Going through the roof

The investment strategy is always to hold these shares until the end of the first quarter, or if the fundamentals are supportive, to run the gains a while longer. So for now I am happy to run with these fantastic gains which follow on from the massive 24.7 per cent three-month returns made by holding the homebuilders in the first quarter last year and in 2012 too.

FTSE 350 Homebuilders share price performance (26 November 2013 to 10 March 2014)

Strong operational progress sector wide

The share price rises may be significant again this year, but they are fully supported by the operational progress being made. For instance, Barratt Developments (BDEV: 444p) has just announced that its interim pre-tax profits soared 73 per cent to just shy of £140m in the six months to end December, buoyed by a 19 per cent rise in completions to around 6,200 homes and a 13.9 per cent increase in average selling prices. The rise in profits also reflects a sharp increase in operating margins which jumped from 2.5 percentage points to 11 per cent. Analysts expect more of the same this year.

A forward order book of £1.74bn, up more than a half at the same stage in 2013, suggests that an 80 per cent hike in full-year profits to £346m is achievable. On this basis, expect EPS of 27.4p. But as always the market is looking beyond this year and for the financial year to end June 2015, analysts predict another hefty rise in profits to just under £500m to produce EPS of 36p. On this basis, the shares are hardly overly priced on 12 times prospective earnings.

And with balance sheet gearing only 5 per cent of shareholders funds of £3.15bn, the ramp up in output and profits should underpin a sharply rising dividend. The estimates are for a payout of 6p a share in the current financial year to June 2014, rising to 10p in fiscal 2015, and 15p the year after. On this basis, the forward dividend yield is decent enough at 2.2 per cent, rising to 3.3 per cent. The shares don’t look overly expensive on a price-to-book value basis either, trading on 1.4 times net asset value, the lowest multiple in the sector. In part that is down to Barratt’s lower return on equity than for other players.

Improving returns on capital

However, with the company’s return on capital employed (ROCE) rising to 14.2 per cent in calendar 2013, up from 9 per cent in 2012, and all land acquired since 2009 having a minimum requirement of a ROCE above 25 per cent, then the company is making stellar progress to its 18 per cent ROCE target by 2018. It could easily be surpassed because on the 60 sites completed to date that have been acquired since 2009, the average ROCE has hit an eye-watering 38 per cent. This largely reflects astute land buying at the bottom of the cycle and a very favourable tailwind of rising house prices in London and southern England, in particular.

So, with house prices still rising in the buoyant south east, and the government’s Help-to-Buy initiatives driving mortgage approvals to their highest level since before the 2008 financial crisis, there is every reason to expect Barratt to generate the profit growth analysts predict. In fact, the risk to estimates looks to be on the upside given the geographic spread of its operations, a move to increase its London weighting and the significant contribution from Help-to-Buy home purchases (29 per cent of total completions in the last six months of 2013).

In the circumstances, it’s hardly a surprise that the shares have risen strongly since I advised buying at 339p at the end of November ('As safe as houses, 27 November 2013). They have put in an eye-catching performance since the start of last month too when I included them in my 2014 Bargain share portfolio. The price then was 394p. In fact, the shares are the best performing housebuilder in the past three months. This is partly due to the valuation anomaly with peers correcting itself, but also due to technical buying by institutions and market participants.

Playing footsie

In fact, I suggested this would happen in my article early last month because Barratt was knocking on the door of the FTSE 100 at the time. In the event, when the FTSE International Committee met for its quarterly index review on Wednesday 5 March, the company was an automatic entry into the FTSE 100. Its market capitalisation has soared to £4.33bn, placing it as the 88th largest listed UK company by market value to join Persimmon (PSN: 1391p) in the blue-chip index. Barratt will enter into the FTSE 100 at the close of trading on Friday, 21 March.

As a consequence I can envisage further technical buying of its shares in the run up to that date. The chart set-up is supportive too: the 14-day relative-strength Index (RSI) is not that overbought, the shares are modestly above the rising 20-day moving average, and there isn’t much overhead resistance until the summer lows around 540p, dating back to 2006. As a result, I would recommend you continue to run your bumper profits.

Profit surge at Taylor Wimpey

Barratt Developments was not the only homebuilder in my 2014 Bargain share portfolio. I also included rival Taylor Wimpey (TW.: 120p). That was partly because the FTSE 250 company was also set to benefit from technical buying of its shares if its market capitalisation increased enough to also be included as a constituent of the FTSE 100 at the FTSE International Quarterly Index Review. In the event, the company just missed out is second on the reserve list of companies to enter the blue-chip index, just behind 3i Group (III).

Possible technical buying of the shares wasn’t the only reason I was positive. The operational progress and potential for substantial capital return also underpinned the investment case.

In a full-year result announcement, Taylor Wimpey has revealed that the company sold 11,696 homes in 2013, up 7 per cent on 2012, buoyed by demand from the government's Help to Buy mortgage lending scheme. Average selling prices on private completions also rose 7 per cent, reflecting a shift to better sales locations and higher market prices. The net result of higher volumes and selling prices was a surge in operating margins surged to 13.4 per cent last year, up 2.4 percentage points on 2012.

In turn, with revenues rising from £2bn to about £2.3bn in the 12-month period, the combination of higher selling prices, more completions and better margins drove both adjusted pre-tax profits and EPS up by 46 per cent to £268m and 6.7p, respectively. Latest guidance is for another “200 to 300 basis point improvement in margins in 2014.” As a result the combination of rising sales and higher margins underpins Peel Hunt's current year pre-tax profit estimate of £390m on revenues of £2.6bn, to produce EPS of 9.4p. The respective figures for 2015 are revenues of £2.9bn, profits about £500m and EPS of 11.8p.

So, with Taylor Woodrow's shares trading at 120p, the forward PE ratio is only 10 for 2015, hardly an excessive rating given the multiple tailwinds of easy monetary policy, supportive government housing schemes, UK population growth and net migration that are driving demand at the same time that local government planning policies are holding back supply.

Happy capital returns

The company is also releasing value from its land bank. That’s because Taylor Wimpey has a short-term consented land bank of just over 70,000 plots, or six year's supply at current build rates, and a strategic land bank of 110,000 plots, or 10 years' supply. By comparison Barratts has a 4.4 year consented land bank. This is more than it needs so the company plans to release value from these land holdings and return cash to shareholders. In future, it will operate a land bank closer to five years given the huge strategic land bank. The board plans to payout £50m of special dividends this year, rising to £200m in 2015. In total that is 7.7p a share.

True, that is far less than I anticipated in my analysis last month and seems quite a conservative payout considering Taylor Wimpey is forecast to generate free cash of between £1.7bn to £1.8bn over the next four years, the equivalent of 58p a share or half the current share price. The company could easily treble that payout without having a negative impact on its debt free balance sheet. It therefore would not surprise me at all to see the board accelerate the payout later this year on the back of the company’s bumper cash generation.

So, although some investors will be disappointed by the scale of the proposed special dividends, I still see scope for Taylor Wimpey’s share price to make headway to my 160p a share fair value target and continue to rate them a buy at 120p.

Please note that my colleague Jonas Crosland has provided an excellent write-up on Bovis Homes (BVS: 917p) post results. The article (‘Bovis has built in value’, 28 February 2014) highlights the company’s undervaluation to peers and confirms my own view that there is upside towards the top-end of my 930p to 980p target price range. If you followed my earlier advice, I would continue to run your bumper profits.

Finally, I note that analysts at Credit Suisse have downgraded their view on the UK homebuilders to ‘neutral’ on valuation grounds. I have read the report and though I acknowledge the bank’s first rate record at certain market calls, my own view is that the equity bull market in the homebuilders still has some mileage left.

Please note that I have written another column today (Undervalued Russian value play, 10 March 2014). I am currently working my way through a large number of announcements from companies on my watchlist and which I plan to update. These include: LMS Capital (LMS), BP Marsh Partners (BPM), Eros (NYSE: EROS), First Property (FPO), Trading Emissions (TRE), 32Red (TTR), Polo Resources (POL), Global Energy Development (GED) and Raven Russia (RUS).