Housebuilders: they're cheap for a reason

By Euan Stuart Oct 31, 2005

“Morgan Stanley has cut its earnings forecasts for housebuilders by 19% - 27%,” reports Marc Rivalland in the Investors Chronicle. “Low-margin, volume builders such as Barratt Developments, Wimpey and Persimmon will be hardest hit (but) higher-margin operators, such as Berkeley, Bovis, Redrow and Wilson Bowden, will do better. Deutsche Bank also turned bearish on this sector,” he says, which is why “stocks fell across the board.” But if you’re expecting the journalist in question to be bearish as result of this, think again. Rivalland reckons “housebuilders get unjustifiably hammered at this time of year.” He cites the strategy of the magazine’s companies editor, Simon Thompson’s, of making money out of housebuilders by buying on 1 January each year and cashing his shares in on 31 March. As such, a sell-off now is “an important feature of Simon’s strategy”. Think of this, says Rivalland, as a good thing: the housebuilders are just getting cheaper all the time.

Indeed, housebuilders are nothing if not cheap. The four stocks that Rivalland claims have “the best-looking charts are those of Belway, Bovis, Redrow and Wimpey”. The average price to earnings ratio (PER) of these four stocks is about 5.4x, with Wimpey being the cheapest, on only 4.7x. So low is this figure that many people argue that even if we are facing a housing-market slump, any earnings impact must already be in the price. What’s more, if the bear case has been overstated and earnings aren’t going to be hit too badly, the housebuilders could surge. But charts can turn and I think that this particular sell off is more than just seasonal. Rather, it marks the top of the cycle. Think back to the summer of 1989, when the last housing bubble was still rocketing skywards, and when the stockmarket also saw fit to pay a very low multiple for the sector. Persimmon and Wilson Bowden traded on only four times forecast profits back then; Belway, Westbury and McCarthy & Stone got to three times, and Berkley Homes just 2.2 times.

In the event, even those figures were too high. Housebuilders are strongly geared to the economic cycle, which means great profits in good times. But things can turn nasty fast. If the cycle turns, they can face falling land-bank values, rising debt-service costs, rising wage costs and falling final prices. They lose money if they sell stock at knock-down prices, but if they don’t sell, they lose even more. In short, they suffer the mother of all margin squeezes. Sure enough, by the early 1990s, Berkley’s profits had been all but wiped out and low-margin, high-volume builders such as Wimpey, Westbury and McCarthy & Stone (M&S) all dived into the red. Wimpey’s share price dropped 75%, and M&S plummeted more than 90% by November of the following year. Back in 1989, these stocks may have looked cheap, but they were cheap for a reason. 

And that is probably also the case now. MoneyWeek readers will be familiar with our bearish view on the housing market, and hence land values, and it is a matter of record that interest rates have been rising for over a year now. Meanwhile, wage inflation is running at nearly twice the rate of the consumer price index. With mortgage applications down 40% year-on-year and first-time buyers priced out of the market for the last couple of years now, the writing on the wall is positively bill-board tall. House prices, and hence revenues, will soon fall, just as costs rise. Then it won’t be long before the housebuilders’ shares collapse.

Published in Tips & advice | More articles by Euan Stuart

Related articles

FREE - MoneyWeek's daily investment emailJohn Stepek

Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.