Homebuilding is a cyclical industry, and it's had a crazy last few decades with some huge bubbles and bursts. But if you can plan for those peaks and valleys -- and you totally can -- the industry has some fantastic companies with huge growth potential that long-term investors won't want to skip.

In this week's episode of Industry Focus: Energy and Industrials, host Sarah Priestley and Motley Fool contributor Jason Hall go through the basics of the homebuilding industry today, then share three specific companies that long-term investors might want to consider. Click play, and find out what risks to watch out for in this industry, which U.S. states and regions are seeing the biggest new housing booms, where demand for new homes is coming from, what that trend means, and more.

A full transcript follows the video.

This video was recorded on May 3, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 3rd of May, and we'll be discussing home builder stocks. I'm your host, Sarah Priestley, and joining me on Skype is Motley Fool contributor Jason Hall. Jason, thank you for joining me today!

Jason Hall: I love being on the show with you, Sarah! It's so much fun!

Priestley: [laughs] I'll pay you later for those kind words.

Hall: Awesome. You can Venmo me the money.

Priestley: Yeah, Venmo. We could have a whole show just on Venmo. I'm personally perturbed that it's already May. I feel like I'm going to blink and it's going to be November or something.

Hall: Yeah, this year is going by ridiculously fast.

Priestley: It is. I feel like I sound very old when I say that, but it's true, nonetheless. It's just absolutely nuts. Jason, you pitched this show idea to me last week, and I loved it so much because I've visited a few cities recently, and just seeing massive amounts of construction going on. Vince Shen, who hosts the Tuesday CG show, he just came back from Austin, and he said that the skyline was just a sea of cranes. And, one of the biggest growth areas for construction is actually Southern California, which is where you are, Jason. Are you seeing much of a construction boom?

Hall: Yeah, I am. The city I live in is really weird. They have such crazy laws about expansion. But, outside of my city, there's huge demand. The economy is pretty good in Southern California. There's tons of jobs, lots of high-paying jobs. It's really good. 

You mentioned Texas. My brother lives in San Antonio, and San Antonio is booming. Dallas is booming. Houston, booming. Texas is a real hotbed for home growth. The Southeast, parts of Florida, the Carolinas, around Atlanta, booming. Really huge. We'll talk about where it's coming from. I've been a front-runner here, I've been pounding the table on home builders for two and a half years. I've been terribly early on a few, but I feel a little vindicated over the past year.

Priestley: And so you should. Home building in the U.S. has obviously been through a tumultuous decade, or couple of decades, in fact, with the boom that preceded the Great Recession, and then the bust that followed. But now, the industry is once again, this upward trend where residential construction continues to climb up, and we have a period of historically low inventory for houses for home buyers. It's about 14% below demand. 

This is obviously an industry that's so closely watched as a barometer for the health of the overall U.S. economy, and buyer confidence and builder confidence are really closely watched. How's the U.S. feeling toward home buying right now?

Hall: Some information, actually, that you shared with me yesterday, that's interesting -- the National Association of Home Builders does a confidence survey of home builders, and it also does (unclear 3:08). January was 72 and April is 69, so it's come down a little bit, but still, I think that's in the 10-year high area.

Priestley: It is, yeah.

Hall: It's still relatively high.

Priestley: Yeah, absolutely. We've seen the same thing happen in the home buyer index, too. There has been a slight decline, which has caused some of the stocks that we're talking about today to dip so far this year, over cause of buyer confidence. But, actually, we're still at 10-year highs, so we need to put this into perspective and say that there are valid concerns being raised around labor shortages and increasing costs. But, overall, I think the market is incredibly healthy.

Hall: On the home buyer side, the National Association of Realtors is constantly doing surveys and releasing data. One of the things that their chief economist talks about regularly, has talked about regularly for the past year, is a lot of the confidence issues, the negative aspects of buyer confidence they've seen are from young, entry-level home shoppers that just, there's no inventory. They can't find anything. So, some of that negative aspect is simply an issue of lack of supply, which is what the home builders are working to fix.

Priestley: Absolutely. We kind of touched on this in the opener, but I find the geographical spread of this new construction fascinating. It's focused on pockets, as you said. To go through some brief numbers, for instance, in the fourth quarter of last year, Raleigh, North Carolina had the highest portion of new homes, followed by Austin, Texas, as we talked about, and Nashville. The most homes being built per capita: North Port, Florida; Raleigh, North Carolina; Austin, Texas. Most about to begin -- this is looking at permits for new builds -- is Houston, which you said; Dallas, which you also said; Phoenix, Arizona; and Seattle, Washington. So, an incredible concentration of growth going on in some of these areas.

Hall: Right, yeah. And, a lot of these areas, there's actually an interesting thing. One of the companies we're going to talk about, Meritage Homes (NYSE:MTH), on their latest earnings call and in their latest release, it's not just first-time buyers, it's not just millennials. That's a huge secular trend, millennials moving into the home-buying market. It's the largest segment of the population. They're going to be driving housing sales for the next 20 years, potentially. But Meritage Homes also said that they're seeing a lot of demand in their entry-level communities from retiring baby boomers who are downsizing. So, it's creating dual demand from two opposite ends of the age demographic.

Priestley: Very interesting.

Hall: In a lot of these areas, like parts of Florida, the Carolinas, Phoenix, those are areas that there is a concentration of retirees, too. So, there's two sources of demand that are good for housing right now.

Priestley: Yeah. And we're seeing house prices go up, obviously, because we have this historically low inventory. But, then, there are industry headwinds in the form of labor and material cost. I think the average construction of a single-family home increased 1.2% year over year, and now stands at $244,000. Lumber futures, we've talked about this, I think, on previous shows, about the impact of the tariffs. Lumber futures are up 27% just since the start of the year. We also have cost and availability of land.

There are some builders also struggling for credit on single-family properties. I think that's why we're seeing so many multi-family apartment buildings and things like that going up in cities. It's not just that it's an efficient use of space. I think, also, the credit is possibly more free-flowing for those projects.

Hall: Yep.

Priestley: That's the situation as it stands. We've obviously talked about home builder confidence falling slightly. We definitely need to put that in context of everything else that's happening here. Inventory being constrained like this is an economist's dream example of causing the price increases. There is still going to be the demand there. As you said, we have the millennials looking for their first properties and baby boomers coming up and looking to downsize. It's creating this swell of demand for these smaller properties. And I think the average size of a new build has come down a lot since 2014. People associate millennials with being cash-strapped, but a lot of baby boomers have money to spend on these forever homes that they're looking for. So, it shouldn't be as bad as some analysts would have us to believe.

Hall: I think it's also important to remember that housing is cyclical. There will be, if the economy slows down a little bit, and we go through a small period of recession, housing starts will drop, home sales will slow down. And it might go for a few quarters, and then pick right back up. 

I think the key is, there's a potential secular trend that could last 10 years, in terms of strong, consistent, steady home builder growth, new home building growth, with the occasional little blip on the radar. So, investors really should think about this with a true long-term multi-year perspective, and any downturn in the market would probably be more of a buying opportunity for any of these really high-quality home builders vs. "I need to get out of this stock before it gets even worse."

Priestley: Yeah, absolutely. The first stock that you mentioned was NVR (NYSE:NVR). They focus on building luxury homes in Delaware, Maryland, North Carolina, Pennsylvania, and Virginia. They have three distinct brands: Ryan Homes, NV Homes and Heartland Homes. They're actually the most expensive, I think, of the stocks that we're going to talk about today. Their P/E is at 24X. But they're also the biggest, and the past 12 months have seen the stock come up almost 50%. So, great pick! What exactly attracted you to NVR?

Hall: I've followed NVR for a few years. Typical hindsight bias, I'm kicking myself for having never bought the stock even though I've been really interested in the company. The reason NVR trades at a little higher valuation than most of the home builders out there is, it has a different model in terms of the way that it acquires properties. It uses less leverage. 

Your typical home builder are these large home builders that build these big communities. They want to own a pretty substantial amount of land that's ready to develop, several years' worth of potential land in their inventory. That requires a lot of debt for an asset that they're simply sitting on, that they're not getting any return on yet. It also creates more risk. When those downturns do happen, they could be left holding a ton of inventory that they're not going to be able to develop as quickly. So, interest expenses and things like that, and higher leverage, can be an issue.

NVR uses a model that's more based on buying options. It'll typically put around 10% down to hold the option to acquire a finished plot of land that it can then develop within a set period of time. So, it doesn't have to take on all the debt and then service that debt for land that it might hold for two or three or four years before it actually develops. So, because of that, it's certainly in a better position to ride out the downturns, because it's not sitting on all this inventory that it can't leverage in any way. 

The downside is that it can increase its costs a little bit when there's a boom, when things are going really well, it may not be able to generate the highest potential profits. But the downside risk and the reduced leverage has proven, as the housing market has been weird over a lot of the past decade, it's really proven a super effective model to be a home builder.

Priestley: It is a clever model, because presumably, during economic downturns, people are going to be happier to accept less for the land. Are these previously agreed contracts? Or is this just the right to buy at the set price at the time?

Hall: They're options to buy.

Priestley: Options to buy, OK. They had a great first quarter, in a good time. They had a 17% uptick on revenue year over year. They delivered top and bottom line growth. And they've done this, considering that the average selling price has dropped slightly. But, as we've just talked about, this is kind of this migration to the smaller format, more easily accessible for millennials, first-time home buyers, and also retirees. So, that makes perfect sense. And, as you said, this is a really good stock if you're interested in the secular trends around it, but you don't necessarily want the downside risks.

Hall: Right. If you look at NVR's most recent quarter, Ryan Homes, one of their operating units and brands that they build under, is focused on the entry-level market. If you look at their average selling prices and the average prices for orders, those prices have come down. On one hand, their average prices are falling, that's not good. But, in this case, because the demand is in the entry-level and the lower end of housing, that's an indicator that they're effectively shifting into that, where that demand is going to be. So, it's not a bad thing to see their average sale prices dropping right now.

Priestley: And one thing that we love here is skin in the game, inside ownership. I think management are required to own between 4-8% times their annual salary in stock, to ensure a long-term focus on shareholder returns. So, that's another tick in the box for NVR. 

The next company is one that you've already mentioned, Meritage Homes. Much smaller. Their market cap is $1.8 billion. NVR's is $11.4 billion. Meritage's stock is up 17.5% over the past year. Lower P/E, 13.4X. Their strongest markets are in Arizona, California, Florida and Texas. They're having kind of a resurgence in Georgia, North Carolina, South Carolina and Tennessee. So, all these hot states that we've mentioned already. What is it that you like about Meritage?

Hall: You'll notice a bit of a trend here with where these successful home builders are building their homes, there's no doubt about that. Meritage, founder-led. The idea of skin in the game, you want companies that have a founder that's involved, tend to outperform the market. So, that's one of the things that I like about Meritage. 

Meritage is the one of these that I've followed the longest. I started years ago, actually, before I even started writing for The Motley Fool, when it was recommended in Stock Advisor years and years ago. I got really interested in the company. And a few years ago, the company made the decision to really prioritize entry-level housing. And it's taking a little bit of a different approach. It's more traditional, in terms of a little more leverage. Owns around 35,000 lots -- or controls, because it does a few options, but mostly it buys lots.

But, it also has a focus on energy efficiency, green standards, and things like that, that in the past it's used to increase its profitability by building in certain things that qualify it for certain tax credits. That disappeared last year, and then came back for a year in the tax bill retroactively. But, it's something that's very attractive to millennials who are interested in buying houses that are going to be more efficient, use less energy, and have these things included. So, it really pairs well with its focus on entry-level.

Over the past several quarters, every time the company has talked about its land acquisitions, it's pointed out the percentage of that new land that it's looking to build entry-level homes on, and it's between 75-85%, every time. So, you're starting to see, its margins are coming up, because when you build these entry-level communities, there's a lot less customization that happens. So, when there's less customization, it can generally sell the houses at a higher margin. Its sell price may be lower, but there's more margin because you have less labor involved, less time delay to do the customization work and that sort of thing. It also tends to build more of those houses on spec. In other words, it starts construction on the home without an order lined up from a customer to buy it. Because there's less customization that's going on, it's able to build more of these houses on spec. 

If you look over the past several quarters and the earnings releases, the presentation, and read the conference call notes, you'll see that those things are paying off because margins are improving, it's selling a higher percentage of its homes that it builds on spec. It's really starting to pay off. It really, really is. Its earnings are growing at a really enormous rate. And, I think, in terms of a concentration of starter homes, it's certainly going to build more starter homes than NVR, which will still have a pretty large portion of its homes more in the luxury segment. But it's really starting to pay off.

Priestley: Absolutely. They talked in their first quarter earnings call about their live now communities. They said, single-home models as low as 1,400 square feet. As a resident of the D.C. metro area, 1,400 square feet would be wonderful. [laughs] 

Hall: Sounds enormous, right? That's 1,000 square feet smaller than the average new single-family free-standing home that's been built over the past 10 years.

Priestley: They said they're planning to target 35-40% of their communities located in the entry-level by the end of this year. I think right now, they're at 28%.

Hall: Right.

Priestley: Don't hold me to that. Fantastic company. As you said, 33% increase in pre-tax earnings. Higher home gross margins. They had a diluted earnings per share of $1.07. So, they're doing incredibly well. I would say you're right to have had your eye on them for so long.

Hall: Yeah, it's paying off.

Priestley: LGI (NASDAQ:LGIH) is the last company we're going to talk about. Again, they're another luxury home builder focused in Delaware, Maryland, North Carolina, Pennsylvania and Virginia. Similar market cap to Meritage with $1.5 billion. The past 12 months, this stock is up 124%, which seems incredible.

Hall: [laughs] Well, it is incredible!

Priestley: It is incredible. What led to the run-up?

Hall: One thing I just want to mention, the ticker is LGIH for this one. There is another ticker that is LGI, but it's for a fund. So, let's make sure our listeners know the difference there.

Priestley: Flocking to a fund.

Hall: So, essentially, LGI is the smallest of the three. Headquartered in Texas, by the way. There's that trend again. It's definitely the smallest of the three. In terms of raw growth opportunity, if management continues to execute the way they have, focusing, again, on this entry-level segment of the market, it has a tremendous amount of upside. Over the past year, really about a year and a half, it's really grown at an enormous rate. I'm sure you probably have it right in front of you, in terms of the increased number of houses. We're talking 50-60% increase in sales and earnings. It's just really grown like wildfire. It really has.

Priestley: Yeah. The premise for a lot of this, as we've talked about, is that there's fear around interest rate pressure and things like that, but we do believe that this combined demand from millennials and baby boomers is going to really benefit these particular companies because of their focus on catering to this market.

Hall: Right. I think one thing, too, that's good to point out in terms of the run that we've seen over the past year on the stocks, is also, a little bit of just a valuation recovery. If you go back to this time last year, LGI and Meritage were trading -- I know LGI was trading for, like, 6-7X trailing earnings. It's trading for 15X earnings now. And that's a little bit on the more expensive side for where home builders typically trade, because of their balance sheets and the leverage. But, 15X earnings for a company that grew its profits over 50% last year, and is one of the smallest of the big corporate home builders, is still pretty cheap for that kind of growth. I think Meritage trades for 11.5X earnings, so it's, again, still, pretty cheap for the kind of growth potential that you have there. So, nobody should think that they've missed out because these stocks have gone up so much in the past year.

Priestley: Absolutely. Just to recap, this is a capital-intensive and very cyclical industry, so we're wanting a long-term investment plan on these. But, we think the little bit of a decline we've seen at the start of this year because of fears over buyer and builder confidence and investment rate increases is slightly overblown and there's still plenty of opportunity in this market.

Hall: Absolutely, yeah. Interest rates are going to continue to climb, but we're still very cheap, if you look at some of the historical average rates --

Priestley: Yeah. Millennials are still going to want to move out of the basement. [laughs] 

Hall: [laughs] Absolutely.

Priestley: Perhaps. Maybe not. Is there anything that we've missed that you want to let listeners know about?

Hall: I don't think so. I think, again, the key things, there's still a tremendous pathway for growth from millennials and from boomers. It's going to be cyclical, like you said. So, focus on the long-term trends. I think that's it. At this point, I'm just repeating what you said without anywhere near the beautiful way that you're able to say it.

Priestley: [laughs] I don't know about that. Thank you so much for being on the show with us, and for bringing this fantastic idea and educating us on these stocks today.

Hall: Absolutely.

Priestley: That's it from us. If you would like to get in touch, please feel free to email us at industryfocus@fool.com, or tweet us on Twitter @MFIndustryFocus. Thank you to Austin Morgan for producing the show. As always, the people on the program may own companies discussed, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Jason, I'm Sarah Priestley. Thanks for listening and Fool on!

Jason Hall owns shares of LGI Homes and Meritage Homes. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool owns shares of LGI Homes and NVR. The Motley Fool recommends Meritage Homes. The Motley Fool has a disclosure policy.