Lennar Corporation (LEN), Toll Brothers Inc (TOL): Time to Exit the Builder Stocks

It is time to sell the builder stocks, despite good news in the housing sector. Homebuilders are too pricy, and the low interest rates that feed the industry will climb.

There is no doubt that the U.S. housing market is finally recovering after a severe and protracted slump. For the first time since 2008, the construction and sale of homes will add not only jobs but needed tax dollars as the economy gains strength, thanks to the Federal Reserve’s effort to keep interest rates at historical lows.

Lennar Corporation (LEN)

As seen in the recent January and February housing numbers, the recovery is continuing, with new home sales at the highest level since 2008. No one expected that strong of a number for January. In the West, sales were up an astonishing 45%. Supply stands at a low of 4.1 months, a number not seen since 2005. Multiple offers above asking prices are common in California. Builders scramble to catch up to the demand as permits for new construction rise. In February, sales fell to a yearly rate of 411,000, but this is still 31% more than February 2012.

The housing industry’s increasing momentum is clear. There has been a reversal in the fortunes in the industry and despite a continued high level of foreclosures, even the number of delinquent loans is falling.

It is for exactly these reasons why you should sell your builder stocks and lock in profits. Let’s look at three large builders:

Lennar Corporation (NYSE:LEN). This $8 billion (market capitalization) company, located in Florida, builds single-family homes in 16 states. They also develop and sell land. Management owns 4% of the stock and their sales growth increased for each of the last four quarters by over 30%. Gross margins rose from a negative 10.9% in 2009 to a positive 10.95% in 2012. Nothing is wrong with those numbers.

However, the other number you should watch is the stock price. In August 2011 the stock bottomed at $12.72 and today it is in the low $40s; the price tripled in less than two years.

Toll Brothers Inc (NYSE:TOL). The $6 billion dollar builder constructs single-family homes in luxury communities. Management owns 12% of the stock, so they are particularly focused on growing the company. Their sales grew at 30% or higher for the last four quarters and their profits margins went from minus 11.17% to 18.63%. Like Lennar Corporation (NYSE:LEN), profits steadily increased since 2010.

Their stock bottomed $14.38 in October 2011 and it currently sells in the mid $30s – more than doubling.

M.D.C. Holdings, Inc (NYSE:MDC) is smaller than the other two, with a market cap of $2 billion. They build homes on the lower end, catering to first-time and move-up buyers. They lost money every year since the Great Recession of 2008 and only turned a profit starting in 2012, with earnings per share of $1.28. Their gross margins never fell to negative territory but they are not improving either at 15.32%.

Sales are recovering at a higher rate than for Lennar Corporation (NYSE:LEN) or Toll Brothers Inc (NYSE:TOL), coming in at over 40% for the last four quarters. Their stock bottomed in December 2011 at $16.67 and now trades in the high $30s. Not nearly as impressive as the other two yet still close to a 100% return in a little over a year.

All three stocks have had a great run-up in price and therein lies the problem. There is a relationship between price and earnings that goes back centuries, not only in the stock market but also to the tulip craze of 1636, when a bulb sold for more than its weight gold. More recently the dot-com bubble proved that, if a company does not have earnings, then stock prices are going to fall.

But the builders post decent earnings, so why the worry? It’s the annoying relationship of stock value to earnings. The long-term price to earnings (P/E) average for the Standard & Poor’s 500 is 15.

Based on today’s earnings, Lennar Corporation (NYSE:LEN) sits at 39, Toll Brothers Inc (NYSE:TOL) at 62 and MDC Holdings at 32. These are well above the average. What about forward-looking earnings? Based on estimates, these three companies are at 8, 26 and 17. These P/E ratios are not on the extreme but certainly higher than normal.

Plus, look at the Federal Reserve’s effort to keep interest rates artificially low. Builders are in a cyclical industry. When the economy does well, they do well, when interest rates are low, they do well. The economy may well be recovering, albeit slowly; because of that slowness the Fed has kept its foot firmly on the pedal, flooding cash into the economy.

Low rates won’t last forever, though. At the most recent Fed meeting, the 12 governors discussed tightening; in other words, letting interest rates rise. What do you think will happen to the sales of homes once that begins?

That’s why it is time to exit the builders – take profits and be happy. While the sector’s stock prices and sales could continue to rise for a while, the headwinds of higher interest rates are starting to appear. You do not want to own these stocks when they become hurricane force. Since investors and traders always look forward, they will likely sell these stocks before the problem hits.

The article Time to Exit the Builder Stocks originally appeared on Fool.com and is written by Larry Light.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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