Homebuilders: The wild ride isn't over

NEW YORK (CNNMoney.com) -- Homebuilder stocks had a glorious run until the housing market peaked in the summer of 2005. Since then it's been nothing but pain from every direction.

Many of the big homebuilders saw their stocks rise fivefold or more in the five years up until summer 2005, when the housing market peaked. Since then four of the biggest five homebuilders have skidded 40 percent or more, with the exception of No. 1 Lennar, which has fallen "only" 34 percent.

Lennar plus the other four - D.R. Horton (Charts), Pulte (Charts), Centex (Charts) and KB Home (Charts) - all have taken a hit as housing sales slumped and inventory skyrocketed.

The selloff has made some investors wonder if it's time to get back into the stocks. Some say that the top players in the industry will emerge stronger from the shake-out, but even some investors who are bullish long-term say it's too soon to buy back in.

"What's happening in the industry now makes a terrific opportunity to own these stocks," said Walter Stevenson of Stevenson Capital Management.

But managers of long-term funds have the luxury of long time horizons and very diversified portfolios. For individual investors, you'd better have a strong stomach, lots of patience, or both, since the selling may not be over.

This week has taken the wind of out of the sails for even some of the sector's biggest advocates.

Monday brought news that the pace of new home sales sank to the slowest in six years in February, and on Tuesday Lennar (Charts) said first-quarter earnings plummeted 73 percent. As if that weren't enough, smaller builder Beazer (Charts) said the FBI was investigating its mortgage business.

Not exactly roses there. But even Stevenson acknowledges these are stocks meant for long-term investors.

"This is obviously a difficult time for the sector right now and we don't know how long it's going to go on," he said. "We may have to wait a year or two for this thing to shake out."

Things are in fact so bad this year that industry leader Lennar declined to give an earnings estimate for 2007 and D.R. Horton's CEO recently had some less than kind things to say about the rest of the year.

"I wasn't entirely shocked that (Lennar) management threw the guidance out the window," said Ted Parrish, co-manager of the Henssler Equity Fund, which owns Lennar shares. "Where they lost credibility is when their CEO [Stuart Miller] said two months ago that 2007 was going to be a better earnings year than 2006, and then later he changed his tune."

Investors eyeing homebuilding stocks are trying to pinpoint the bottom for the housing market, and the stocks, especially since previous calls have proven premature.

On Tuesday, Miller told investors on the company's conference call that some markets were still seeing declines, according to Reuters.

That comment and other recent signs probably mean the industry is still a long way from the bottom, said Morningstar analyst Parrish Glover.

"There's a reason why D.R. Horton's CEO said, ''07 is going to suck'," Glover told CNNMoney. "If you're going into homebuilding stocks, you have to be doing so with a long-term mentality. We're not even expecting a recovery in the next 18 months. Even for the next three to five years, we're not looking at an especially robust market."

"This kind of bull market that's deflating is something that comes around once every 20 years," he said. But he said that companies with strong management could emerge stronger from the trying times.

"There are several essential things for a company to weather this," he said. "We look for companies with geographic diversity - not too much exposure to a single regional market - plus efficient management, limited land holdings, and a conservative growth strategy. If you find a firm with that approach, it can be an excellent long-term investment."

He cited Calabasas, Calif.-based Ryland Group (Charts) as an example of a builder with a prudent growth strategy, noting they're one of a handful of builders that hasn't invested heavily in land - holdings that have been sinking in value, for the most part, since the housing market peaked.

Ryland also uses about 30 percent of its cash to buy stock back from shareholders, and has avoided selling homes to buyers with subprime mortgages, Glover said.

He also cited Hovnanian (Charts) as a stock trading at a discount to its book value - its assets minus its liabilities.

"For an investor to have a real margin of safety, they're going to have to wait until you're essentially buying the company for the value of their hard assets," said Glover. "You're getting the opportunity to earn future earnings for free. Right now, Hovnanian is the only company trading at a discount to the value of its assets."

He added that it was important to be careful because companies were being forced to mark down the value of some land holdings.

So while brave investors may want to dip back into housing stocks now, they may have to put up with some rough weather.

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