The Bullish Bell Tolls for this Homebuilder

The housing sector has been on a long slow road to recovery over the past few years, but the homebuilding stocks have sold off hard during the past few months. With signs of strong spring selling season on tap this group offers a good risk/reward and one name stands out.

The homebuilding industry has long been the engine driving a big portion of the U.S. consumer led economy. When the oil industry, which had been strong source of corporate spending and infrastructure investment, went into a tailspin last year it put even more of the burden on the housing market. One it was unable to shoulder, as the weight of a slowing economy and a broad stock market sell-off became too much for the shares of homebuilders to shrug off. But I think the stocks sold off too much.

My basic investment thesis rests on two basic principles:

  • Economic, demographic and financial factors are aligning to create sustainable housing recovery built upon based solid fundamentals.
  • Valuations of the homebuilding stocks are now historically low and should see a multiple expansion as earnings accelerate, leading to a significantly higher share price.

Job security is probably the number one factor when considering purchasing a home. The trend of new jobs being added at a 200K per month and unemployment down below the 5% level are firmly in place. More importantly, there continues to be an increase in wages, which continue to post an average 0.4% monthly increases on a year-over year basis. The fact major corporations such as Wal-Mart (WMT) and McDonald’s (MCD) have pro-actively raised their minimum wages suggests a tightening of the jobs market and will help first time buyers.

Offsetting this has been the sharp decline in oil prices, which has turned boon towns in the Dakotas and the Texarkana region into sharp downturns. In fact, one of the reasons housing stocks sold off recently was a decline in sales in the regions previously having the largest gains.

In the long term that’s OK, as those areas were becoming bubble-like pockets. Better to find an equilibrium now, rather than letting it inflate too far.

Demographics

The bull case is bolstered by the fact household formations have now built up pent up demand, especially since the rental market has seen very large price increases, which should finally motivate millennials to move out of their parents’ homes and start a family of their own.

The millennials born during the early 90’s represented the highest birthrate since the 1950’s boomers, with over 4.2 million births in 1990 alone.

Birth Rate 02.25.16

That bulge in births has led to the U.S. currently having the largest population in the prime 24-54 age bracket in its history during the coming year – some 125 million. They are now coming of an age when they should start forming families. This ties in nicely with the improving job market and raising wages.

Prime Age Population 02.25.16

For those who cite the demographic trend toward a move into urban centers I say two things: it really doesn’t undermine a bullish housing thesis, in that people forming families still want a place of their own and buying is no longer simply associated with a suburban single family house.

In fact, the latest report from the National Association of Homebuilders showed during the fourth quarter, those between the ages of 24-35 accounted for 35% of new home sales (this includes multi-unit dwellings), up from just 28% during the year ago period.

In fact it is one of the reasons I have Toll Brothers (TOL) as my top pick. Though they are best known for higher end luxury homes the company was early in adding urban properties, such as condos and loft type multi-unit buildings, to its mix to capture the trend of millennials living, and buying, in downtown areas. And not just in the tier one cities, we see revitalization all over the map.

Toll recently reported solid earnings and provided upbeat guidance, citing expectations for continued low interest rates to spur demand and support higher prices.

Indeed, recent strong earnings from Home Depot (HD) yesterday suggest raising home prices are making people more comfortable with once again investing in their homes and apartments.

From a technical perspective Toll Brothers chart seems to have put in a bottom near the $25 level.

TOL Chart 2.24.16 (1)

The Trade:

I want to keep this simple and allow for sufficient time for the stock to gain traction through another two earnings reports. I’m targeting September $25 Call.

  • Buy the September $25 Call for $4.50 a contract

My price target is $35 a share, which would give these calls a minimum value of $10 per contract for an over 100% gain.

— Steve Smith

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About the Author: Steve Smith