What A Model For Analyst Ratings On Homebuilders Suggests For Next Seasonal Trade (ITB)

BrianAJackson/iStock via Getty Images A Successful Seasonal Trade on Homebuilders October/November launches what I call the seasonal trade on home builders. From that time through the following April to May, home builders typically outperform the S&P 500 (SPY). The 2022-2023 season was an extraordinary period of outperformance. From the end of October 2022 to the end of May 2023, iShares U.S. Home Construction ETF (BATS:ITB) gained 30.0% versus the 8.0% for the S&P 500. My analysis last year of the prospects for the seasonal trade led me to call an early end to the seasonal trade (February 5), especially given ITB looked stalled, and the market signals turned bearish. While I missed some of the run to fresh all-time highs for ITB, the ETF’s value at the end of May ironically hit right around where I made the call in February. ITB outperformed the S&P 500 5.4% to 0.0% from my season-ending call in February to the end of May. ITB is back to trading in the former trading range that defined the end of the 2023-2024 seasonal trade (Trading View)My analysis of the prospects for the seasonal trade produced a simplified framework for understanding Wall Street analyst ratings on homebuilders. So far, that framework is holding up well. My mistake last year was in anticipating analyst downgrades as a catalyst for providing entry points for the seasonal trade. This time around, I know to wait for clearer evidence of revenue peaks and gross margin declines below the 25% threshold. Correlating Revenue Growth and Analyst Ratings Since October, Lennar Corporation (LEN) pulled itself into my universe of “revenue growers”. This group still includes D.R. Horton (DHI), PulteGroup (PHM), Meritage Homes Corporation (MTH), and Toll Brothers (TOL). MTH is clinging to the edge of the group. DHI continues impressive revenue growth. Each of these builders is a component of ITB. Builders with growing revenues (TTM) (Seeking Alpha)My remaining universe “revenue peakers” are KB Home (KBH), LGI Homes (LGIH), Century Communities (CCS), Tri Point Homes (TPH), and Taylor Morrison Home Corporation (TMHC). A revenue peak occurs when a distinct high in revenue precedes a notable decline. Builders with peaking revenues (TTM) (Seeking Alpha)Predictably, analysts maintain buy ratings on all the clear revenue growers. These buy ratings have held since the beginning of 2023. That year was also a turning point in the ratings with PHM overcoming the field. MTH is the one stock that has fallen from the field with a “hold” rating after the start of this year. This downgrade aligns with MTH’s stalled revenue growth and presages an eventual transition of MTH from the revenue growers to the revenue peakers. Analyst ratings for builders with growing revenues (TTM) (Seeking Alpha) Also predictably, analysts rate almost all the revenue peakers as holds. TPH continues to stand out as the lone exception with a buy rating. Perhaps TPH will finally follow LEN’s lead and get a promotion to revenue grower. For now, revenue looks like it is still stabilizing (per the graph above). Analyst ratings for builders with peaking revenues (TTM) (Seeking Alpha)The Gross Margin Effect While revenue trends still provide a sufficient predictor of analyst ratings, gross profit margins also still provide confirmation. The 25% gross margin threshold stands as a distinct dividing line for revenue growers versus peakers, and thus a similar dividing line for analyst ratings. LEN is the only revenue grower with a gross profit margin below 25%. PHM stands out at 30%. Gross margins for builders with growing revenues (TTM) (Seeking Alpha) All the revenue peakers have gross margins below the 25% threshold. Thus, TPH is the only builder with a buy rating and a sub-25% gross margin. Gross margins for builders with peaking revenues (TTM) (Seeking Alpha) These handy rules allow for quick and simple interpretation of the implication of the financial results for homebuilders assuming a change in analyst ratings will move the stock prices for builders. Sidenote: I will include M/I Homes (MHO) and perhaps other builders in the framework in the next update. MHO may be transitioning from a revenue grower to a peaker, although its gross margin is comfortably above 25%. MHO still looks healthy (Seeking Alpha)A Resilient Weighted Analyst Rating Builder performance has been so consistent since last October that my market cap weighted rating for a broader universe of homebuilders barely changed, even with the loss of mid-tier builder M.D.C. Holdings (MDC) to acquisition. I was hoping to test the impact of downgrades of individual builders on ITB. However, downgrades like MTH stand out as an exception. Accordingly, my market cap weighted average analyst rating remains at 3.8, a representative buy rating on ITB. As a reminder, I used the Seeking Alpha stock screener for the “homebuilding” sector to select stocks for the members of this weighted rating. The total market cap of these builders grew from $154.8B to $208.2B, a 34.5% increase despite the loss of MDC. For reference, ITB increased in value by 39.3% while the S&P 500 increased 26.3% over this time. The overall consistency in builder performance combined with stability in analyst ratings makes me expect a relatively “quiet” start to the 2024-2025 seasonal trade on homebuilders. Waning Builder Confidence Does Not Dissuade Analysts While the analysts remain upbeat on homebuilders, the builders are losing confidence in the housing market. This month, home builder confidence hit its lowest point of the year. The NAHB/Wells Fargo Housing Market Index (HMI) fell to 42 after finally turning positive (50 and above) in March and April of this year. The HMI was in negative territory for the six prior months. The November bottom in sentiment came just one month after ITB bottomed. Analysts were right to stay the course even as builders did not. Of course, the sentiment surveys may be overly influenced by private and smaller builders, which outnumber the public builders. The top 10 builders have accelerated their share gains in recent years and are now responsible for 42% single-family home closings (as of reporting June, 2023). Regardless, my lesson from last year is not to over-estimate the impact of builder confidence on the performance of the stocks of home builders. However, if a sell-off is around the corner, it would come just in time to deliver better entry points for the 2024-2025 seasonal trade. Builders Continue to Hold the Advantage Another reason to avoid over-estimating the impact of builder sentiment on builders stocks is that builders continue to take share from the much larger existing home market. Last year, I thought the advantage of homebuilders would start to erode this year. I figured a reversion to the mean would finally start to weigh on market dynamics. Such a reversion has yet to begin. Existing home sales have even fallen further behind. According to Mortgage News Daily, existing home sales continue to trend downward while new home sales trend upward. Existing home sales sit at pandemic lows which in turn were lows last seen around 2010. New home sales are well off their pandemic lows and bottomed last year above the pandemic lows. Existing vs New Home Sales since late 2009 (Mortgage News Daily)Thus, homebuilders can continue to thrive in a slowing market as long they take an increasing share from existing home sales. Conclusion and the Trade The Federal Reserve is of course, the elephant in the room. The extended drama over the first rate cut and the official end of tight monetary policy has put the housing market in a bit of suspense. Even the first cuts may not ignite a boost in sales if buyers continue to wait for even lower rates. Hanging in the balance is the labor market, which remains strong but has likely seen its best days in a while. A weakening labor market could weigh on consumer sentiment, which is already quite low, especially given the strength of the overall economy. Fortunately, the framework of revenue grower/peaker and the gross margin 25% threshold could provide clarity that cuts through the macro-economic uncertainties and noise. As long as builders are not shifting into peakers and sub-25% margin earners, the seasonal trade in builders, and buys in ITB in particular, should stay on schedule.

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