Sunday, June 10, 2012

Is the US Housing Market in Recovery and What Stocks to Buy?

Wells Fargo $WFC and JPMorgan $JPM gave results on Friday and, although they both beat estimates, the market immediately greeted them with a 3%+ markdown. The key interest for long term market investors is to discern from these numbers, how the US economic recovery is faring.
In particular, Wells Fargo is a key barometer of US household finances and, the housing market. As the largest mortgage originator in the US, Wells Fargo is effectively geared to the housing market. Therefore, the scope of this article will be to look at the US housing market in the context of finding an investment thesis that will benefit from the trends articulated.

With Citigroup and Bank of America $BAC reporting soon, it is important for investors to understand the underlying trends behind future earnings numbers. In particular, Bank of America appears to be a high beta play on a US recovery. So this kind of analysis is essential.


Wells Fargo & JPMorgan Bullish on Housing

JPMorgan reported that mortgage applications were up 33% on last year and Wells Fargo reported an 84% increase. Both made bullish predictions on the housing. Quoting from Wells Fargo’s conference call, CEO John Stumpf said,
‘But when you have the dynamics of higher rental rates and lower home values at great financing rates, there's a point in time where the market's going to clear and you're going to see improvement. I think we're getting very close to that tipping point, and we've seen it in some of the markets.’
 Similarly, JPMorgan’s CEO, Jamie Dimon, was quoted as saying that housing was ‘very close to the bottom’.
These statements will be music to the ears of Warren Buffet, who is a significant holder of Wells Fargo stock. Here are some quotes from his last annual letter to Berkshire Hathaway shareholders.
‘Every day we are creating more households than housing units… …At our current pace of 600,000 housing starts –considerably less than the number of new households being formed- buyers and renters are sopping up what’s left of oversupply… …Fortunately,  demographics and our market system will restore the needed balance- probably before long. ‘
There can be little doubt that Buffet is invested in Wells Fargo as a consequence of his confidence in housing. Essentially, banking stocks are geared to the economy. When unemployment is falling, credit quality improves, bad debt provisions tend to fall and, banks start lending again.
All of which, leads me to wonder what exactly is the point of managements handing out shareholders cash to employees bonuses when bank earnings are actually guided by the economy?  However, that is another issue. It's timeto go back to housing.


Housing Market Outlook

Returning to what Warren Buffett said, new housing starts have been below 600,000 since the fall of 2008. To put this into context, they rose from 1.2m to 1.8m at the height of the housing bubble in 2006. However, whilst new household formulation in the US tends to add about 1.3m new households every year, homeowner vacancy rates still haven’t fallen back to traditional averages yet. These figures are from the Census Bureau.


Whilst the trend is clearly getting better, the data is still indicating that a strong recovery is not imminent. Moreover, the shadow inventory in the housing market is holding back the housing market. However, the best way to gauge a demand/supply imbalance is through prices!
House prices are still weak, but the trend does appear to be improving. Here is the monthly change in the Case-Shiller Home Price Index.
 
Another useful indicator is the NAHB/Wells Fargo Housing Opportunity Index, which is a measurement of housing affordability. It is at an all time high and, reflects ongoing low interest rates and falling home prices.

Throw in falling unemployment and increasing credit quality and a positive prognosis for the housing markets ills could be easily created. For example, credit quality data from the FDIC suggest that bad debt provisions at the banks remain on a positive trend.
  How to Play the Sector?

Of the banks, I prefer Wells Fargo because of its exposure to the US mortgage market. It is also a US centric play which should alleviate it from potential problems with deteriorating European sovereign debt issues. However, housing is such a broad sector that there are plenty of ways to get exposure.
One of my favourites is Home Depot $HD although Lowes $LOW is also an option for similar reasons. These two home improvement stores are behemoths in terms of market position and, any uplift in housing prospects is likely to drop straight into their bottom line.

 Home Depot is attractively valued because it continues to generate huge cash flows and, last year, only paid 30% of its free cash flow in dividends. There is ample scope for more buybacks and dividend increases. It is a similar situation with Lowes which paid out 25.6% of its free cash flow in dividend, but Lowes starts with a lower yield. In addition, I prefer Home Depot because the company has been executing better than Lowes in recent years.

Another option, which is little discussed, is credit information provider Equifax $EFX. This company is heavily exposed to the increasing issuance of credit in the US economy. Therefore, if banks and corporations are extending credit again, Equifax will be an obvious beneficiary. Analysts are forecasting double digit growth for the next few years and, I think there could be upside to those estimates. Equifax has gross margins over 60% and, I like the way this sort of business is leveraged to cyclical growth in theUSand secular growth in emerging markets such as Brazil.

In conclusion, there are positive signs for housing and credit in the US. Granted, investors have heard this before over the last two years. Yet, I am going to issue some famous last words and state that ‘this time it’s different’.