Housing Stocks 1: Bet now on the real-estate rebound

Simple Strategies11/2/2007 12:01 AM ETBet now on the real-estate reboundIn the midst of the mortgage mess, it may seem early, but that's the best time to beat Wall Street to the profits. I found two home builders worth a look.By Harry Domash (MSN)Editor's note: To view the stock screens mentioned in this column, download the free MSN Money Investment Toolbox.Most home builders' share prices have dropped 50% or more over the past year. But these money-pit stocks could be ready for a comeback.That's not to say the bad news about the companies will get better right away. In September, existing-home sales dropped for the sixth straight month, and the median sales price fell by the largest amount on record. September new-home sales climbed, but only because builders slashed prices. Indeed, the median price for a new home plunged 9.7% from September 2006. Inspired by these reports, pundits are telling us that the housing market will continue its death plunge well into next year. But will it? Consider this.Employment is still strong and plenty of folks who have the desire and the means to buy aren't doing it. Why? For most of us, buying a home is the biggest investment we'll ever make. Would you buy a house when everyone is telling you that home prices are headed down? Me neither. But the demand isn't going away. The ready and willing buyers are waiting for a signal that home prices have stabilized. Everybody wants a bargain, and many will rush to buy if they think that prices are headed back up. That signal could come early next year. As you probably know, the real-estate credit market froze up in August. Mortgage makers were closing their doors in droves, and many buyers sat on the sidelines waiting for the mortgage market to settle down.When a home sells, it usually takes one to two months from when an offer is accepted until escrow closes and the sale is reported in the sales figures. So the lackluster September sales figures reported last week reflect what happened in August. Because many deals take two months to close, October numbers won't be much better. Then come the holiday months, which are always slow for real estate. But come January, with mortgages readily available to qualified buyers, sales will likely pick up. If you agree with that scenario, this is the time to take a serious look at home builders' stocks. Don't wait for January. The market moves in advance of actual news. I built a simple screen to ferret out the stocks likely to do the best when the market recovers. Out of 25 home builders, only four stocks passed the tests. Then, after I checked an additional risk factor that can't be done by screening, only two stocks survived. Here are the details, starting with the screen.=====================================================================1. Industry Since the MSN Deluxe Screener has a separate industry category for home builders, I started by limiting my search to the 25 stocks in that category. Screening parameter: Industry name = residential construction 2. Low debt With rampant price-cutting and sales levels at multiyear lows, many home builders are reporting losses. Given that situation, plus the chaotic credit markets, the last thing we need is home builders burdened by high debt. Unfortunately, almost all builders borrow to finance land purchases and construction costs. So, rather than set an arbitrary limit that most builders would flunk, I require only that passing candidates carry debt at or below the industry average.What happens when someone goes into default and then foreclosure on a home mortgage? MSN Money's Jim Jubak details three scenarios and provides tips for investors looking at debt instruments. To measure debt, I use the debt-to-equity ratio, which compares total debt to shareholders' equity (book value). Zero ratios reflect no debt -- and the higher the ratio, the higher the debt. Screening parameter: Debt-to-equity level <= industry average debt-to-equity level Adding that stipulation reduced my list of home-building candidates to seven stocks. The average ratio for the home-building industry was 0.72. If you want to see more candidates, try searching for stocks with debt-to-equity ratios below 1.0 instead of comparing with the industry average.3. Profitable As is the case with almost any category of stock, all else equal, you'll do best by limiting your selection to the most profitable players in the group. While there are several ways to measure profitability, return on invested capital (ROIC) is especially useful for analyzing home builders. Here's why. As I noted earlier, almost all home builders rely on borrowing to finance their operations. ROIC tells you whether a company could profitability employ its borrowed funds. For example, a home builder earning 10% ROIC could borrow at the current 5% or so corporate rate and make a good profit. However, a 3% ROIC company would pay more servicing its debt than it would earn on the borrowed funds. I set my minimum acceptable return on invested capital at 10%. Because all home builders are currently facing unusually severe market conditions, I used the five-year average figure because it's more representative of long-term performance. Try reducing your minimum ROIC to 8% or 9% if you want to see more stocks, or raise it to 12% or 13% if you want to limit the field to the most profitable companies.Screening parameter: ROIC five-year average >= 10 4. Analysts' advice There are all sorts of factors affecting the outlook for individual home builders that few of us have time to research and analyze -- things like the location and desirability of raw land inventory, reputation with consumers, etc. Because analysts who cover home builders spend their days contemplating such issues, it makes sense to pay attention to their findings. These analysts issue "buy" and "sell" ratings on the stocks that they cover. MSN Money compiles the individual ratings into consensus ratings using these categories: strong buy, moderate buy, hold, moderate sell and sell.Because analysts are often faulted for being easy graders, you should take heed when they advise selling a stock. Thus, I rule out stocks with any version of sell ratings.Screening parameter: Mean recommendation >= hold =====================================================================Adding the last two conditions reduced my list of candidates down to only four stocks.Company name Recent price ROIC: 5-year Average home price Lennar (LEN) 23.22 22.6 $300,000 MDC Holdings (MDC) 40.2 14.5 $350,000 NVR Inc. (NVR) 483 47.3 $375,000 Toll Bros. (TOL) 22.69 13.7 $650,000 Besides the information turned up by the screen, I've also listed the approximate recent average selling price of each firm's homes, which I found in their recent quarterly reports and/or SEC filings. You can see that Lennar builds relatively lower-priced homes while Toll Bros. targets more affluent buyers. That's significant because some experts think that the upscale market would be less affected by an economic downturn than the market for lower-priced homes. Because the strength of the home market varies greatly depending on the geographic area, the location of each home builder's current operations should be taken into account. Currently, the weakest home real-estate markets include numerous sections of Florida, Las Vegas and the noncoastal sections of California.What happens when someone goes into default and then foreclosure on a home mortgage? MSN Money's Jim Jubak details three scenarios and provides tips for investors looking at debt instruments. This table shows which builders have significant operations (more than 5% of total) in the riskiest areas. Company Florida Las Vegas Inland California Lennar yes no yesMDC Holdings yes yes yesNVR no no noToll Bros. no no no For me, Lennar's and MDC Holdings' operations in the weak markets make them vulnerable. So, that leaves NVR and Toll Bros. as the only two viable candidates, at least at first look. But don't take my word for it. Do your own due diligence. The more you know about your stocks, the better your results. At the time of publication, Harry Domash did not own or control shares of companies mentioned in this column.