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Homebuilder Stocks Upgraded Ahead of Earnings

By Rich Smith – Sep 25, 2019 at 12:07PM

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Lennar, Toll Brothers, and KB Home all win outperform ratings.

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Six years ago, investment banker Raymond James whispered a secret to investors in homebuilding stocks:

Based on our data documenting the performance of public homebuilders, we find the period running between mid-November and Super Bowl Sunday typically works best (generally November 15-January 31 on average) for this trading window. Most impressively, by our count, the homebuilding sector has outperformed the S&P 500 nine consecutive years during this calendar period, and 23 of the past 29 years.

Raymond James calls this annual investment in homebuilders its "hope trade" -- an early Christmas rally for investors in the housing sector.

Now, a quick glance at the calendar confirms that it's not November yet. Nevertheless, this morning, the analyst announced that it is making a "preemptive move to upgrade" shares of Lennar (LEN 5.21%), Toll Brothers (TOL 4.27%), and KB Home (KBH 6.00%).  

Why?

Construction workers read plans for a house under construction

Image source: Getty Images.

Two catalysts on the horizon

Raymond James' upgrades are actually "preemptive" in more ways than one. On the one hand, yes, the analyst is certainly making its annual call in favor of homebuilders a bit earlier than the calendar dictates for investors following the "hope trade." If you're a gambler hoping to roll the dice on homebuilders this fall and winter, you should in theory still have another couple of months to make your play.

The reason that Raymond James doesn't counsel waiting, however -- the reason it is telling investors to buy homebuilder shares today -- is because two of the three companies named above have earnings reports coming out before the "hope trade" window opens on Nov. 15. Indeed, KB Home is expected to report its Q3 earnings after the market closes this evening, and Lennar will report just one week later. (Toll Brothers probably won't report again until November.)  

And there's a big reason Raymond James thinks you should get into these stocks before the earnings news comes out.

Bullish housing data in August

In a word, that reason is: data.

Raymond James is rushing out its buy ratings early this year because it believes that the "upcoming earnings announcements ... will reveal decidedly improved housing fundamentals and potential upside to current consensus FY20 estimates."

As the analyst explains: "August data demonstrated a decided (and perhaps under-appreciated) inflection in supply and pricing conditions, revealing a far more bullish backdrop for homebuilders into year-end." And assuming this is reflected in the upcoming earnings results, this means that housing stocks could conceivably take off early this year.

What the data said

So what was it about August's data, exactly, that has Raymond James feeling so bullish? Let's take a look at the Census Bureau's report on "Monthly New Residential Construction" in August 2019 and find out.  

According to the Bureau, "Privately owned housing units authorized by building permits in August were at a seasonally adjusted annual rate of 1,419,000" -- up an impressive 12% over August 2018 levels, and up 7.7% sequentially over July 2019. Likewise, privately owned housing starts in August jumped 6.6% year over year, and single-family housing starts grew 4.4% sequentially from July.

"Privately owned housing completions," meanwhile, grew 5% year over year. All of which suggests that demand for housing is growing faster than homebuilders are completing new houses -- a clear bullish sign for homebuilding stocks.

What it means for investors

Despite the propitious data, though, homebuilder stocks continue to trade at very reasonable-seeming valuations. Lennar shares, for example, cost only 9.5 times trailing earnings today, a bargain in a market where the average stock trades for 22 times earnings. KB Home costs a bit more at 12.7 times earnings. Toll Brothers, a bit less (8.4 times earnings).  

Projected growth rates for the three companies all look respectable -- even encouraging -- with analysts forecasting 10% growth for Toll Brothers, 11% for KB Home, and 12% for Lennar, resulting in attractive PEG ratios for everyone but KB.

All three stocks, meanwhile, pay modest dividends. With Lennar paying 0.3%, and Toll Brothers and KB Home offering 1.1% apiece, they all provide a bit of protection -- just in case Raymond James turns out to have jumped the gun here in defying its own branded "hope trade" and upgraded these homebuilder shares too early.

Speaking of which...tune in again after market close to see how KB Home performed in Q3, and maybe we'll get out first clue whether Raymond James was right after all.

Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Lennar Corporation Stock Quote
Lennar Corporation
LEN
$78.43 (5.21%) $3.88
KB Home Stock Quote
KB Home
KBH
$27.48 (6.00%) $1.55
Toll Brothers, Inc. Stock Quote
Toll Brothers, Inc.
TOL
$43.80 (4.27%) $1.79

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