(FORTUNE Magazine) – Nobody has been a bigger booster of homebuilder stocks than CGM Realty fund's Ken Heebner. He began buying them in 2001, and ever since he's talked up their managements, touted how much business they're grabbing from private developers, and scoffed at any and all talk of a housing bubble. By June 2004, Heebner had grown so bullish that 79% of his fund was invested in D.R. Horton, Lennar, Pulte, and other big builders.

A major figure in the fund world since the 1980s, Heebner has made plenty of shrewd moves over the years. None paid off more brilliantly than this one. Buoyed by his bet-the-house stake in homebuilders, CGM Realty returned an average of 28% a year between July 2000 and July 2005--a period, you may recall, in which most stock funds were waist-deep in red ink. Best of all, homebuilders' earnings just kept on growing.

That is why Heebner's next move proved so stunning. Between last December and July, he unloaded every homebuilder stock he owned, not only in CGM Realty but in all the CGM portfolios.

Why did he do it? Heebner says he'd become increasingly concerned about lax lending practices in the mortgage business--practices he believed were fomenting a dangerous rise in speculative buying. "What's changed," he says, "is that more people are buying homes as investments and financing them heavily with interest-only mortgages that seem to be underwritten with little attention to the borrower's ability to repay." Much of the speculation may well be centered in select markets like Las Vegas, Miami, and San Diego. "But the problem from the point of view of these companies," he says, "is that they make much of their profits in the hot markets where the speculation is occurring."

Given Heebner's exquisite timing buying into the stocks, will his decision to bail out prove equally prescient? Our answer: Don't bet on it. And that is no knock on Heebner. He took his homebuilder profits and plowed them into hotel REITs and natural- resources companies that have their own virtues. Homebuilding, though, remains the rare stock market sector in which high double-digit earnings growth can be had for a single-digit price/earnings ratio. That's because memories of past housing busts loom so large on Wall Street--especially today, when every pundit under the sun believes that the real estate market is another bubble ready to burst.

Fortunately for investors, there's a lot of hot air in all the bubble mongering. If we were truly on the verge of a housing collapse, the inventory of new homes for sale would be rising rapidly, and housing starts would be blowing through all-time records --much like the record number of IPOs that came to market at the height of the tech stock bubble. Neither is happening. In fact, housing starts over the past five years have been running slightly below the pace they set in the 1970s--when the U.S. population was 30% lower and immigration rates were half what they are today. "Look, I get paid to worry," says KB Home CEO Bruce Karatz, admittedly not a neutral observer. "But absent some macroeconomic event that creates serious job loss, it's very hard for me to envision a scenario that would dramatically affect housing demand and in turn drive down prices."

Real estate bears counter with their own data and arguments, many of which hinge on the affordability (or lack thereof) of housing in hot markets. Bulls and bears can debate those issues till they're blue in the face (see "The Great Real Estate Debate" on fortune.com). But when it comes to judging the merits of homebuilder stocks--as opposed to homes themselves--builders' dirt-cheap valuations give bulls a big margin of error. "If they were at 20 or 30 times earnings, I might share [Heebner's] fear," says Ron Muhlenkamp, another veteran fund manager, who has made a big bet on homebuilders in his Muhlenkamp fund. "But eight or nine times earnings covers an awful lot of sins."

Muhlenkamp's point: The risks are amply reflected in homebuilders' valuations. KB Home, for instance, has boosted earnings 60% over the past four quarters and 34% a year on average over the past ten years. In any other industry that kind of performance would command a premium multiple. Yet like many of its peers, KB Home trades at around nine times projected 2005 earnings. By comparison, the S&P 500 has a P/E ratio of 17.

In other words, this is not Cisco circa 1999. Citigroup Smith Barney analyst Stephen Kim thinks homebuilder stocks are attractively priced even if bears are right about a looming downturn. Historically homebuilders have traded at 15 to 20 times trough earnings at the tail end of an economic cycle, says Kim. Were history to repeat itself, Kim anticipates that most homebuilders could weather a 35% drop in earnings without much impact on share prices. "At the end of the day, it'll all be a tempest in a teacup," says Kim, who for two years running has boasted one of Wall Street's top stock-picking records, according to research tracker Starmine.

How you play homebuilder stocks right now depends largely on the depth of your contrarian streak. Muhlenkamp's biggest holding is NVR (ticker: NVR), and of all the builders NVR may be best positioned to get through a downturn. (Don't let NVR's $900-plus share price scare you. A reluctance to split the stock can be a sign that management is focused on long-term shareholders.) NVR has been an innovator in an industry not known for new ideas. The company holds down costs by manufacturing wall panels, roof trusses, and other components in factories rather than at its building sites. It also protects itself from the vagaries of the raw land market by avoiding outright purchases and instead controlling land via options exercised only when construction is ready to begin. Of course, that cuts both ways: When land prices are rising fast, NVR doesn't get the same earnings boost as its peers. NVR's 29% projected earnings growth for 2005 is the lowest of the eight top builders.

The truly aggressive homebuilder plays are KB Home (KBH) and Standard Pacific (SPF). Real estate is about location, and that's what distinguishes this duo. Standard Pacific and KB Home rank first and second among big builders in their exposure to ultra-hot markets like Phoenix, Las Vegas, California, and Florida, according to Wachovia housing analyst Carl Reichardt.

For his part, Reichardt believes that more "speculative excess" exists in those markets, which makes builders there more vulnerable to an economic downturn. That's one way to look at it. Another is that Florida and California are where the population is growing fastest, and it would thus be silly to fault those companies for building there. After all, nobody blames Apple for relying too heavily on the teen market for iPod sales. And yet KB Home and Standard Pacific still get marked down a notch by Wall Street. They trade at 8.7 and 8.4 times earnings, respectively, whereas the builders with the least hot-market exposure, Ryland and Toll Brothers, boast P/Es of 9.4 and 13.0. "It's unjustified," says Greg Geiber, a homebuilder analyst with A.G. Edwards. It's also a wrinkle that investors can exploit. Geiber points out that at the rate California's population is growing, the state will need to add 200,000 new housing units a year--60,000 more than what's being built.

D.R. Horton (DHI) is a play-it-down-the-middle pick that should track the broader sector. Operating in 21 states, D.R. Horton is the nation's leading homebuilder. But its stock is not priced like your typical industry leader: It trades at zero premium to the industry's 9.4 average P/E, despite its superior earnings growth (41% a year over the past three years) and its recent addition to the S&P 500. And like all big builders, D.R. Horton has been quite adept at using its financial muscle to elbow out private developers with shallower pockets in the scramble for raw land. Since 1992 the market share of the top 20 homebuilders has risen from 11% to 30%.

While luxury-home builder Toll Brothers (TOL) may be a tad pricey and a little lacking in regional cachet--Toll's core markets are the good but not great Mid-Atlantic states--the stock has other things going for it. For one, Toll is a well-run outfit that is tapping into the surging demand for new luxury homes. The stock is also an intriguing buyout play. CEO and co-founder Bob Toll is 64 years old, and since the beginning of June, he and his brother, Bruce Toll, have unloaded more than $200 million worth of Toll stock. (The company says the sales were intended to diversify the brothers' personal assets.) "Eventually Bob Toll is going to sell the company," says Sam Lieber, manager of the Alpine U.S. Real Estate Equity fund. Lieber's list of likely bidders: Centex, D.R. Horton, Lennar, and Pulte--and General Electric and Berkshire Hathaway are dark horses. "It's a stock to own," says Lieber, "just because of the potential that sometime over the next three to five years the company could be bought at a premium valuation."

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Safe as houses? These homebuilding stocks have low price/earnings ratios, giving investors some bubble protection.

Note: Data as of Aug. 3. Stock prices are rounded. Price/earnings ratios based on estimated 2005 earnings. FORTUNE TABLE / SOURCE: BLOOMBERG