What is the right public market valuation for an economically sensitive company near the peak of a business cycle? That question has bothered me for over 20 years, ever since I covered the auto industry for all of the 1990s cycle. Beyond “something less than a market multiple”, there is no consensus approach or pat answer. Five times forward earnings feels too cheap, and fifteen times too dear. But that’s all just a feel, not math.
Looking at the valuations of the large US homebuilder stocks just now, it is clear investors face exactly this question. Here are the current forward valuation multiples and dividend yields for the top five, and a few comparisons:
- DR Horton: 10.0x, dividend yield 1.1%
- Lennar: 8.2x, yield of 0.3%
- NVR: 13.6x, no yield
- Pulte Home: 8.4x, yield 1.1%
- Toll Brothers: 8.7x, yield of 1.0%
- Average: 9.8x, a 40% discount to the S&P 500 at 16.5x forward earnings
- For comparison, GM trades for 5.9x earnings, Ford is at 7.3x, Deere at 12.9x, and Caterpillar at 13.1x. All three yield 2% (DE and CAT) to 4-5% (Ford and GM)
In other words, the big homebuilders trade for exactly the same forward multiple as a blend of the major auto and machinery companies: 10x earnings. The group has lagged pretty miserably this year, with the DJ Home Construction Index (which the ITB exchange traded fund tracks) down 11% in 2018. That has sparked some bullish calls, calling 10x earnings too cheap for the group.
Here is our take, informed by lots of grey hair following deep-cycle valuations: cyclical stocks never experience meaningful PE expansion at business cycle tops. There is simply too much uncertainty about forward demand to make that leap. In the case of homebuilders, rising interest rates put too much of a question mark on demand, regardless of how strong the cycle looks right now. And we will concede the current news flow is great. It just doesn’t matter to valuations.
Now, all is not lost if you want to look at this group as a potential investment. You just need to believe one of two things (or both, if you are feeling especially generous):
#1. Industry consolidation. Better economies of scale always drive valuations higher as long as they eventually show up in operating margins. Cyclical company managements tend to sell at two points in the cycle. The first is at the bottom, but only if they have to. The second is at the top, usually because they do not want to deal with the next downturn.
#2. You believe the next downcycle will be modest, the industry will be able to generate profits into the next upturn, and you plan to hold all the way through. There is a reason Ford and GM trade so cheaply to Cat and Deere; the US auto industry imploded in the Great Recession, and the machinery names did not. Modest downturns allow cyclical companies to restructure, so earnings power is typically higher on the other side of the valley. Add in some multiple expansion, and this is a good recipe for a 3-5 year holding period.
Our take: discretion is the better part of valor when it comes to the homebuilders. Pervasively positive news hasn’t helped the group of late. Multiples can contract further, if for no other reason than higher interest rates. We’ll keep watching the group, but it feels early to take a shot.