While investment themes like artificial intelligence (AI) have grabbed much of the attention of investors this year, homebuilders have sneakily outperformed the S&P 500 year to date. That news may be surprising to some, especially when you consider that the U.S. has been in a housing recession over the past year.
Warren Buffett's Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) recently released an SEC Form 13F, which shows its trading actions in the second quarter. The form indicates that Buffett (through Berkshire) opened new positions in three different homebuilders.
What does Warren Buffett see in the homebuilders? And should you follow his lead?
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Despite a lousy backdrop, the builders are rallying
The housing economy has been beset by headwinds stemming from the massive increase in interest rates over the past year. Existing home sales have collapsed, mortgage origination is a fraction of what it was a couple of years ago, and home price appreciation peaked a year ago. Yet, if you compare the S&P SPDR Homebuilder ETF (XHB 1.22%) versus the S&P 500, it has outperformed year to date.
New home sales in June 2023 were up 23.8% compared to June 2022, while existing home sales were down 18.9% compared to a year ago. The reason for the big divergence is largely due to the interest rate lock-in effect. Many people who might be interested in selling their home are seeing mortgage rates above 7% and are reluctant to give up their current 3.5% mortgage rate.
This is the "hate the house, love the mortgage" phenomenon. This decreases the inventory of homes for sale, which is an opportunity for the builders since there is no seller who has to give up a low rate.
Buffett is buying the builders
Berkshire Hathaway initiated positions in three homebuilders: D.R. Horton (DHI 0.78%), Lennar (LEN 0.98%), and NVR (NVR -1.01%). D.R. Horton is a builder that focuses on entry-level, move-up, active-adult, and luxury homes. That said, about two-thirds of its sales are in homes under $400,000, so it is more focused on lower price points. Geographically, it is focused on the South and Sunbelt regions of the U.S., which are seeing strong population growth. In the latest quarter, D.R Horton's earnings per share fell 16.5%.
Lennar is a diversified homebuilder focusing on entry-level, move-up, active-adult, multigenerational, and luxury homes. Lennar earns about two-thirds of its revenue from its East and West Coast markets. Lennar's average sales price in the latest quarter was $449,000, which was a decrease year over year. Lennar's earnings per share declined 33% year over year in its latest quarter.
NVR is a homebuilder that focuses on properties in the Mid-Atlantic, Southeast, and some Midwestern states. NVR's average selling price was $447,300 in its latest quarter, which is similar to Lennar's. In the second quarter, earnings per share fell 5.8% while average selling prices decreased 5%.
Earnings are falling, but the future looks bright
With all three of these builders reporting declining earnings per share, it seems hard to reconcile why the homebuilders, in general, are faring well and why Buffett is interested. Homebuilding is a classic early-stage cyclical, which means it is one of the first industries to emerge from a recession. This didn't happen after the Great Recession because of excess inventory. The excess inventory problem has now reversed, and the National Association of Realtors estimates a housing gap of 5.5 to 6.8 million units. To put that into perspective, housing starts are running at a 1.4 million-unit pace.
US Housing Starts data by YCharts.
We could be in for a long boom in homebuilding
To meet this needed supply, homebuilders will need to push out a lot of properties over the next several years. Interest rates have been an issue, but the Federal Reserve might be near the end of its tightening cycle, which will help matters. There is still a shortage of construction workers, but the high pay of skilled trades is drawing more workers into construction, and employment has passed its peak during the housing bubble of 2006. At the same time, lumber costs are back at more normal rates, which will help keep costs down.
The stock prices of the builders have begun to price in a major recovery in homebuilding, and the divergence between new home sales and existing home sales shows that new homes are where the momentum resides. Buffett is betting that the long-awaited housing boom is upon us. With a bit of additional research, this might be a bet that investors want to make as well.
