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The Borderline Good, the Intractably Bad, or the Exceedingly Ugly?

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It's easy to be a contrarian when everyone else is.

No, that's not one of Yogi Berra's many famous malapropisms. It's a pinched original (if there is such a thing), but a truthful one. It is easy being a contrarian when price-to-earnings and price-to-book ratios are low, but not when the price has failed to plummet and the news is still relatively good.

True contrarians, on the other hand, strut their stuff when everything is low -- price, margins, news, outlook, and sentiment. Such is the case with the beaten and battered homebuilder sector. The iShares Dow Jones US Home Construction ETF (NYSE: ITB  ) is down 75% after hitting the market in May 2006. (Funny how these things always seem to hit the market at all-time highs.) Meanwhile, the National Association of Homebuilders/Wells Fargo Housing Market Index posted a July reading of 17, when a reading of 50 splits the sentiment between optimists and pessimists.

There isn't much good out there in the sector, but NVR Industries (NYSE: NVR  ) comes the closest; this is mainly because it focuses on the mid-Atlantic states, with approximately 34% of its home settlements in 2008 occurring in the relatively recession-proof, government-employee-riddled corridors of Washington, D.C., and Baltimore. What's more, NVR remains surprisingly flush with cash -- $1.2 billion as of the most recent reporting quarter -- and is remarkably devoid of long-term debt, which constitutes only 15% of its capital structure. Nevertheless, the stock is trading at a 36% discount to its 2005 highs.

MDC Holdings (NYSE: MDC  ) and Toll Brothers (NYSE: TOL  ) represent the intractably bad. Both are down around 60% and 80% from their 2005 highs. Like NVR, both build homes in the mid-Atlantic region, but they're also extended out to recession-addled Nevada, Arizona, and Florida. Moreover, both are carrying a larger proportion of long-term debt to equity compared to NVR, producing debt-to-equity ratios of 97% and 80%, respectively. The higher the long-term debt-to-equity ratio is, the more quickly bad things can happen in a turbulent environment.  

Hovnanian Enterprises (NYSE: HOV  ) represents the exceedingly ugly, and with good reason. Its stock reached the $70s in 2005; today it's trading at around $3. Like MDC, Toll Brothers, and NVR, Hovnanian builds homes for the Mid-Atlantic market, but it also builds homes for Florida, Arizona, and Ohio. Based on markets served, its prospects would appear no worse than those of MDC or Toll Brothers. Toss financial risk into the mix, though, and everything changes. The company is up to its metaphorical eyeballs in debt. Long-term debt dwarfs equity, putting it in a very tenuous survival position – one reason it remains a persistent topic of bankruptcy scuttlebutt.

So, would a contrarian prefer the good, the bad, or the ugly? Everyone who follows housing knows NVR is the class company of the field, but the class company doesn't equate to the class stock, because the stock price reflects its superior standing. Hovnanian simply has too much debt, which is why its name and the word “bankruptcy” are often uttered in the same sentence.

That leaves the bad. MDC and Toll Brothers have been sufficiently pounded by the market – reflected in their steep discounts – but both are likely to survive. In short, they have more room to improve than NVR, but are less likely to fail than Hovnanian, so that's where I'd hang my contrarian hat.

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Fool contributor Stephen Mauzy, CFA, does not hold positions in any of the stocks mentioned above. MDC Holdings is a Motley Fool Hidden Gems selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy regulates all Fool commentaries.

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Related Tickers

10/25/2016 4:02 PM
HOV $1.58 Down -0.05 -3.07%
Hovnanian Enterpri… CAPS Rating: **
ITB $25.94 Down -0.77 -2.88%
iShares Dow Jones… CAPS Rating: **
MDC $23.77 Down -0.90 -3.65%
MDC Holdings CAPS Rating: ***
NVR $1557.00 Down -20.08 -1.27%
NVR CAPS Rating: ****
TOL $28.22 Down -0.54 -1.88%
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