Last night, while the outer bands of Tropical Storm Colin gave us some nice windy, rainy conditions here in Central Florida, I fielded several calls about yesterday's piece on housing stocks. The basic tone was along the lines of, "How can you possibly be bullish on builders when the world is ending and millennials are not buying houses because they like to rent downtown and aren't getting married? Everybody knows the housing markets have changed forever and no one wants to buy a home."
Some of that is true. The millennial generation has preferred renting in urban locations, but that is getting pretty expensive in many areas. The other fact to consider is one Ivy Zelman mentioned in her Barron's interview over the weekend. Millennials are getting older as the leading edge of the millennial generation is now 34. We may not being seeing spikes in the marriage rate, but birth rates are going up. That tells me that even if they aren't getting married, the millennials are having kids and folks with kids are going to begin to want a house with a yard for the kids and access to good schools, health care and the like. My 32-year-old daughter and her husband have lived the downtown millennial rental life for a few years. Guess what they did this weekend? Moved into their new house.
Zelman made another strong point in the interview. She pointed out that investors are increasingly buying and renting single-family homes. She pointed out that 10%-15% of the new single-family homes are being purchased by rental investors. She said, "There's a shortage of shelter. We're pretty indifferent whether shelter should be owned or rented. We're just saying there isn't enough." Sam Zell is fond of asking where is the demand coming from and it appears to me that long-term demand for single-family homes will increasingly come from millennials who are growing up. They may buy, they may rent, but they will be looking for homes and not just apartments over the next decade.
Yesterday I highlighted the ultimate long shot, but today I want to look at some stocks that have big total return potential but are not as much of an all-or-nothing selection as Hovnanian (HOV). M.D.C. Holdings (MDC) is a builder that focuses on first-time and first-time move-up buyers in Colorado, Virginia, Maryland, California, Washington, Arizona, Utah, Florida, Illinois and Nevada. The company is seeing decent growth with gains in revenues and margins and has had eight quarters in a row of new-order growth. The current backlog is up 50% year over year to $1.43 billion, so we could see very strong results from this company going forward. In spite of decent growth and strong prospects, the stock trades at just 92% of book value right now. You get paid to wait for the market to recognize the bright prospects as the stock yields 4.25% at today's price.
KB Homes (KBH) seems undervalued to me at current levels as well. I can tell you it is very active in this market as I drive by several of their developments on a regular basis. I confess to having been skeptical about where the demand for all the building in West Orlando was going to come from, but so far they are selling everything they build rather easily and quickly. They have seen decent results so far in 2016 with revenues up 28% and deliveries increasing by 23% in the first quarter of the year. Margins are showing signs of improvement and SG&A costs have been coming down as management focuses more on cost control. The backlog grew from $1.1 billion in 2015 to $1.4 billion at the end of the first quarter of 2016. The stock is selling at just 73% of book value, so it appears to be a bargain at the current price.
It looks to me like the big picture is slowly changing. Since the credit crisis hit, the story has been millennials eschewing homeownership in favor of renting, and they had a preference for urban locations with lots of entertainment and lifestyle choices. It has been a powerful and profitable story, but only Peter Pan never grows up. As this generation moves into their 30s and family creation becomes more important, they will turn to single-family homes. It doesn't matter if they buy or rent, but millennials will begin to show a preference for a house and a yard near good schools, and that bodes well for homebuilders.
Stay small and move slow as the overall market still looks iffy to me, but select homebuilders should be moving up your long-term buy list.