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NEW YORK (CNN/Money) – Inflation and the possibility of higher interest rates are the latest bugaboos for investors.
But despite these fears, many homebuilder stocks are trading near their 52-week highs.
That may seem odd. A pickup in inflation, after all, could spark the Fed to raise short-term rates at a more aggressive pace, which would put upward pressure on mortgage rates. In turn, that could lead to a cooling down of the torrid real estate market.
And there are signs that a slowdown may be in its early stages. The Commerce Department reported Monday that new home sales for January fell 9 percent. Economists were expecting a slight increase. In addition, the National Association of Realtors reported Friday that existing home sales dipped slightly in January.
So is the house party on Wall Street about to come to end?
A solid foundation for growth
Homebuilders took a hit on Monday morning following the release of the new home sales data but analysts don't appear to be overly concerned.
"I'm not worried -- you tend to see a lot of bouncing around in new home sales from month to month, particularly in the wintertime," said Todd Vencil, an analyst with BB&T Capital Markets.
And though the Fed has been raising rates since last June, earnings for many homebuilders haven't suffered.
Last week, Toll Brothers (Research) reported that fiscal first quarter earnings more than doubled, beating estimates by 15 percent. The company also raised its guidance for the year. On Thursday, Hovnanian Enterprises (Research) is expected to report a 27 percent increase in sales and nearly 40 percent jump in profits for its fiscal first quarter.
Lawrence Horan, an analyst with Parker/Hunter, said he expects robust profit growth for the foreseeable future. "Barring a major economic dislocation, such as a big pickup in inflation, I think home builders can grow their earnings at a double digit basis for the next two to three years," he said.
But what about January's drop in home sales? Shouldn't that have an impact on the stocks? Vencil said as long as mortgage rates don't shoot up, investors should expect stability in the housing market, not a major decline.
No bubble in housing stock valuations
Ron Muhlenkamp, manager of the Muhlenkamp fund, owns several homebuilder stocks in his fund and argues that home sales don't have to keep hitting record levels to justify higher stock prices for the group.
That's because the home building industry is fragmented and Muhlenkamp thinks that the larger companies will continue to wrest away business from smaller rivals.
"I don't see the number of homes being built increasing that much but we do see big builders gaining market share form the little guys," Muhlenkamp said. Some of his favorites are NVR (Research), Meritage Homes (Research), Centex, Beazer Homes USA, Toll Brothers and Pulte Homes.
Finally, fans of the group point relatively low valuations.
The S&P Homebuilding Index trades at 8.7 times 2005 earnings estimates even though earnings are expected to increase 29 percent this year and 14 percent annually, on average, for the next five years. The S&P 500 trades at 17.3 times earnings, and growth is forecasted at 6 percent this year and for the next few years.
But if homebuilders keep posting boffo earnings numbers, this discount to the overall market will probably narrow, analysts said. Horan and Vencil both think that homebuilders deserve to trade at earnings multiples in the low teens. Horan likes Pulte (Research) and Centex (Research) and Vencil said that his top picks in the sector are Centex, Beazer (Research) and WCI Communities (Research).
And Muhlenkamp said that inflation fears probably would soon pass, noting that long-term interest rates have not ticked up dramatically despite the rise in short-term rates. So he thinks any dips in the homebuilder stocks probably gives investors a good opportunity to scoop up more shares.
"Mortgage rates are right around where they should be and there's nothing necessarily that should change that," Muhlenkamp says. "People keep resurrecting fears but don't look at the underlying opportunities and anytime there's fear it's a good time to buy."
Parker/Hunter's Horan owns shares of Centex and KB Home. His firm does not have investment banking relationships with the companies mentioned. BB&T's Vencil does not own shares of any of the stocks mentioned and his firm has no investment banking relationship business with companies mentioned.
