Looking for the cheapest stocks in the market now? Two industries stand out: home builders and steel makers.
The common denominator in both groups is that investors don’t think currently robust earnings will last. The stocks discount disastrous downturns for both industries that are unlikely to materialize. Home-building stocks have fallen 40% or more this year.
The losses in home builders’ and steel makers’ shares reflect a broad pullback in economically sensitive stocks. Yet, balance sheets have rarely been stronger for these industries, offering a financial cushion in a potential recession.
While a doubling in mortgage rates to 6% is reducing housing demand, a prolonged and deep downturn seems unlikely, given strong demographic trends and limited supply. “The home builders are pricing in an Armageddon scenario and a repeat of the great financial crisis when home prices fell 30%,” says Stephen Kim, housing analyst at Evercore ISI. “The stocks are cheap and more than compensate for the risk.”
Kim thinks they could double over the next year.
Bespoke Investment Group noted last week that the 40% decline in home-building stocks from their prior highs marked the sixth such drop in the past three decades. The average one-year gain following those declines has been 43%, with the only negative reading coming in 2006.
Home-builder profits remain at record levels, as was apparent in Lennar’s (ticker: LEN) latest quarterly report. Lennar is the No. 2 U.S. home builder behind D.R. Horton (DHI). Lennar acknowledged that the market is softening, but Chairman Stuart Miller said land impairments, which hammered home builders during the 2008 financial crisis, were unlikely unless the market falls “an awful lot.” That reassured analysts and investors, and Lennar rallied, gaining 8%.
At around $70 a share, Lennar trades for four times projected 2022 earnings and below its book value of $74 a share. Lennar and other builders have ramped up stock buybacks and boosted dividends this year.
Wedbush analyst Jay McCanless says the stocks are trading for an average of just 80% of year-end 2022 tangible book value. Builders are benefiting from growing demand from companies that rent out single-family homes.
*Sept. fiscal year end, **Nov. fiscal year end, ***Oct. fiscal year end, E=Estimate
Source: Bloomberg
McCanless favors Horton, which generated an outsize 34% return on equity in the year ended in March. Horton shares, at $67, trade for four times earnings.
McCanless says high-end home builders could be more insulated from rate hikes because of their affluent customer base. He favors small-cap builder Tri Pointe Homes (TPH), now trading around $16, or three times 2022 earnings. The luxury leader, Toll Brothers (TOL), trades around $44, or four times 2022 estimated profits and below book value of $46 a share. Some 20% of Toll buyers don’t need a mortgage; they pay cash.
Steel stocks are among the most volatile. The companies generally had record first-quarter results and guided to similar performance in the current quarter.
Yet the stocks have been hammered on recession fears as steel prices, measured by hot-rolled coil steel, have fallen below $900 a ton from $1,500 earlier this year. Steel makers should still generate ample profits at current prices, suggesting the risk/reward is attractive.
Alan Kestenbaum, the CEO of Canadian steel maker Stelco Holdings (STZHF), says the steel market is becoming “very challenging. Prices have been falling every single week.”
The demand outlook is good. The auto industry, which accounts for 25% of U.S. steel demand, is operating below capacity due to chip shortages, and could boost production in 2023. Other key steel users, including infrastructure and energy, are also in good shape. One positive sign is industry consolidation. Four producers now account for over 80% of U.S. steel output.
U.S. Steel (X), at $19, trades for under two times 2022 earnings. The company’s plan to build a big new “mini mill” for about $3 billion hasn’t played well with some investors, who would like to see more cash returned to shareholders.
Cleveland-Cliffs (CLF), another big integrated steel producer, doesn’t have grand expansion plans and has a shareholder-focused CEO in Lourenco Goncalves. Its stock, at $16, trades for three times projected 2022 earnings.
Industry leader Nucor (NUE), at $107, trades for four times earnings and yields nearly 2%. It has an attractive business mix, but its capital allocation is questionable after it recently agreed to pay $3 billion for a maker of garage doors at a huge premium above its own valuation.
Steel Dynamics (STLD), which, like Nucor, operates mini mills using scrap steel as an input, completed a major new mill this year in Texas. Its stock trades for $66, or three times earnings.
Stelco operates a lucrative single blast-furnace mill in Ontario and may have the group’s most investor-oriented CEO in Kestenbaum. Stelco has boosted its dividend several times and bought back a lot of stock. The stock, at around $26, yields 3.6% and fetches just two times estimate 2022 earnings.
Ultracheap stocks can offer nice upside potential and a margin of safety. Home builders and steel qualify.
Write to Andrew Bary at andrew.bary@barrons.com