on the march, rising nearly +8% since the middle of last week. The index actually spiked a day before last week’s monthly jobs report, which Nathan Slaughter recently discussed. [Read why he thinks the U.S. will add two million jobs next year — and how you can profit]

Rising employment is seen by many as a panacea for this long-suffering sector. Yet we’ve already seen a few false dawns already: The Philly index surged from 95 in late 2009 to 130 in April, only to fall back below 100 a few months later. Now that’s it back just above 100, might we re-visit those April highs? And if so, what are the best stocks to play in a resurgent housing sector?

Another lost year for housing
It sure has been a tough six months for the major players: Shares of PulteGroup (NYSE: PHM) are off more than -40%, while Beazer Homes (NYSE: BZH), M/I Homes (NYSE: MHO), Ryland Group (NYSE: RYL) and KB Home (NYSE: KBH) all shed more than -25%. To be clear, few expect to see the housing market post a major upturn next year. Instead, industry bulls would like to see only modest improvements in hopes that the stage would be set for a more sustained in advance in 2012 and 2013.

And there’s no doubt that current sector share prices are very cheap in the context of such a possible rebound in 2012 or 2013. We don’t need to see the white-hot conditions of 2005, 2006 and 2007 — just a normal healthy housing market. The key would be tame interest rates. Current low mortgage rates, combined with currently low housing prices make home ownership an awfully compelling option — if consumers are feeling more confident, and if interest rates stay low.

If you believe that such a scenario will play out, here are two names to focus on…

Toll Brothers (NYSE: TOL)
This homebuilder may have started to turn the tide, thanks to its exposure to the higher end of the housing market. Toll delivered an unexpected profit in the quarter ended July, and though a seasonal slowdown is expected to lead to more red ink for the October and January (2011) quarters, analysts increasingly think that Toll can stay in the black after that as sales and profits start to steadily rebound.

It will be some time before this or any other housing stock looks cheap on a price-to-earnings (P/E) basis, as industry as profits will be uninspiring until at least 2012 if not 2013. Instead, analysts measure these stocks in relation to book value, and shares, which currently trade at around 1.2 times book value, are likely to rally up to 1.5 times book value according to analysts at UBS — good for a +30% gain from current levels.

That’s just a near-term target. If and when the housing rebound is truly underway, shares have considerably more upside, but that may not come before 2012.

D.R. Horton (NYSE: DHI)
Investors have started to bid up shares of this homebuilder in anticipation of this Friday’s earnings release. If the last quarter is any guide, D.R. Horton should deliver a rare bit of cheer in the sector. In the quarter that ended in June, the company announced a modest uptick in demand for homes in its medium-priced communities.

D.R. Horton is surprisingly looking to build more houses “on spec,” which means they are starting to build without a firm buyer in hand for each house. It may seem like a risky move, but the company has ample cash to both invest in growth while also pay down debt. The company has paid back $1 billion in debt in the past year.

The decision to keep building has surely paid off, as the company is expected to report full year earnings of $0.73 a share this Friday. (Most other homebuilders continue to shoulder losses). Profits may cool a bit in fiscal 2011, but analysts thinks D.R. Horton’s earnings power could approach $2 a share in a few years once housing is back on the mend. EPS averaged $4 in the middle of the past decade, but investors would cheer a rebound to just half that level. If that happens, shares would trade up from a current $12 to around $20.

Action to Take –> It seems counter-intuitive to seek out value in housing stocks when the sector is in such a deep slump. But sector shares have pulled back sharply in the past six months, creating fresh value, and would rotate back into favor if employment trends continue to strengthen on the heels of last Friday’s jobs report. In truth, all housing stocks would gain in a housing recovery scenario, but Toll Brothers and D.R. Horton look to be best able to hold their own if 2011 and 2012 bring more of the same.