This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

It's a great time to buy a new [homebuilder]
Sales of new homes in the U.S. took a tumble last month, but that's not keeping one analyst from recommending the sector. This morning, Washington, D.C.-based Compass Point reversed course on a number of losing bets against homebuilders, announcing upgrades for Hovnanian (NYSE: HOV  ) and KB Home (NYSE: KBH  ) to "neutral," and lifting Lennar (NYSE: LEN  ) and Standard Pacific (NYSE: SPF  ) all the way to "buy."

Why? Let's take a look at each in order, beginning with...

Hovnanian
According to StreetInsider.com, which reported the ratings this morning, Compass Point still isn't thrilled with Hovnanian's "footprint" or its "price points." That said, the analyst does think risks have declined over the past few quarters and believes the homebuilder should be able to refinance its "significant debt maturities." Indeed, Compass notes that Hovnanian may even earn a profit in 2013, and perhaps earn as much as $0.46 in 2014.

But Compass still doesn't think you should buy it. Why not? Well, for one thing, Hovnanian currently sports a negative book value. Do you think it's a good idea to spend $6.12 on a share of a company whose net assets are worth less than $0?

Didn't think so. Plus, even if Hovnanian delivers as promised -- earns a profit this year and a bigger profit next year -- its forward P/E ratio is still 12.5, versus an annual growth rate that most analysts agree won't exceed 5% over the next half-decade. In short, Hovnanian at "only" $6 a share isn't a value play. It's a value trap.

KB Home
Similar story with KB Home. Again, Compass's rating is pointing up on hopes that the "risk profile" has been reduced by "an impressive common equity and convertible notes offering." As such, KB isn't going BK anytime soon.

But that in and of itself isn't enough to justify a buy rating, in Compass's opinion or in my own. The analyst's criticism centers on KB's still-too-low average selling price and its focus on cash-poor, first-time buyers. Me, I'm more worried that KB remains unprofitable on a trailing-12-months basis and sells for a lofty 3.7 times book value. P/E-investors may find it even more worrisome that KB sports a higher forward price-to-earnings ratio than does Hovnanian (19.5) but a lower rate of projected growth (4%).

In short, if you dislike Hovnanian, you really kind of have to hate KB Home.

Lennar
Now for the "good" news. One homebuilder Compass Point really likes today is Lennar, which the analyst praises for moving to diversify its business into multifamily homes, reducing its risk and capitalizing on "what will likely be a side-by-side [Ed.: alongside single-family homes] housing recovery with multifamily."

Compass sees Lennar earning as much as $2.44 per share in 2013, up 50% from last year. It thinks about a 20x multiple on those earnings is appropriate, assigning Lennar a $49.50 price target -- but again, I beg to differ.

Lennar shares already sell for 2.4 times book value -- not as bad as the other homebuilders discussed so far, but still a far sight above the 1x book value range for a "cheap" homebuilding stock. Also, while Lennar sells for 18.5 times projected 2013 earnings (a bit cheaper than KB), and has a long-term growth rate estimated at 6% (a bit faster than KB), the first number still looks too high to make Lennar a "value" stock, while the second number is far too slow for a supposed "growth" story.

Long story short: To justify Compass's recommendation, Lennar's going to have to grow a whole lot closer to the 50% the analyst posits for this year than the 6% the rest of Wall Street estimates for the next five years. If you want to push the "buy" button on this one, make sure to do it with two fingers... crossed.

Standard Pacific
Last and least -- but only just barely -- risky of the four stocks Compass endorsed today is Standard Pacific. This one has the virtue of being a relatively fast grower in the industry, pegged for 10% long-term earnings growth on the Street. Compass likes the company's "earnings power" and focus on "markets that have been the primary beneficiaries of the housing rebound in 2012." Problem is, such premium performance comes at a premium price.

The trailing P/E ratio at Standard-P is 52 today. Fast-forward a year, and it's still only expected to drop to about 29. I hate to beat a dead horse here, people, but even if 10% growth is twice what the other guys are expected to achieve, it's still far too slow to justify these kinds of P/E ratios.

Foolish final thought
The question naturally arise: If all these housing stocks are overpriced, does that mean there's no value to be found anywhere in the industry? Fortunately, the answer is that there does appear to be one homebuilding stock with some potential. It just doesn't happen to be one of the ones Compass Point mentioned today: Toll Brothers (NYSE: TOL  ) .

Priced at just 13.2 times earnings, growing at anywhere from 15% (according to S&P Capital IQ ) to 27% (Yahoo! Finance), and selling for a cheaper price-to-book value (2.0) than anyone else named so far, Toll Brothers looks to me like the rare combination of low price and high growth rate that could make you some money in the homebuilding sector today. If you're dead set on investing in this red-hot industry, I'd suggest you begin your research with this one.


 

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 29, 2013, at 9:14 PM, DGReid wrote:

    With a growing population, it seems obvious that home inventories will eventually be consumed, but smaller homes mean less profit and faster build times producing less employment. These homes also produce lower property taxes which, while good for the owner, doesn't help the local government as much. We are not going back to the days of building small mansions. The prosperity isn't there. Higher building numbers may just mean Levittowns are back. Little boxes, little boxes, and they're all made out of ticky-tacky, and they all look just the same.

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Related Tickers

12/26/2014 4:03 PM
HOV $4.02 Down +0.00 +0.00%
Hovnanian Enterpri… CAPS Rating: **
KBH $16.08 Up +0.02 +0.12%
KB Home CAPS Rating: **
LEN $43.76 Up +0.39 +0.90%
Lennar Corp CAPS Rating: **
SPF $7.22 Down +0.00 +0.00%
Standard Pacific C… CAPS Rating: ***
TOL $32.72 Down -0.02 -0.06%
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