I am a value investor through and through, so it is extremely rare that a stock trading at 52 times next year's expected earnings would grab my attention. The company would have to be seeing extraordinary growth and be a market leader in an industry with significant upside potential.
But these kinds of opportunities are usually already priced into a stock, making it too expensive. That is, unless the industry just underwent an historic bust and investors are still too apprehensive to see a major multi-year rebound on the horizon.
I'm talking, of course, about the housing market.
You haven't seen anything yet
Sales of existing homes rose 10.4% in the 12 months to July for an annual rate of 4.47 million new homes, according to The National Association of Realtors (NAR). Year-to-date, sales were up 8.6%. More important, the pace of existing home sales is approaching its pre-boom average of about 5.3 million houses sold annually.
The inventory of unsold homes, a key measure of supply, increased slightly to 2.4 million and represents about 6.4 months worth of sales. Listed inventory is 23.8% below a year ago, when there was a 9.3-month supply. The National Association of Realtors' considers six months of inventory to be a normal market, so it seems housing demand is bouncing back.
Then there's construction of new homes, a segment that has grown tremendously in the past year. For instance, sales of new homes increased by 3.6% on the year, to a pace of 372,000 in July, a two-year high for the NAR report. Supply on the market fell to 142,000 homes for sale, representing just 4.6 months of sales -- also a record low.
The chart below shows that leading up to the bursting of the real estate bubble in 2007, builders had constructed a running excess of 2.38 million homes more than the long-run average of 1.44 million new homes per year. Construction dropped off a cliff during the recession and has only recently rebounded to about half of the long-term average.
Investors who saw this growing trend in new home construction have been able to make a lot of money. Shares of homebuilders like Pulte Group (NYSE: PHM) and Lennar Corp. (NYSE: LEN) have increased by 250% and 150% during the past 12 months alone. Home improvement retailer Home Depot (NYSE: HD) has seen its stock price jump by 73% during the same period.
Trouble is, while the rise in homebuilder stocks and home improvement stocks has been impressive, it is already old news and most likely will not continue at that pace. Take for instance the SPDR S&P Homebuilders (NYSE: XHB), a fund of 37 companies in the sector that trades at 20 times trailing earnings, about twice as expensive as its historical average of about 10. In other words, these stocks are likely going to need to keep posting huge numbers in order to keep up with their frothy stock valuations.
But if the opportunity is not in new-home construction, yet there's a bona fide rebound on our hands, then where could the real opportunity be for investors?
A market leader with growth potential
Zillow (Nasdaq: Z) is a leading real estate listing site, with a share of almost 7% of the market, even higher than the National Association of Realtors' official website and second only to Yahoo (Nasdaq: YHOO). Even better, the company has an advertising agreement with Yahoo that collects revenue on visits to both sites.
The company receives revenue not just from the normal advertising model, but also from its popular mobile smartphone app and premier product services for real estate agents. A tiered subscription service allows agents to attract and connect with potential clients, and a "Mortgage Marketplace" app allows lenders to advertise directly to buyers.
The real growth in the next few years will be from mobile traffic. The company reported record mobile usage in the second quarter, with 168 million homes viewed on a mobile device. Revenue jumped 75% from the previous year to $27.8 million . Revenue has grown at an annual pace of more than 70% in the past four years, even through the depth of the housing crash.
Zillow finally became profitable last year and has no long-term debt on the balance sheet. Its first-mover advantage in the mobile real estate space, along with its 14 patents and pending patents, should help it maintain market dominance and counter any new competition.
Risks to Consider: Although it has somewhat lagged other housing market stocks, Zillow has jumped 55% since January and trades at 135 times trailing earnings. Any short-term hiccups in housing data could send the stock down, but the long-term recovery should keep revenue growing quickly. As with any speculative bet on a high growth stock, the total investment should be small relative to your entire portfolio.
Action to Take --> Zillow is setting itself up as the go-to site for real estate buyers, agents and lenders. Mobile traffic will continue to propel its tremendous growth, and it should be able to monetize traffic through both advertising and applications. Be prepared for possible bumps in the road, as with any speculative growth stock, but the external environment and company fundamentals make this a great stock to own during the next few years.