FND - XHB: Taking Profit And Switching To A More Selective Approach

2024-01-03 12:05:40 ET

Summary

• 2023 has been an amazing year for homebuilders with the SPDR Homebuilders ETF registering a 52.3% gain since we initiated our bullish view in November 2022.
• Although we are still bullish homebuilders, current valuations are no longer as deeply discounted and attractive enough to generate meaningful alpha in our view.
• We recommend a more selective approach, reducing exposure to XHB and focusing on high-quality names like D.R. Horton and Lennar Corporation.
• We see an opportunity to take some profit on XHB for now, and to wait for better opportunities to buy the dips.
• Accordingly, we downgrade our "Buy" rating on XHB to a "Hold".

2023 has been an amazing year for homebuilders with the SPDR S&P Homebuilders ETF ( XHB ) registering a 52.3% gain since we initiated our bullish view in November 2022 . Valuations have also improved substantially with XHB currently trading at more reasonable multiples of 15.4x Forward P/E and 3.6x P/B, according to fund data published by State Street Global Advisors.

Although we are still bullish homebuilders given that the U.S. remains stuck in a chronic housing shortage, current valuations are no longer as deeply discounted and attractive enough to generate meaningful alpha in our view. Hence, we see an opportunity to take some profit on XHB, and to wait for better opportunities to buy the dips.

To be clear, however, we are not abandoning the homebuilders theme entirely. Sky-high mortgage rates and economic uncertainties can only hold back demand for housing temporarily. We believe that the pent-up demand for housing has yet to be fully reflected in home prices, and that there is a multi-year runway for home prices to head even higher from here. Homebuilders and real estate asset managers are likely to emerge as the biggest beneficiaries of this trend.

To express our bullish view on this theme, we prefer to take a more selective approach by reducing exposure to XHB and concentrating on high-quality names like D.R. Horton ( DHI ), which we still maintain a "Strong Buy" rating. Despite registering a 113% gain since we initiated our view on DHI in October 2022, the stock is still trading at an undemanding Forward P/E of 10.9x. Another high-quality name would be Lennar Corporation ( LEN ), which is also trading at around 10.4x Forward P/E. Therefore, we see DHI and LEN having more room for further upside compared to XHB.

The table above shows the most recent top ten holdings of XHB.

Performing a quick check on the valuations of these companies revealed that most are still trading at undemanding multiples of around 9x to 10x. XHB is carrying an elevated multiple of 15.4x just because a handful of outlier companies are trading at rather exorbitant multiples. These outliers include Floor & Decor Holdings ( FND ), Lennox International ( LII ), and Home Depot ( HD ), which are trading at Forward P/Es of 50.7x, 24.8x, and 22.9x, respectively.

This adds to our core view that the low-hanging fruits for alpha will become increasingly more difficult to find in 2024. Thus, the strategy of investing broadly across an entire sector is likely to result in more moderate returns going forward.

We believe that a more selective approach will be necessary to further extract alpha for our bullish homebuilders theme, and observing discipline on valuations will be key in driving performance.

We also see increasing risks of an imminent pullback in equity prices, as the bull market rally is looking exhausted near term. Taking some profits off our big winners makes a lot of sense at the moment, and we look to re-enter should we see a decent pullback in prices.

In Conclusion

Valuations on XHB are no longer as deeply discounted and attractive enough to generate meaningful alpha in our view. We see an opportunity to take some profit on XHB for now, and to wait for better opportunities to buy the dips.

Accordingly, we downgrade our "Buy" rating on XHB to a "Hold".

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