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The 2 Best Stocks To Profit From 'Housing Rebound 2.0'

Joseph Hogue

The recovery in U.S. housing has been the pervasive theme since the financial collapse and has offered some of the best returns in the market. Extreme uncertainty over subprime loans and falling real estate prices drove homebuilders and building products to fire-sale prices by 2011.

Hindsight, curse that it is, has most of us looking back at the triple-digit gains in some housing-related companies over the two years to mid-2013 and wondering why we couldn't see the writing on the wall.

But you shouldn't beat yourself up too badly -- you just might get another chance.

The SPDR S&P Homebuilders Index Fund (NYSE: XHB) has underperformed the market with a gain of just 11% over the last year and a loss of 1% over the past six months. The weakness is in stark contrast to the 60% gain the index posted in the two years to mid-2013, along with triple-digit gains in shares of homebuilders like KB Homes (NYSE: KBH) and Hovanian Enterprises (NYSE: HOV).

Weakness in housing-related stocks follows abysmal housing data over the last six months of 2013 and the first quarter of this year. Against winter weakness and the disappointing spring selling season comes strong evidence of a rebound for the rest of 2014 -- and one fact that could support the industry for years.

Rebound 1.0: 2011 to 2013
It is first helpful to understand the first stage in the housing recovery. By mid-2011, housing and housing-related shares had reached bargain-basement prices.

A record 2.9 million properties received foreclosure filings in 2010, 1 in every 45 properties across the country. Bank-owned properties and those in some stage of foreclosure accounted for 24% of all sales.

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The NAHB/Wells Fargo Housing Market Index fell from its consistent range between 60 and 70, dropping under 20 for three years. Single-family housing starts dropped from their annual rate near 1.8 million in 2006 to less than 400,000 and languished there for years.

By mid-2011, investors were starting to wonder if real estate could ever be an investment again. As with most great investments, it is that moment of capitulation that drove huge profits.

Over the next two years, investors and homebuyers snapped up property. The housing rebound drove construction and sales of building products, which fed a general rebound in the economy.

But the good times could not last forever.

Rebound 2.0: July 2014 To...
From the middle of last year, the housing market again fell on hard times. New construction on single-family housing fell 20% from its 2013 peak, and sales of existing homes tumbled nearly 14% to March. The historically cold winter behind us, many are starting to wonder if we completely missed a spring selling season, and housing-related shares have been hit.

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It seems that slow spring selling season may be giving way to a summer boom. New-home sales increased to a 504,000-unit pace in May, the highest in six years, and inventories decreased to a 4.5-month supply. Sales of existing homes jumped 4.9% in May to an annualized pace of 4.9 million units, and April sales were revised higher. The Housing Market Index jumped 4 points to 49 in June, which could preview stronger builder activity to come.

Tracking the long-term cumulative supply of new homes is what has me most excited. Despite a rebound in the Housing Market Index, home starts have yet to recover to the long-term average. According to Census Bureau data, single-family housing starts averaged 1.1 million a year in the decade to 2000 but have averaged just 515,000 a year over the past five years. The market has transitioned from a surplus of 2.5 million homes at the peak of the boom to a current deficit of 1.2 million homes.

Housing formation has slowed over the past couple of years as boomers and millenials change the demand picture (as my colleague Dorian Davis explored recently), but that doesn't explain a deficit in new homes that could reach 1.5 million by next year. Construction of new homes will need to pick up over the next several years if the United States is to avoid a serious lack of supply.

Against the potential for a renewed rebound in housing, two companies in the homebuilders and building products sectors stand out from the pack.

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Brookfield Residential Properties (NYSE: BRP) is a relatively small builder with exposure to both Canada and the United States. Shares jumped 89% in the two years to mid-2013 but are off by 14% over the past six months. Shares trade for 13.1 times expected 2014 earnings, which are forecast to rise 31% from last year. Sales are expected to increase 20% this year, to $1.6 billion, and 17% next year.

Brookfield has a significant business in land and land development, with 28% of revenue from land closings in 2013. The company is positioned to benefit from rising land costs and gross margins as high as 46% for land sales last year. By comparison, gross margins on home sales were only 21% last year.

My price target of $26.25 for BRP is based on a multiple of 15 times estimated earnings of $1.75 over the next four quarters, representing upside of nearly 30% from current levels.

Masco Corp. (NYSE: MAS) is the largest company in North America for kitchen and bath cabinetry and insulation installation. Shares increased 61% in the two years to mid-2013 but are off 2.6% over the past six months. Shares trade for 22.1 times expected 2014 earnings, which are expected to rise 31% this year from 2013. Sales are projected to rise 6.7% this year, to $8.7 billion, and another 8.2% next year.
Last year was first year in the past five that the company did not recognize an impairment charge, and investors may still have the chance to build a position on the turnaround. While shares are relatively expensive, I like Masco for its diversified exposure to both new sales and remodels. My target of $25.30 is based on a multiple of 22 times estimated earnings of $1.15 a share over the next four quarters. That's upside of 17%.

Risks to Consider: After triple-digit returns over the past few years, many housing-related stocks are looking relatively expensive. While the housing market should eventually return to long-term averages for sales, supporting the industry in general, investors need to be more discerning and watch for "best of breed" names.

Action to Take --> Another rebound in housing should be supportive of all companies in the industry, but investors should still be selective. Builders like Brookfield Residential, with strong exposure to rising land prices, and building products companies like Masco, with exposure to both remodeling and new homes, should do relatively well.

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