Why UK housebuilders could offer value today

How quickly things change. In October, Megan looked at housebuilders and argued that their ultra-low single-digit price-to-earnings (P/E) ratios were likely to be a sign that a downturn in earnings hadn’t yet been fully priced in.

Today, the picture is quite different. P/E ratios are in double digits. According to Stockopedia data, earnings at the eight biggest housebuilders on the London market are expected to fall by an average of 30% over the next 12 months:

Order books are shrivelling and volume forecasts have been slashed at many of the big names. And yet… these companies all boast strong StockRanks and their share prices have rallied powerfully from October’s lows:

Housebuilders (blue) vs FTSE All-Share Index (grey)

Indeed, over the last seven months, these stocks have been among the best performers in the FTSE 350, rising by an average of about 35% and outperforming the market by c.20%:

Housebuilders (blue) vs FTSE All-Share Index (grey)

Timing is everything when investing in cyclical stocks, as I discussed recently. In this piece I’m going to investigate whether housebuilders still offer value or whether the stock market – which always looks forward – has already priced in a recovery.

Housing market: mortgage lending hits net zero

Let’s start with a look at the latest data on market conditions. Is the housing market slowing, crashing – or actually doing okay?

According to the Bank of England, mortgage lending hit net zero in March. In other words, new lending was offset by repayments. According to the bank, this was the lowest level of new lending since June 2011, excluding a brief period during the Covid-19 pandemic.

A more forward-looking measure is mortgage approvals. These rose in March but remain nearly 20% below 2022 levels, according to the Bank. In addition, this chart shows that approvals are still running well below pre-pandemic norms:

Source: Bank of England Money and Credit report March 2023

We can see the distortion caused by the pandemic, the impact of rising interest rates, and last year’s disastrous mini-budget. But there’s also an improving trend in 2023, as the market has begun to stabilise.

So far this year, housebuilders have reported improving reservation rates compared to the final part of last year. For example, this chart shows Taylor Wimpey’s reported private sales rates since 2020:

The latest data from housebuilder Halifax also suggests that prices have made a partial recovery from the dip seen last autumn, and are now broadly unchanged on one year ago:

Source: Halifax HPI April ‘23

Interestingly, Halifax says that while existing house prices have fallen by 0.6% over the last year, new-build prices have risen by 3.5% over the same period.

This mirrors my impression that housebuilders don’t like to cut new home prices. Instead, they prefer to offer incentives to attract customers in slow markets. Persimmon (LON:PSN) recently suggested that its current use of incentives is equivalent to a 3% reduction in price:

“Incentives on new home reservations continue to run at around 3% on average, with good interest generated by our part exchange and 10 months mortgage free campaigns.”

Right now, I think it’s probably fair to say that no one quite knows what the outlook for the housing market is. With unemployment low and wages still rising, I guess it’s possible that a major slump will be avoided.

But there’s no escaping the combination of higher living costs and higher borrowing costs. Nationwide chief economist Robert Gardner made this comment in the lender’s April house price report:

“But any upturn is likely to remain fairly pedestrian, as it will take time for household finances to recover, since average earnings have been failing to keep pace with inflation, and by a wide margin over the last few years. Mortgage interest rates are also likely to act as a headwind.”

Mortgage rates have doubled over the last year. As older fixed-rate deals expire and are remortgaged, a growing number of borrowers will find their payments rising. In turn this could put added pressure on house prices:

Source: Nationwide HPI April ‘23

My feeling is that buyers and sellers may still be hoping that interest rates fall quickly again. I’m not entirely convinced by this argument. I suspect they’ll stick at this level for a while – current rates aren’t high, after all.

More broadly, I think it’s worth considering that the combined inflationary effect of ultra-low mortgage rates, Help to Buy and various Stamp Duty holidays has now been withdrawn from the housing market. I wonder if we could see housebuilders’ profit margins reset at slightly lower levels than over the last decade.

Are housebuilders cheap?

Affordability could be an issue for a little while yet, in my view. I think the market may need to rebalance slightly, but structural demand for new housing seems likely to remain strong.

The big UK housebuilders have prospered before without needing near-zero interest rates or government subsidies. I don’t see any reason why they can’t continue to do well in the future. Many are already adapting by shifting their focus to bulk deals and social housing.

The big risk for shareholders is that volumes will dry up to the extent where housebuilders suffer liquidity issues. That happened to some in 2008, but I think it’s much less likely this time.

Unlike in 2007, the majority of housebuilders have net cash or very low levels of gearing, even when land creditors are included. (These contracted future payments for land purchases are debt-like liabilities, but are typically excluded from net debt.)

While order books are shrinking, unwinding inventories should lead to a reduction in working capital and an influx of cash, even as profits fall. Housebuilders can flex their production capacity and are already indicating that they’re scaling back spending on new builds and land purchases.

Valuation: I use two main metrics to gauge the valuation of these asset-backed, cyclical businesses:

• Price/Book ratio: from a value perspective, it’s best to view housebuilders as an asset play. Buying these shares below their book value is usually the best way to provide margin of safety.

• CAPE 10y: the Cyclically-Adjusted Price-to-Earnings ratio. In other words, a P/E ratio comparing the current share price with 10-year average earnings per share.

I’ve put together a test portfolio of housebuilder stocks so we can see how they score on these two metrics:

In aggregate, these companies are trading broadly in line with their last-reported book value, and at 8.5 times their 10-year average earnings.

If I exclude Berkeley Group, whose business model tends to attract a higher valuation, then these figures fall to 0.9x book value and a CAPE10y of eight.

I think this rating implies a reasonable margin of safety, on a medium-term view.

Opinions seem to vary among analysts as to the best opportunities among housebuilders right now. I received an analyst note in my email recently suggesting housebuilders selling more lower-priced homes were the most attractive, for affordability reasons.

Personally, my inclination is to focus on higher-quality builders with more stable track records and affluent customers.

Time will tell which approach performs best. But one sensible strategy to profit from this market might be to buy a basket of housebuilder shares. By doing this, an investor could avoid company-specific risk and hope to profit from mean reversion when the sector recovers.

Final thoughts

I think the big housebuilder stocks offer reasonable value today. But like all value investments, they aren’t without risk.

One concern for me is that investors may have drawn false hopes from recent strong trading, while overlooking the scale of the downturn expected this year.

Taylor Wimpey and Persimmon, for example, are forecasting volume reductions of c.30%-40% this year. Big falls in profits are expected across the sector.

Barratt Developments (LON:BDEV) is expected to report a 40% fall in earnings in FY24 (y/e 30 June 2024).

Earnings at Taylor Wimpey (LON:TW.) are expected to fall by more than 50% in calendar 2023.

Similar numbers apply to most of the big listed housebuilders at the moment. Dividend cuts also seem likely to me from those companies that haven’t already cut their payout.

All of this is a normal part of the business cycle for these firms. But I don’t see any signs of financial distress yet.

However, I fear that any investors who are using recent profits and dividends as a reference point could be disappointed over the next 18 months.

In my view, there’s a risk that this year’s share price rally has run slightly ahead of itself. I wouldn’t be surprised to see a partial retreat before a more sustainable recovery takes place.

Even so, I believe housebuilding stocks do offer value at current levels and could be a rewarding value investment over the next few years.

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