We think the time has finally come for the U.S. housing market to get beyond its false starts and begin a multiyear boom that could benefit investors. Low interest rates, demographics and a solid economy should provide staying power for a resurgent housing market.

 

For advisors seeking to capitalize on potential housing growth, the obvious sector to explore is home builders, but there are other more subtle ways to invest in the trend. We believe the housing boom will endure. But our focus has been on identifying undervalued stocks with idiosyncratic factors that should benefit from the upswing.

It’s Not Just Starter Homes

While much of investors’ focus has been on first-time buyers, the high end of the market is also showing strength. Move-up homes in the $500,000 to $749,000 range year-to-date have enjoyed the largest growth in sales with an increase of 47% year over year, according to industry estimates.

Same Business, Different Approach

By holding multiple home builders operating in 12 states, our firm, Heartland Advisors, is attempting to blunt the risks of investing in single regions. The housing companies we invest in also specialize in different types of properties. One of our longtime investments, M.D.C. Holdings Inc. (MDC) generates roughly 40% of its sales through first-time buyers, whereas another portfolio holding, WCI Communities (WCIC), focuses on higher-end dwellings in Florida. By owning construction companies with varying target markets, we believe we are able to mitigate the risk tied to a single demographic group.

At the same time, we seek consistency in our holdings by picking those with attractive valuations.

At 1.16x book value, M.D.C. is trading at a nearly 32% discount to its peers and features a 3.4% dividend yield when the industry average among North American builders is 0.5%. Additionally, on a price-to-sales basis, the stock is trading at just 80% of its counterparts. We’ve been longtime owners of the company, which operates under the Richmond brand, partly because of its conservative approach in the space.

Many builders stock up on vacant land, which provides a tailwind during up markets since it appreciates with housing inventory. Alternatively, when the market softens, undeveloped land often gets marked down and can sink formerly attractive balance sheets. M.D.C. keeps its land portfolio light, instead focusing on generating returns from building.

KB Home (KBH) is another holding trading at compelling valuations. KB takes a different approach to property inventory but one that we believe is also prudent. After the credit crisis, the company focused on selectively acquiring land at attractive rates in markets that feature high household incomes and a scarcity of buildable parcels. The strategy has created operating leverage for the company and should result in significant margin expansion as the real estate market continues to grow. It is trading at just 87% of book value and 10.4x next year’s estimated earnings despite five consecutive years of increasing sales, so we believe the market isn’t fully appreciating the upside opportunity for the stock.

WCI owns or controls 13,500 home sites in the fast-growth Florida market, focusing on coastal areas. In our view, the company has a great supply of land in a robust region. Often builders that hold significant acreage have weaker balance sheets, but WCI is an exception. It has $146 million in cash and less than 20% net debt. Given that the cost of its real estate is largely already realized, we believe its operating leverage results in greater upside potential than downside risk. The company saw new orders jump 53.8% in the second quarter of 2015 and its backlog grow by nearly 45%. As the pace of building quickens, we believe WCI’s land will prove a valuable asset to boost top-line growth. The company’s focus on serving second-home buyers and active adults as well as its higher average selling price of $476,000 provides another unique aspect that diversifies demographic risk in the portfolio.

Beyond the Builders

While owning construction companies is the most direct way to participate in the resurgence of housing, we believe the powerful trend will also affect other industries from raw materials to home décor.

The paper and forest products industry, for instance, is beginning to benefit from housing activity. While pricing has been under pressure for wood products because of softer demand in China, some of the weakness has been offset by demand from domestic construction. Producers expect prices to stabilize and expect demand in North America to continue increasing with the uptick in renovations, remodeling and new construction. When that happens, we believe, performance should resume its historical correlation with housing as illustrated below.

Source: FactSet Research Systems Inc. and Heartland Advisors Inc., 8/31/1995 to 7/31/2015
Housing data is seasonally adjusted
Past performance does not guarantee future results.
 

Our holdings in paper and forest products generally trade at discounts to their peers in the industry and to their own five-year historical averages. We believe this will give them additional downside protection while lumber prices stabilize.

Another area that should benefit from household formation is specialty retail, which can thrive whether people are building new homes or moving into apartments.

We believe one company set to benefit is Pier 1 Imports (PIR), which operates in the competitive home décor space. Pier 1’s margins eroded after it engaged in promotional discounting and spent to strengthen its e-commerce presence. As its profit levels were compressed, its valuations followed and, based on forward earnings, the stock now trades at a nearly 14% discount to its 10-year median price-to-earnings ratio of 14.8x.

The company now has an attractive valuation and, with internal improvements, it should be able to reap additional benefits as consumers increasingly focus on homes. We believe its online marketing efforts will be beneficial and that the bulk of its associated obligations have already been paid.

The Numbers Behind Our Optimism

According to recent census data, 30% of the 80 million people in the millennial generation live with their parents. That’s up from 23% for the same age group in 2000. Trends in household formation suggest many of those millennials are starting to venture out of the nest. As the chart illustrates, the number of new households formed rose significantly toward the end of 2014 and has continued to expand. Through the first half of 2015, the number of households has increased by 2.2 million from the same period a year ago. The flood of those millennials moving out on their own should provide a pipeline of home buyers for the next several years.

Source: Cornerstone Macro Economic Research, 3/31/1958 to 6/30/2015
Rolling average computed quarterly, using 8-quarter moving windows.
 

The explosion in household formation has put pressure on the rental market, which, in turn, is making home ownership financially attractive. Vacancy rates for rental properties hit a 10-year low at the end of the second quarter at 6.8%, down from an average of 9.1%. As excess apartment capacity has tightened, rents have edged up to all-time highs in nominal dollars. Meanwhile, housing prices are still more than 20% below their peak from 2006 to 2007.

The housing market is also being affected by interest rates, which are at historic lows and more than 200 basis points lower than they were in late 2006. This offers an additional discount for home buyers. The upshot is that the difference in monthly payments between renting and owning has shrunk, making homeownership more attractive.



Source: Raymond James Research, National Association of Realtors, Federal Housing Finance Agency, and Bloomberg L.P., January 1990 to July 2015
 

Budding upward pressure on wages should also contribute to the affordability of housing. With unemployment hovering around 5.3%, the Federal Reserve has noted there is evidence that pay is beginning to creep up as some industries compete to fill open positions. We expect that trend to continue.

Summary

While we believe there are several reasons for optimism about housing, recognizing an emerging theme is only the first step in capitalizing on the opportunity. We are convinced that a focus on valuations, management and business strategy is key to identifying companies with the greatest chance for success. Additional analysis is then required to select a group of companies with unique attributes that together provide the greatest opportunity for success regardless of how the broader theme plays out.

(As of June 30, 2015, Heartland Advisors on behalf of its clients held approximately 5.58%, 1.72%, 0.82% and 3.53% of the total shares outstanding of M.D.C. Holdings Inc., WCI Communities Inc., KB Home, and Pier 1 Imports Inc., respectively. Statements regarding these securities are not recommendations to buy or sell. Portfolio holdings are subject to change. Current and future holdings are subject to risk.)

Adam Peck, CFA, vice president and portfolio manager of the Value Plus and Value Funds and their corresponding separately managed account strategies.