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Industry Outlook

The year 2016 marked considerable improvement for the housing sector since the recession in 2008. Despite concerns regarding the possibility of a series of interest rate hikes by the Federal Reserve, optimism surrounding the housing market remains largely unaffected.

Nonetheless, the 2017 outlook for the U.S. homebuilding industry is quite compelling given affordable interest rates, housing starts and new home sales below historical levels, and tight inventory indicating pent-up demand.

Also, an improving economy, modest wage growth, low unemployment levels and positive consumer confidence raise optimism about the sector in 2017.

However, a tight labor market, limited land availability and constrained mortgage environment restrict the ability of homebuilders to respond to growing demand.

Delving Deeper

Recently housing data by the Commerce Department has been a mixed bag. New U.S. single-family home sales fell 10.4% in Dec 2016 from the prior month to a seasonally adjusted annual rate of 536,000 units after three straight months of strong gains. The figure marks the lowest since Feb 2016. The post-election rally in mortgage rates may have repulsed potential buyers. Sales were also down 0.4% from Dec 2015.

Nevertheless, U.S. single-family home sales increased 12.2% to 563,000 units in 2016, the highest since 2007 and the fifth straight year of sales growth.

New home sales, which account for a fairly small share of U.S. home buying activity, are expected to pick up this year as builders step up construction of single-family homes. Housing starts rose 11.3% in Dec 2016 to a seasonally adjusted annual rate of 1.23 million, per the Commerce Department. Overall, single-family starts were up 9.3% in 2016 while construction of buildings with five or more units fell 3.1%.

Lack of skilled labor has been denting demand for housing. Again, home sales are being constrained by an acute shortage of properties for sale.

Sales of existing homes fell 2.8% in December due to higher mortgage rates, rising prices and lack of homes for sale, per the National Association of Realtors.

Meanwhile, the median sale price of a new house increased 7.9% year over year in Dec 2016 to $322,500. Rising mortgage rates will likely make home purchases costlier this year.

Given the weak sales, the inventory of new homes grew 4% to 259,000 units in Dec 2016, the highest since Aug 2009. The stock of new houses is presently below half of the peak scaled during the housing boom.

At this pace, it will take 5.8 months to clear the inventory, the highest since Sep 2015, Also, it was higher than 5.0 months recorded in November.

That said, the number of building permits — which indicate future construction trends — rose 4.6% in the month of Jan 2017 from the preceding month, the highest since Nov 2015.

Again, housing starts fell 2.6% to a seasonally adjusted annual rate of 1.25 million units last month, per the Commerce Department. This may be due to unusually wet weather conditions in California after years of drought.

With overall permits now beating starts, homebuilding is expected to bounce back in the coming months.

Further, the National Housing Association of Home Builders or NAHB/Wells Fargo Housing Market Index or HMI scaled to 67 in Jan 2017. This reading mainly reflects builder perceptions of current single-family home sales and sales expectations for the next six months. Although HMI dropped 2 points month-over-month, it remained steady over the trailing six months.

Is There Some Upside Left?

The industry has slightly underperformed the broader market over the last five years which suggests a value-oriented path ahead. We find the price-to-book ratio as the best multiple for valuing homebuilders because of their asset-driven nature.

The industry currently has a trailing 12 month P/B ratio of 1.24. This level compares favorably to what the industry witnessed over the last five years. The ratio is lower than the average level of 1.82 and almost near its low of 1.15 over this period.

Additionally, it compares favorably with the market at large, as the current P/B for the S&P 500 is at 3.71 and the median level is 3.02.

Overall, the valuation from a P/B perspective looks attractive when compared to its own range in the time period. Moreover, its lower-than-market positioning calls for some more upside in the quarters ahead.

The SPDR S&P Homebuilders ETF (XHB - Free Report) and the iShares U.S. Home Construction ETF (ITB - Free Report) , the two largest exchange traded funds focusing on homebuilders and related fare, have rallied 5.8% and 8.9%, respectively, so far this year.

Q4 Earnings Trend

The Q4 earnings season has almost come to an end and investors should be content with the performance of the broader construction sector. The Q4 earnings season has so far seen quarterly releases from 92.3% of the construction companies in the S&P 500 cohort. According to the latest Earnings Preview, 58.3% of the companies have surpassed earnings and 66.7% have beat revenue expectations.

Total earnings at these companies increased 9.3% on 8.1% growth in revenues. Total earnings for the sector are expected to increase 11% on the back of 6.7% revenue growth, which might prove profitable over the long haul.

Zacks Industry Rank

Within the Zacks Industry classification, homebuilding companies   are broadly grouped in the Construction sector (one of the 16 Zacks sectors).

We rank 265 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by more than twice as much. The Zacks Industry Rank for homebuilding is currently at #176 (bottom 31%). Though the industry picked up pace, equity market volatility, labor shortage as well as land availability issues are marring its prospects. Additionally, one factor that could be dampening investor sentiment is the odds of a hike in interest rate.

The ranking is available on the Zacks Industry Rank page.

Our top picks from the homebuilding industry are NVR, Inc. (NVR - Free Report) and PulteGroup, Inc. (PHM - Free Report) , which sport a Zacks Rank #1 (Strong Buy). We also favor D.R. Horton, Inc. (DHI - Free Report) and William Lyon Homes (WLH - Free Report) , both carrying a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Bottom Line

Despite concerns regarding the health of the economy, homebuilders are increasingly optimistic about the opportunities ahead. However, labor shortages, a slight slowdown in sales, intensifying competitive pressure and rising land and construction costs are major headwinds.

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