FORTUNE -- It takes a lot of courage to be a bull on homebuilder stocks these days. They exist, for sure. And they aren't on mind-bending drugs. In fact, they see the world much as the housing stock bears do. You won't find any uplifting messages in their reports on the economy and housing.
What differentiate this small breed from the bears are their views on value. They largely argue that even if the economy goes into a double dip; even if home prices fall after rising modestly in the spring; even if inventory of homes continues to rise, some of these stocks are just plain cheap.
That's because homebuilder stocks have been brutally beaten as of late. The ISE Homebuilder Index is down 80.24% over the past five years vs. a loss of 11% for the S&P 500. The group got a reprieve during the massive rally that ended earlier this year but have been slammed since May, when the homebuyer tax credit ended, falling 23% in the past few months vs 6.5% for the S&P.
"Home sales data supports our positive homebuilder thesis," writes Michael R. Widner, homebuilding research analyst for Stifel Nicolaus. He upgraded KB Home to buy from hold in mid-July.
Positive is a term that many view as generous. In this world, positive usually means not nearly as bad as everyone was expecting. Put the Paxil back on the shelf.
Take existing home sales. They were down 5.1% in June to an annual pace of 5.37 million, better than the median 5.1 million pace predicted by economists in a Bloomberg survey. And new home sales in June were 330,000 - the second worst in the 47-year history of the data series - but better than the 310,000 consensus. Housing share prices jumped briefly on the "positive" news. "This shows how bearish sentiment was going into the market," says Joshua Steiner, managing director, Hedgeye Risk Management, and a vocal housing bear.
Go back a month, and the news worsens. In May, new home sales plunged to 267,000, the worst on record; but the industry had braced for the sharp drop because they knew that the tax credit for homebuyers, which expired April 30, had artificially boosted spring sales. Summer would be payback time. Some investors had factored that in.
UBS analyst David Goldberg sent out a report last week urging investors to buy on the dip during the current earnings season. Like anybody else who has studied the real estate market, he sees many bumps in the road but he expects the recovery to resume later in the year. One source of optimism for Goldberg: He predicts that the big write-offs are well behind homebuilders and that they will try to avoid discounting prices, even if that means fewer sales. Goldberg's report sounds more optimistic than the homebuilders themselves: the homebuilder confidence index registered 14 in July, the lowest in more than a year.
The bears doubt that prices can hold. "Home prices are still too expensive, relative to historic metrics," says Barry Ritholtz, CEO and Directory of Equity Research for Fusion IQ. Unemployment is high and wages haven't budged in a decade, Ritholtz explains in a blog post last month. Prices need to come down. Prices are off as much as one-third from the peak, but at Hedgeye Risk Management, Josh Steiner says big price decline still lie ahead -- anywhere from "single digits to as much as 20%."
The inventory overhang in the existing home sector poses big competition to new homes, even though that sliver of the market has a record low backlog of 210,000 homes.
Ritholtz focuses on two metrics to explain the problem: One, historically, mortgage debt represented 40% of home value. Today it's 62%. That's too much debt relative to the value of housing, he says. Two, homebuilders built "about five million excess homes" relative to the fundamentals that typically govern household formation. That means going forward, the pace at which new formation absorbs excess housing is likely to be slow.
And then there are the foreclosures, possibly as high as 5 million units, as well as something called shadow inventory -- homes that owners would like to sell but would at higher prices. At a minimum that's likely to be in the 2 million range and could even be twice that, says Ritholtz.
The bulls aren't exactly disputing those problems
"Longer term, we continue to envision a much-slower-than-usual housing recovery," Raymond James says in its report recommending builder shares. Part of the reason for that: The number of aging baby boomers looking to downsize will outstrip "potential first-time buyer." Also, "excessive inventory" and "unsustainable levels of government support" will dampen demand. And let's not forget that a huge number of homeowners are underwater - their mortgages are bigger than the value of their homes.
Nonetheless Raymond James (RJF) has raised near-term ratings on KB Home (KBH), Lennar (LEN), and Standard Pacific (SPF); the firm added that it is sticking with its "outperform" rating on MDC Holdings (MDC).
Others are also raising ratings. Ticonderoga Securities moved Meritage Homes (MTH) to buy from neutral this week. UBS (UBS) lifted Beazer Homes (BZH) mid-July to buy and Zelman and Associates boosted M/I Homes (MHO) to buy from hold as well.
The reasons for the upgrades are both price-based and company specific.
"KB Home now represents our current favorite idea in the sector, based on its strong focus on entry-level buyers, disciplined spec construction strategy, and 20%+ valuation discounts relative to peers." Raymond James writes in an earnings update. Stifel Nicolaus also says the stock is cheap -- "lowest valuation metrics of the group" -- in analyst-speak.
UBS likes Beazer because the analyst has become convinced that the small cap company is managing risk better and is trimming overhead. Many of the publicly traded companies have also been building cash and are in a good position to invest in land and build -- or have already bought land on the cheap. In the case of Lennar, Raymond James likes its gross profit margins -- more than 18% last quarter -- and the potential for profits in its Rialto subsidiary, which has invested in nonperforming loans in a partnership with the FDIC.
A few housing economists agree that even with a dim outlook for housing, a few companies may come up winners -- especially if more builders go out of business, both big and small, private and public. The population is still growing by about 1.2 million households annually. Even in places like Las Vegas demand for new homes will return. No one wants the 4,000-square-foot McMansions.; who knows, they could be destined for bulldozers. But 1,700 square foot homes -- people are showing interest in those.
"New home builders are experts at land development and will find deals at a time like this," writes the stock-watching blog Ychart. "Look for them to do that, use their cash on hand, build more right sized homes at a lower cost (and better margin) that fit demand and return to back to profitability in 2011."
The bears just shake their heads. 'This isn't the trough; it will take close to a decade to work off the overhang; we're only about half-way through.' The bulls don't necessarily disagree with that scenario. But they still see value for individual firms. Someone will be building somewhere and someone will be buying.
"From a macro perspective there's no reason to be in homebuilders," says Barry Ritholtz. For now, given the volatility in the group, it's a place for traders and professionals, not long-term investors. "There's no such thing as toxic assets, only toxic prices," Ritholtz says.
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