Beware the new builder bubble

Pulte's deal to buy Centex could spark a wave of mergers. But with homebuilder stocks perking up, experts say investors should look at likely buyers, not targets.

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By Paul R. La Monica, editor at large

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Homebuilder stocks, like the broader market, have bounced back sharply in the past month. But they are still trading well below last year's levels.

NEW YORK ( -- Signs of stabilization in the housing market during the past few weeks helped lay the foundation for a nice pop in homebuilder stocks. Now, a big merger in the sector could be setting the framework for a continued rally in the group.

With Pulte Homes (PHM, Fortune 500) agreeing to buy rival Centex (CTX, Fortune 500) for a premium of 38% to Tuesday's closing price, investors excitedly bid up shares of other homebuilders Wednesday morning on the hopes that they too would succumb to the urge to merge.

Shares of Hovnanian Enterprises (HOV, Fortune 500) and Lennar (LEN, Fortune 500) each gained about 7% in late morning trading. Standard Pacific (SPF) and Beazer Homes (BZH), two of the hardest-hit builders during the housing slump, shot up 10% and 15%, respectively. But both stocks still trade for only about a buck a share though.

So will more homebuilders rush to pair up? Probably.

"There will be more consolidation. Now that these companies have written down the value of their land holdings, it's cheaper to buy another homebuilder than to go out and buy land," said Merrill Ross, senior analyst with BGB Securities, a research firm owned by money manager Aegis Financial.

Most homebuilders have suffered from weak demand for the past year or so as the housing boom led to a glut in inventory that may take years to truly work through.

Many of the leading homebuilders, including Pulte and Centex, lost money in 2008 and are expected to remain in the red this year. And many of the stocks are trading as if the housing market will never come back -- several trade well below book value, or the price they would likely fetch if they were forced to liquidate.

That said, Ross warned investors should not get too enthusiastic about the homebuilding group. She thinks that even though there will be more homebuilder mergers, some stocks that were rising sharply Wednesday because they were thought to be takeover targets may not wind up getting bought.

"The Pulte-Centex merger is just the beginning. But some companies are too damaged and have too much debt to be acquired," she said.

For that reason, she said investors might want to focus more on companies that are likely to be survivors of the downturn, i.e., ones that may be doing the buying instead of looking to sell.

Ross mentioned D.R. Horton (DHI, Fortune 500), KB Home (KBH, Fortune 500), MDC Holdings (MDC) and Meritage Homes (MTH) as examples of companies with strong balance sheets and an attractive portfolio of land holdings. Her firm's Aegis Value fund owns Meritage.

Stephen Kim, a senior analyst focusing on global real estate for money manager Alpine Woods Capital Investors, agreed that the builders that may go on shopping sprees could be better long-term bets than takeover targets. To that end, he said shares of D.R. Horton could be a good investment.

Interestingly, the stock fell almost 6% Wednesday. Kim said that's probably because most investors realize the company, which is currently the nation's largest homebuilder but will be leapfrogged by the combination of Pulte and Centex, may be the only builder that won't be viewed as a takeover target. Everyone else in the sector may be fair game.

"There may be a history of guppies eating whales in the homebuilder world, but the one that is too big to be bought is D.R. Horton," Kim said. "And D.R. Horton has a history of being partial to growing through acquisitions."

Kim added that he views NVR (NVR, Fortune 500), a builder that has remained profitable during the downturn and has more than $1 billion in cash and no debt, as being a safer investment for individuals looking to buy builders now on the hopes that the housing market will improve over the next few years.

Still it may be a bit premature to declare that the worst is over for the group, merger-mania speculation notwithstanding. So a pullback could soon be in the cards.

"Generally speaking, we're probably near the bottom in sentiment for homebuilders. But I wouldn't be chasing this particular rally. I am not of an opinion that this is THE signal to jump back in to the group," said Kim.

For this reason, he said the Alpine U.S. Real Estate Equity fund, which as of December owned NVR, Lennar, Centex and Pulte in its top 25 holdings, has been more actively trading builder stocks instead of taking long-term positions just yet.

The SPDR S&P Homebuilders (XHB) exchange-traded fund, which includes the shares of most top builders, is up about 35% since the broader market took off in early March. And even though this ETF is still 50% below its price of a year ago, Ross said it may be too late to find rock-bottom bargains.

"At the moment, we're not as heavily invested in the real estate sector. We may have missed the point where the homebuilders were really deep-value stocks," she said.

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