The Best Stock to Own for a Housing Recovery

Here’s some good news, if you’re up for it: I’ve found a stock that could return 200% or even more over the next three to five years.

These aren’t the 1990s, though, so it isn’t simply a matter of buying shares and then watching the price rise. Much more patience is necessary to reap the potential rewards of this stock because returns are heavily influenced by the housing market, which is expected to remain in a slump for a while longer.

#-ad_banner-#A sharp rebound could be just around the corner, though. The National Association of Home Builders (NAHB) predicts 800,000 housing starts (new residential building projects) in 2012, a 34% gain compared with the 597,000 forecasted for all of 2011. Moody’s chief economist Mark Zandi says housing starts should jump by 49% next year, to about 1 million, based on factors like record corporate earnings and fewer mortgage delinquencies.

If the NAHB and Zandi are right, then the future looks very bright for Masco Corp. (NYSE: MAS), a Michigan-based building materials company.

Masco is big player in the home improvement products space, boasting name brands like Behr and Kilz paint, Kraftmaid cabinets and Peerless and Delta faucets. The company had a long history of profitability before 2008, but the recession and housing slump have taken a toll, as you may have guessed. Overall sales fell 36% in the past four years, from $11.8 billion in 2007 to $7.5 billion in the past 12 months. Diluted earnings per share (EPS) fell a whopping 394% during that time, from $1.05 in 2007 to a loss of $3.09 in the past 12 months. Investors have responded by punishing the stock, which is down 35% year-to-date and has lost an average of 22% for the past three years.

But when a housing recovery does occur, there may be no better way to play it than by owning stock in Masco. It’s a solid firm that has been around for decades, and I think shares have been way oversold, especially since management has been taking meaningful steps to maximize profits the moment housing rebounds. A key strategy has been to improve cost-efficiency — for example, by trimming $180 million in salaries and other fixed costs from the cabinetry, installation and specialty products segments. Together, these segments pulled in about 40% of revenue, or $3 billion, in the past 12 months. (Specialty products include things like windows, patio doors and staple gun tackers.)

Also, the company is almost finished with a series of hefty one-time charges against earnings totaling $2.7 billion. These charges date as far back as 2003 and are mainly related to the cost of acquisitions, such as the purchase of Erickson Construction in 2007, and to “goodwill impairment.” Goodwill is an accounting term for intangible assets like brand recognition and customer loyalty. Since the tough economy has cost Masco many customers, the value of its customer loyalty has fallen precipitously (by an estimated $1.5 billion). One-time charges have to be accounted for on the company’s financial statements, which should look much better going forward as these charges wind down.

Sales of decorative and architectural products such as paint, stains and hardware, which account for 22% of revenue, have barely suffered at all despite a tough economy because people are currently more inclined to do home improvements than buy new homes. Indeed, revenue in this segment is off less than 5% from the 2006 peak of $1.8 billion. Gross margins have also been resilient, only falling to 23.5% from the 2006 peak of 27.5%. Analysts say this segment is especially likely to achieve record sales with only a modest gain in housing activity. Decorative and architectural products tend to be cheaper, but they can make a big difference in a home’s appearance, so consumers may initially spend more money on these products in a housing upturn. A stronger housing sector should also stimulate sales of kitchen and bathroom cabinetry, not only in new construction but also for renovations, since kitchens and bathrooms are the two most frequently remodeled rooms in peoples’ homes.

The plumbing segment, which generates about 35% of sales, has also held up reasonably well. Although revenue in this segment is currently about 20% below peak levels ($3.3 billion in 2006), analysts say things might have been even worse if not for strong sales of innovative new products such as Touch20 for faucets (a technology that lets the user adjust the flow of water by touching the faucet with a wrist or elbow rather than the hands.) Like cabinetry, plumbing supplies should also sell well when the housing market improves because of increased demand for new construction and existing home renovations.

Risks to consider: The biggest risk is the NAHB and Mark Zandi are wrong and housing continues to languish for another two or three years or more, depressing Masco’s profits and stock price for longer than expected.

Action to Take –> Consider investing in Masco Corp. Shares have exceptional total return potential in a housing recovery for the reasons I mentioned and, during the next three to five years, could rise from around $8 now to $25 to $35, for a gain of about 210% to 340%, according to analyst estimates. Sure, investors may end up waiting longer than expected for housing to improve and Masco shares to rise. In the meantime, however, they’d be able to take some comfort in the stock’s attractive dividend yield, which is currently 3.8%.