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ETF INVESTING: Home-builder ETF Passes Newsletter Analyst's Inspection
Dow Jones

BOSTON (Dow Jones) -- Splintered home-builder stocks are looking to some analysts like bargains for buyers brave enough to weather more storms in the housing market.

In particular, a diversified exchange-traded fund that tracks housing stocks is winning plaudits from investment researcher Morningstar Inc.

The ETF, iShares Dow Jones U.S. Home Construction (ITB) , is an "opportunistic play" for long-term investors to consider, analyst Sonya Morris wrote in Morningstar's recently launched ETF investment newsletter.

"For patient investors who don't get rattled easily, I think this is an intriguing way to gain exposure to a beaten-down sector," Morris noted.

The home-builder portfolio joined a small group of other ETFs that Morningstar sees as attractively valued: Diamonds Trust (DIA) , Industrials SPDR (XLI) and Vanguard InfoTech ETF (VGT) .

This non-core portion of Morningstar's model ETF portfolio consists of more volatile, sector offerings that can quickly drop off the buy list as valuations change.

Morris isn't recommending loading up on home-builder stocks or calling a bottom for this troubled sector, saying the home construction ETF should represent no more than about 3% of the portfolio. She cautioned there could be more pain ahead for housing stocks that could test investors' resolve.

Morningstar takes a long-term investment view and even the opportunistic plays require a two- to three-year horizon, or longer, Morris said in a telephone interview about the home construction fund.

"This ETF is only for long-term, risk-tolerant investors, and even they should keep it to a tiny portion of their portfolios," the analyst explained in the newsletter. "If you prefer a smoother rise, skip this one altogether."

Underscoring the volatility, many CEOs of home-building companies are warning they haven't yet sighted a nadir in the housing market.

Broken dream homes

The dramatic pullback in the U.S. housing market and its corrosive effect on builder stocks has been well-documented. While shares of public home builders have climbed since the summer, the Dow Jones U.S. Home Construction Index (DJ_ 3728) as of the market close on Nov. 16 was off about 25% from its 52-week high set in mid-January.

The housing slump has been more pronounced than those in the "soft landing" camp had expected. Adding to the gloom, a government report late last week showed housing starts plunged 14.6% in October to the lowest level in more than six years. Building permits fell 6.3%, the largest percentage decline in seven years.

Ian Shepherdson, High Frequency Economics' chief U.S. economist, called October's 15% decline in housing starts "a sharp poke in the eye for those who argued that September's jump in starts was a signal that the housing crunch is coming to an end."

Home builders have seen orders plunge and many buyers are canceling contracts. Cancellations are being driven by fears of price declines and because buyers are experiencing difficulty selling their own homes.

"We see further downside potential in home-building stocks as deteriorating housing demand, moderating price appreciation and higher costs should erode home-builders' [profit] margins," wrote Banc of America Securities analyst Daniel Oppenheim in a report to clients last week.

"We believe there are likely two more quarters of slop for all builders before we are out of the woods," added analyst Stephen East at Susquehanna Financial Group, in a research note.

Home-builder CEOs who are veterans of housing's boom-bust cycle say this downturn is unique because it wasn't sparked by an economic recession or a spike in interest rates. Rather, the current slump was triggered mainly by oversupply, they say.

Inventories of unsold homes have soared, and speculators who had been eager home buyers are now among the sellers, adding to the supply glut.

Home builders are also seeing profits hit by charges being taken on land that has depreciated in value, and on land options the companies are not exercising.

Morningstar's stock analysts covering home builders, Eric Landry and Arthur Oduma, expect the write-offs to continue for at least another year, but say that taking a charge on options isn't as damaging to the firms' balance sheets as writing down the value of owned land.

Although there was a "land grab" the past three years to scoop up real estate in tighter markets, the analysts said builders have generally grown more disciplined than in previous cycles when it comes to buying and financing land.

Still, Morningstar sees profits being squeezed on lower construction activity.

"On average, we expect a 10% to 30% drop in unit volume for these companies over the next year and a half," Landry wrote in the November ETF newsletter.

Still, he noted that long-term fundamentals for home builders are positive, including a growing population, immigration and attractive demographics.

"If they manage to come through the current downturn relatively unscathed, the market may finally be willing to give them some credit and reward them with higher valuation multiples," Landry said.

Putting down stakes

This long-term view factors into Morningstar's home-builder ETF recommendation. Of the three housing-related ETFs, Morris chose the one she said provides targeted exposure to companies that focus exclusively on builders: iShares Dow Jones U.S. Home Construction.

"It offers the purest exposure to home-building stocks," the analyst said.

Rivals SPDR Homebuilders (XHB) and PowerShares Dynamic Building & Construction Portfolio (PKB) , both hold home-improvement retailers Home Depot Inc. (HD) and Lowe's Cos. (LOW) , Morris pointed out.

Also, the SPDR includes paint manufacturer Sherwin-Williams Co. (SHW) as a top holding, and the PowerShares fund owns construction-equipment maker Caterpillar Inc. (CAT) and materials provider Vulcan Materials Co. (VMC) .

The iShares fund's expense ratio of 0.48% is higher than the 0.35% charged by the SPDR Homebuilders, but below 0.6% for the PowerShares product.

"I'm willing to give up a few percentage points in expenses in order to get more focused exposure to the sector, since that's where I think the return potential lies," Morris said.

The analyst said she's encouraged that some respected value-oriented investors, Bill Miller at Legg Mason Value Trust (LMVTX) and Ron Muhlenkamp of Muhlenkamp Fund (MUHLX) , have dipped a toe into the builder group, even if the moves look premature.

"Those fund managers are disciplined investors who are willing to endure stretches of underperformance to achieve long-term success," Morris said.

The Bill & Melinda Gates Foundation, the Microsoft Corp. founder's charitable organization, also recently disclosed new ownership stakes in some value-priced builder stocks.

"You need to approach this ETF with a similar mindset," Morris added. "There could be volatility ahead that might test your patience."


  (END) Dow Jones Newswires
  11-19-06 2254ET
  Copyright (c) 2006 Dow Jones & Company, Inc.
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