DHI - Navigating Seasonal Trends And Analyst Ratings In The Home Building Sector

2023-10-19 10:22:32 ET

Summary

• Home builders typically outperform the S&P 500 from October to April/May, but the risks of the seasonal trade are high this year.
• Builder confidence is declining while analyst optimism remains high, setting up a potential trough for the seasonal trade.
• Revenue growers have higher analyst ratings than revenue peakers, and downgrades on these stocks could impact the sector and related stocks.

The Seasonal Trade Starts With Big Risks

October starts the time of year when I consider initiating seasonal trades on home builders . From now through the following April to May, home builders typically outperform the S&P 500 ( SPY ). The last season was an extraordinary period of outperformance. For example, from the end of October 2022 to the end of May 2023, iShares U.S. Home Construction ETF ( ITB ) gained 30.0% versus the 8.0% for the S&P 500. That outperformance continues at the time of writing with gains of 31.9% and 11.4% for ITB and the S&P 500 respectively since the end of October, 2022. I prefer to trade from a much narrower gap, so the risks of the seasonal trade look particularly high this time around. An 8% mortgage rate (and possibly higher yet?) make the trade look even more precarious. Adding to my wariness is the persistent bullishness of analysts despite the increasing headwinds facing the industry .

Diverging Builder Confidence and Analyst Optimism

Home builder confidence plunged for the third month in a row in October.

The NAHB/Wells Fargo Housing Market Index (HMI) fell to 40 after peaking at 56 in July and troughing at 31 last December. Even sentiment in the South region, where a bottom in starts in April extended the 2022-2023 seasonal trade , has not been this low since February. Note well that builder sentiment peaked at the same time as ITB (at the end of July, I made the case for a potential peak in ITB right before I took one last swing at a home builder stock, Tri Pointe Homes ( TPH ) ).

So with builder sentiment trending downward and now negative (HMI below 50), I am surprised analysts are not getting ahead of potential bad news from the next swath of earnings from builders. I took a look at the ratings on a sample universe of builders and discovered that those builders who are still increasing revenues (trailing twelve months ((TTM)) tend to have the highest analyst ratings. So, if (once?) these builders report declining TTM revenue, the downgrades could come and set up the price action for a trough for the seasonal trade. If so, the trade may trigger late this year, say, around December.

Correlating Revenue Growth and Analyst Ratings

My "revenue growers" are D.R. Horton, Inc ( DHI ), PulteGroup, Inc ( PHM ), Meritage Homes Corporation ( MTH ), and Toll Brothers ( TOL ).

My "revenue peakers" are KB Home ( KBH ), LGI Homes, Inc ( LGIH ), Century Communities, Inc ( CCS ), Tri Point Homes, Inc ( TPH ), Taylor Morrison Home Corporation ( TMHC ), and Lennar Corporation ( LEN ).

The analyst ratings for the revenue growers show an unanimity in buy ratings (above 3.5). For all of 2023, analysts have held high ratings or increased them for the revenue growers. PHM stands out as particularly strong with a 5+ year rating high and an on-going uptrend.

The analyst ratings for the revenue peakers shows a mixed bag. Analysts are evenly split with three buys and three holds. Ironically, TPH stands out as the most liked in the group even though my trade on TPH did not work out as hoped. Analysts have steadily, albeit slowly, reduced ratings on KBH and TMHC since 2022. (In May, I made the case for TMHC but I aligned with analysts on a hold rating).

So the revenue growers are leading the way with an average analyst rating of 4.0 (the median is also 4.0). The revenue peakers have an average analyst rating of 3.7 (the median is 3.6). Revenue growers DHI, PHM, and TOL hold a near 26% share of ITB's holdings . Revenue peaker LEN is 12% of the ETF.

A Weighted Analyst Rating for Builders

Since ITB includes non-builders - five of the top 10 holdings are non-builders - I calculated an average analyst rating for builders, weighted by market cap. I created the universe of builders using Seeking Alpha's stock screener and filtering for "homebuilding" under the consumer discretionary sector. The 22 stocks have a total market cap of $140.4B and a total enterprise value of $150.5B. The market cap weighted average analyst rating for this universe of builders is 3.8 for both market cap and enterprise value weighting.

With revenue growers DHI, PHM, and TOL constituting 38% of my index, analyst downgrades for these stocks will be a key catalyst for creating the potential trough I prefer for starting the seasonal trade on home builders. Downgrades on these stocks could take the sector down to hold territory (below 3.5) and likely cascade throughout the non-builder, housing-related stocks in ITB. I am looking to test this hypothesis in the coming weeks or months.

The Gross Margin Effect

Analysts zero in on builder gross margins and are highly tuned to trends and historical comparisons for these margins. Accordingly, I assessed a potential relationship between gross margins and analyst ratings.

TOL is the only builder in my sample with gross margins that are still increasing. So I looked for a differentiator other than trend. Revenue growers still have gross margins at or above 25%. All the revenue peakers have gross margins at or below 25%. Thus, I will be watching closing for peaking revenues if the growers drop gross margins below 25%. Similarly, I will look to see whether the revenue peakers continue to experience downtrending gross margins.

Since financially healthy builders can sacrifice margins to maintain revenue growth, the current 25% threshold could shift over time.

Can Builders Continue Holding the Advantage?

Anyone following the housing market knows a standard narrative. Existing home owners do not want to move into more expensive mortgages, so they are only moving if they absolutely have to do so. This change in behavior has created an inventory shortage that provides an opportunity for home builders. So while the overall housing market is still in a recession (based on overall industry sales declines from the peak in 2020), builders have been able to manage their way with resilient revenues and earnings growth off the recession trough. However, this advantage could run its course sometime next year or so.

According to Mortgage News Daily , existing home sales remained relatively flat from 2013 to 2019 while new home sales slowly grew. So, new homes have been gaining share of the total market for quite some time. This dynamic accelerated after new home sales troughed last year while existing home sales continued to trend downward from the 2020 peak. At some point, the relationship could revert to (recent) historical norms. Thus, if high mortgage rates are still burdening buyer's demand and construction loans for supply, then the fortune of builders should flatten to decline by the 2024 spring selling season or shortly thereafter.

If my speculation on the future dynamics of new versus existing home sales plays out, then the current seasonal trade on home builders will likely end early. Moreover, the 2024-2025 seasonal trade may not look attractive at all.

Regardless, I will take things one step at a time. For now, the more immediate interest is seeing how revenue and gross margins unfold in the next earnings season for builders and the resulting impact on analyst ratings.

Be careful out there!

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