Stockwatch: Crash creates cheap income play

Do volume housebuilders still represent value? Their stocks have been sold off amid fears an asset bubble is being pricked after soaring house prices became a global phenomenon - those in the eurozone are rising at the fastest annual rate since 2008.

For example, the five-year chart for Taylor Wimpey shows a very strong rally which consolidates during the second half of 2015 and looks inauspiciously like a "double-top", i.e. a bearish reversal pattern.

A tussle of factors

When Help to Buy was introduced in the 2013 Budget, it surprised a stockmarket that had priced housebuilders for a jaundiced future, with mortgage lending mired. Sentiment, therefore, swung positively and has been supported by housebuilders' strong upturn in profits (see table below). Osborne is extending Help to Buy until 2021 and has also implied the government will loosen planning restrictions, i.e. effectively pressure local authorities to grant more development.

Moreover, governor of the Bank of England Mark Carney has deferred any likelihood of an interest rate rise for the foreseeable future, keeping pressure off mortgage borrowers despite house prices looking expensive relative to incomes. All such influences imply housebuilders of any size should continue to make underlying progress.

Long-term investors may be wary, however. Taxpayers' subsidising of mortgages is contributing to an artificial situation that will correct once interest rates "normalise" to any degree higher. The stockmarket is trying to anticipate this in advance. Latest statistics show a 7.7% jump in house prices for the year to November 2015, the fourth consecutive month of growth, with homes testing a multiple of 12 times incomes. This creates risk of a disruptive effect to home-buying.

Sentiment is, therefore, a tussle: guessing how long the authorities' boosting of the market can last before it inevitably corrects. The vote on European Union membership is also relevant, given immigration has added to housing demand.

Two peas in a pod

Consequently, the market attaches price/earnings (PE) ratios that look modest relative to projections, also for generous yields. The profiles for Barratt Developments and Taylor Wimpey, both in the FTSE 100 index, are remarkably similar.

Earnings growth is expected to moderate from about 50% into a 20% range this year, then about 15% growth for Taylor in 2017 and 10% for Barratt. They trade on forward PEs of about 10 times and yield just over 6%, covered over 1.5 times by projected earnings.

I have drawn attention to both stocks; Barratt, originally at 92p in November 2011 and later as a stalwart share for 2013. Taylor Wimpey, meanwhile, has made spectacular progress since my drawing attention repeatedly in 2009 at 15p, before a one-for-one open share offer at 25p addressed debts and enabled investment. So recent selling may also be motivated by an element of shareholders mindful to protect gains.

Both stocks sport highly attractive PEG ratios (i.e. the PE multiple divided by the earnings growth rate) of about 0.5 on a near-term forward basis. Any ratio below 1.0 implies value. But growth stock measures should not really be applied to cyclicals, the table showing how Taylor Wimpey's PEG rises promptly to 1.0 for 2016. So beware claims of value due to low PEGs: they are a snapshot in time and can swiftly alter.

Smaller housebuilders in vogue

Another factor has been sentiment shifting to favour smaller housebuilders, given they will find it arithmetically easier to achieve growth as the current housebuilding cycle matures.

Investors tend to favour industry leaders during the early- to mid-stages of a bull market, small-caps responding later (it is similar with recruiters, where some larger stocks are stalled, yet those smaller continue to rise).

This is why I have recently drawn attention to the likes of MJ Gleeson and Henry Boot, smaller housebuilders and land traders doing well. In a worst-case scenario, however, these stocks have barely half the yield support of the big-caps, and their tighter market implies a sharp drop if there is selling pressure. That's not to warn on small-caps, more to emphasise yield strength in the majors. A 6% yield should constitute an intrinsic support level and the extent of cover may accommodate a mild profit warning.

Positive trading updates

Both these FTSE 100 companies have issued strong 2015 reviews in January: Barratt citing a 9.4% rise in completions and a 20% rise in forward sales (helped by rising house prices), the company on track for 3.5 years of owned land in reserve and £150 million net cash at end-June.

Taylor Wimpey cites a 7% increase in completions, its order book up 27% and "further progress" in the land bank - also towards a target, for 2015-2017, of converting 65% of operating profit into cash. This should support a progressive dividend policy where the re-rating from below 1.0p to over 10.0p per share results also from introducing special dividends.

Also, with the return on net operating assets rising over 25%, the year ended with net cash doubled to about £225 million - even after distributing £308 million in dividends. "Affordable homes" constituted 19% of total completions.

Director pockets £49,000 of shares

So, while the housing market is liable to meet constraint from soaring prices, financial strength in Barratt and Taylor Wimpey makes their stocks attractive, particularly for income in diversified portfolios. On 18 December a new Taylor Wimpey non-executive director bought 25,000 shares at 196.6p, versus the current price of about 182p, representing confidence in Taylor Wimpey's overall risk/reward profile.

The market price is saying the liability for global recession and bursting of asset values means a 6% yield is necessary for the holding risks of such stocks. But this appears a worst-case scenario, hence an opportunity to accumulate.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.