Smart Investing Daily – Two Strong Companies in a Dead Housing Market

Jared Levy, Editor, Smart Investing Daily
Monday, 29 November 2010

I have been examining real estate investments in several different forms since early 2009, when I was one of the first on CNBC to begin recommending it, albeit cautiously.

Back then, I was recommending the purchase of XHB, a housing ETF that was trading for about $9, as a diversified proxy for an actual investment in real estate.

I was drawn to XHB mainly because the stock had been beaten down so badly and the homebuilders in particular were in such an oversold condition, it seemed that most of them from a valuation standpoint were pricing in a complete bankruptcy situation. This price action, to me, seemed overdone. The XHB hit a high of almost $20 earlier this year…

Know Your Investment Intimately

When investing, you have to be extremely selective in both the angle at which you invest in a sector you like as well as the vehicle (stock, ETF, option, bond, etc.) that you choose. At certain times,

even within the same sector, there can be major discrepancies in price, making some investments relatively cheap and others overpriced. If you choose a sector ETF, make sure you know its components. The XHB, which you might think is all homebuilder stocks, also contains retailers like Tepur-Pedic, Williams Sonoma, and Bed Bath and Beyond. This may or may not be preferred.

The Housing Market

I still see opportunity in the housing market, but now that the fog has cleared and revealed the clarity of the real mess that we have in the sector, I can’t say that I favor the new homebuilders at all.

The extraordinary amount of cheap inventory and highly restrictive loan requirements are going to be major headwinds for the homebuilders on average. I believe home prices are stabilizing (according to data) and we have seen a bottom. But the road to housing price recovery will be slow, perhaps aided by continued low interest rates and inflationary pressures in the future. However, when (not if) inflation rears its ugly head, rest assured that our friends at the Fed, as flawed as they may seem, will begin to increase rates, putting a damper on home values.

(By the way, investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the market with our easy-to-understand articles.)

Where Do We Go Now?

Consumers with the liquidity and credit to purchase bank-owned or short-sale properties for rental or capital appreciation have a strong advantage now. About 35% of existing home sales are foreclosures or other distressed sales, which shows just how many chips are stacked in favor of the buyer.

There is another area I believe will continue to not only provide stability, but major growth…

After heading to both Lowe’s and Home Deport over the weekend, I could not believe the deals and traffic I saw at both companies. Anecdotally, I heard from several sales people at both stores’ Dallas locations that they had record numbers of inventory being ordered on the back end and were seeing strong sales on Black Friday and into the weekend.

The major home repair and design stores like Lowe’s (LOW:NYSE) and Home Depot (HD:NYSE) have a real strong position in this market, in my opinion, for several reasons.

Current homeowners who want to sell their home will make improvements to make their home stand out among the plethora of competition.
Current homeowners who are not able or do not want to buy a different home at this time will most likely spend money at one or both of these stores to improve their homes through the installation of appliances, fixtures, flooring, windows (energy savings), etc.
Investors buying foreclosed properties (which are a large portion of existing home sales) generally need to repair the unit before sale and/or rental. Both Lowe’s and Home Depot offer not only the services, but the products even if the service is handled by a local contractor.
Regular consumers who are taking advantage of Freddie Mac’s large seller credits at closing may choose to use that money (sometimes up to 5% of the sale price) to purchase appliances or make other improvements to their new (pre-owned) homes.

We did see a 2.2% slowdown in existing home sales in October, but remember that data includes the “foreclosure freeze” that halted or delayed many deals in the month. Regardless, last month, the annual rate was on pace for 4.43 million units.

Even with the slowdown, Lowe’s reported a 17% increase in third-quarter earnings (Home Depot was up 21% in the same period), which to me looks pretty darn good in the face of adversity. If consumer health continues to improve, the effect should be slightly more exponential on Lowe’s and Home Depot’s earnings as the consumer spends more on the “extras” that may have higher profit margins. Home Depot guided sales lower, which moved the stock lower, perhaps providing us with a chance to buy it here.

Getting In Now…

On these names, I would be buying the stock and simultaneously selling just slightly out-of-the-money covered calls. This would help provide a hedge against adverse market conditions and any geopolitical events (i.e. North Korea) that could affect the stock negatively. If you don’t trade options, perhaps you can buy smaller amounts of stock to limit your risk.

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