Builders' Shares Have Been Hot,
Sparking Debate Among Investors

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Home-builder stocks are bucking a trend -- one that has the rest of the housing industry in a tizzy.

The Dow Jones Wilshire U.S. Home Construction Index of home-builder stocks has increased about 15% since July 18 -- even as each passing week shows the nation's housing statistics heading down. While the index is still down for the year, that recent rise has outpaced broader market indexes and set off a debate among investors about whether the slowdown might end sooner for the home builders than many expect.

Some bulls believe builder stocks hit a bottom toward the end of July, around the time that the Federal Reserve signaled it was considering a pause in its two-year campaign of interest-rate increases. Since the housing sector is so sensitive to mortgage rates, the signal mattered to home builders. The question now is whether the Fed's pause -- and a recent drop in long-term interest rates -- will be enough to bolster a sector so exposed to a housing slowdown that seems to be getting worse.

According to the National Association of Realtors, sales of existing homes were down 12.6% in August from a year earlier, and the median price of homes sold dropped 1.7% over that period -- the first year-to-year price decline in 11 years. Sales of new homes were down 17.4% in August from a year ago, according to the Census Bureau.

Some stocks seem unfazed by the headlines. For instance, shares of Lennar Corp., which reported on Sept. 8 that it was reducing third-quarter earnings estimates because of the continued housing slump, have risen roughly 6% since then. In 4 p.m. trading Friday on the New York Stock Exchange, Lennar's shares were down 52 cents to $45.12, giving the company a market value of $7.26 billion.

"If the sector stops going down with bad news, it may imply that it has found a bottom," says John Buckingham, chief executive of Al Frank Asset Management, which has $800 million under management and whose investment newsletter, the Prudent Speculator, has recommended more builder shares in recent months. But Mr. Buckingham says his funds haven't added to their home-building stake recently.

These are volatile stocks and bears believe the recent gains could easily be reversed as the housing market continues to slide. Banc of America Securities analyst Daniel Oppenheim last week downgraded Pulte Homes Inc. to "sell" from "neutral" and D.R. Horton, to "neutral" from "buy," citing the recent appreciation of their stocks.

But some bulls aren't dissuaded. Citigroup analyst Stephen Kim declared in a report last month that it is "a buyer's market" for the stocks. Josh Spencer, an analyst who covers the home-building sector at T. Rowe Price in Baltimore, says builder stocks are too inexpensive to pass up.

Even after their rally, many builders trade slightly above their book value, which is a company's assets minus its liabilities, and is often regarded as a rough estimate of how a business would be valued if liquidated. The big players like Pulte, Lennar, Horton and Toll Brothers also trade at less than six times earnings, based on the four most recent quarters of results.

"All historical metrics tell you [to] buy the stocks here," says Mr. Spencer, who says his firm has increased its home-builder holdings in recent months.

Besides being cheap, the bulls argue home-builder inventories may have peaked in some markets. And the pull back in interest rates could help renew demand.

Citigroup's Mr. Kim, whose firm has investment-banking relationships with several home builders, says the stocks could get a boost when the companies report fourth-quarter earnings because cancellations on orders for new homes could decrease and the year-over-year comparisons will be easier. By the first quarter of next year, he believes cancellation rates will be lower and order trends will be better than the first quarter of 2006.

Yet trying to time a rebound in this sector is an extraordinarily risky game, because the fundamentals of the overall market still look so weak, even to the builders. Many builders aren't giving earnings guidance for next year because the outlook is so murky. Moreover, builders are still using incentives to lure in buyers, which eat into their profit margins. A report by Moody's Economy.com said house prices could keep falling until 2008 or 2009 in some areas. Private-equity groups -- investment pools that look for companies they can buy on the cheap, fix up and resell -- have been looking at the battered sector, but are expected to hold off taking any companies private until the housing market bottoms and begins to stabilize.

"We are in uncharted waters and you just don't know if there is reef ahead," says Edgar Wachenheim III, chairman of Greenhaven Associates, a Purchase, N.Y., investment firm, with $3.5 billion in assets under management, who sold off his builder stocks a year ago and is staying away from the sector. "I don't know how any reasonable person can know where the stocks are going to go."

Another dark cloud over the sector is the threat that builders' land holdings will lose value as land prices decline. That could mean that some land may be worth less than they paid for it. The bulls counter that the land issue is overstated because builders are increasingly using options, which allows them to walk away from land deals and minimize their losses.

Some problems may lie ahead when builders construct more houses on land they bought more recently at higher prices. As of the end of last year, 28% of land owned by home builders was negotiated in 2004 and 2005, 46% in 2003, when land prices started to take off, and 26% in earlier years, according to a report by analyst Ivy Zelman of Credit Suisse, which does business with several home builders.

Last week, Ms. Zelman downgraded Horton to "neutral" from "outperform" after estimating that 48% of its owned land is at prices negotiated in 2004 and 2005. Meantime, she upgraded MDC Holdings Inc. from "neutral" to "outperform," citing its relatively short supply of land.

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