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Seeking alpha from the housebuilders

Seeking alpha from the housebuilders
January 4, 2017
Seeking alpha from the housebuilders

Importantly, there are sound reasons why this phenomenon occurs, the most obvious of which is the timing of the reporting season for housebuilders, which starts during February and continues on into March. As a result, we are guaranteed outlook statements from the leading players and generally positive ones too. It's also the time of year when most of us prefer to move house, so there is a fair amount of media interest in the sector to spark investor interest. The upshot is that investor sentiment is generally positive enough to support a re-rating, assuming of course valuations are not overly extended in the first place.

However, once a trading pattern establishes itself, the profits made from following the trend can be quickly arbitraged away as more and more market participants become aware of it. It is therefore worth noting that the factors I identified driving the sector returns all those years ago are the same ones at work today. Furthermore, the trend has become stronger, rather than weaker, even though more investors are now aware of the bumper gains to be made.

In fact, in the past decade you would have only lost money twice (minimal losses) by following this investment strategy and the average quarterly return of 10.3 per cent compares favourably with a flat performance from the FTSE All-Share in the same three-month period. In effect, you are generating a double-digit investment gain by only risking your capital for a quarter of the year. And this standing dish of an investment strategy has clearly stood the test of time: the UK housebuilding sector has rallied no fewer than 31 times in the first quarter since 1980 and produced an average quarterly gain in excess of 11 per cent even after factoring in the six down years.

Moreover, when the trade fails to work, the losses are hardly painful. Last year was a case in point as despite the sharp market sell-off in the first six weeks of 2016, the average loss on the FTSE 350 housebuilders' shares was only 1.8 per cent by the end of the first quarter when I closed my recommended short-term trade ('Housebuilders updates', 6 Apr 2016). In fact, since 1980 there have only been three occasions in the first three months of the year when the sector has both fallen in value and underperformed the FTSE All-Share, highlighting the clear tendency of this strategy to generate 'alpha'.

 

FTSE 350 Housebuilders' first-quarter performance since 1980

YearHousebuilding sector quarterly return (%)FTSE All-Share quarterly return (%)Outperformance (%)
19806.64.62.0
198153.56.047.5
198218.04.313.7
198315.97.88.1
19844.911.4-6.5
1985-10.73.9-14.6
198630.118.711.4
198725.620.25.4
198810.93.07.9
198916.816.10.7
1990-7.0-7.40.4
199118.615.63.0
19927.5-1.48.9
199313.33.210.1
1994-4.0-7.13.1
19952.71.11.6
19965.12.22.9
19975.94.31.6
199821.515.46.1
199934.58.326.2
2000-16.2-4.1-12.1
200114.8-9.123.9
200212.01.310.7
20030.4-8.38.7
200419.0-0.519.5
20058.11.76.4
20068.37.11.2
20070.11.9-1.8
2008-6.5-10.94.4
200916.4-10.226.6
20100.52.8-3.3
201112.70.810.9
201224.73.321.4
201324.79.315.4
2014*12.80.612.2
2015*18.92.016.9
2016*-1.8-0.7-1.1
Quarterly return11.33.28.1
Up years 312731
Down years6106
*Simon Thompson advised buying the sector early on 26 November 2013, so performance period is 18 weeks to 31 March 2014; advised the same trade on 25 November 2014, so performance period is 18 weeks to 31 March 2015; and recommended the same trade on 7 December 2015 and closed it on 6 April 2016, so performance is over 17 weeks ('Housebuilders updates', 6 Apr 2016).

 

It's also worth noting that only twice since 1980 (in 2000 and 2016) has the UK housebuilders' index fallen more than the UK market when equities ended the first quarter in negative territory. On the other eight occasions when the UK market declined in the first quarter, the housebuilders outperformed the FTSE All-Share by an average of 11.9 per cent. In other words, it's pretty rare to see this stock market sector underperform in this specific three-month period even when the general market falls. Furthermore, when the sector rises in the first quarter - as has been the case 31 times since 1980 - then we can expect a very strong outperformance. Indeed, in all bar three of those 31 years it outperformed the FTSE All-Share, posting an average gain of 15 per cent in those 31 'up' periods, or more than three times that of the FTSE All-Share.

Of course, as last year proved, no investment strategy is guaranteed to produce a profit every time. However, I feel that the odds favour a first-quarter rally this year, which is one of the reasons I advised buying shares in three small-cap housebuilders, Inland Homes (INL), Telford Homes (TEF), and Urban&Civic (UANC), just before Christmas in an online-only article ('Built for gains', 19 Dec 2016). There are sound reasons to believe the FTSE 350 players will enjoy one too.

 

Reasons to expect a first-quarter rally

Firstly, this time of the year is when investing in 'cyclical' or 'value' stocks - namely, those that are very sensitive to changes in macroeconomic conditions - does incredibly well. And having seen the share prices of the FTSE 350 housebuilders fall by almost 18 per cent last year, mainly on worries over UK's Brexit and an economic downturn (a reaction at odds with the subsequent positive newsflow from the housebuilding sector), so underperforming the FTSE All-Share by 31 per cent in the past 12 months, then on valuation grounds the set-up is more favourable for a first-quarter rally than it was 12 months ago.

Secondly, the sector is still enjoying relatively benign conditions: mortgage rates are at multiyear lows, so underpinning affordability of home buyers; the rate-setting monetary policy committee of the Bank of England is unlikely to respond to rising UK inflation expectations in the first half of this year with its first base rate rise given its more cautious economic outlook, even if this stance has so far proved wide of the mark post the EU referendum; and housebuilders' profits continue to reap the benefit of cheap land acquired during the depths of the recession. Demand in the housing market is also being underpinned by a raft of government initiatives, record UK employment levels and substantial net migration, so creating additional demand for new housing. At the same time there is a skills shortage stopping the sector boosting output to anything like the level needed to put supply and demand back into equilibrium, a factor that's impossible to gloss over even if the UK government wants to increase the supply of new housing starts.

Thirdly, valuations are once again relatively attractive. On average, shares in the FTSE 350 housebuilders are trading on just shy of eight times forward earnings and offer a prospective dividend yield north of 6 per cent based on the latest forecasts from broking house Peel Hunt. A price-to-book value ratio of 1.7 times doesn't seem unreasonable in relation to an average post-tax return on equity of around 21 per cent.

 

FTSE 350 Housebuilders' key financial data

CompanyPrice (p)Mkt cap (£bn)Share price change 2016 (%)Price-to-book valueForward dividend yield (%)Forward PE ratioNet cash (net debt)Year-end
Barratt 466p£4.7bn-26.1%1.177.7%8.5£592mJun 2017
Bellway2,453p£3.0bn-12.7%1.534.7%7.1£26.5mJul 2017
Berkeley (note one)2,808p£3.9bn-23.9%1.987.1%7.0£208mApr 2017
Bovis820p£1.1bn-19.2%1.145.6%7.9(£8m)Dec 2017
Country side Properties241p£1.1bnna1.833.0%9.9£12mSep 2017
Crest Nicholson456p£1.1bn-18.7%1.777.9%6.3£77mOct 2017
Galliford Try1,291p£1.1bn-15.3%1.787.5%8.3(£8.7m)Jun 2017
Persimmon1,768p£5.4bn-12.4%2.336.2%8.5£462mDec 2017
Redrow427p£1.6bn-8.7%1.553.2%7.3(£139m)Jun 2017
Taylor Wimpey156p£5.1bn-24.4%1.978.8%8.0£360mDec 2017

Notes: 1. Berkeley Group is returning 200p a share per year including buybacks, and 1,000p in total in the five years to September 2021

Source: Forward PE and dividend yields based on forecasts from Peel Hunt

 

Moreover, a high percentage of those net profits are being returned to shareholders as boards recycle cash flow from housing sales back to shareholders, a policy underpinned by robust balance sheets - all bar Redrow have net cash positions or negligible borrowings - and strong land banks. To put the current valuations into some perspective, when I last advised this trade in December 2015, the FTSE 350 homebuilders were trading on an average forward PE ratio of 11.6, offered a prospective dividend yield of 4.3 per cent (including special payouts), and were rated on 2.26 times book value. This means that their forward PE ratios are a third lower than 13 months ago, prospective dividend yields are almost 45 per cent higher, and price-to-book value ratios have declined by a quarter. In my book, that's value and supportive of my favourite first-quarter rally taking place once again.

Fourthly, recent trading statements from the major players have been positive and highlight that demand in the new housing market has not been affected by the EU referendum, contrary to what some leading commentators were anticipating six months ago. Please note that Bovis announced last week that 160 sales have been deferred into early 2017, but this is a timing issue as the company has started 2017 with more forward sales than in 2016. It's also worth taking into account the sharp falls in sterling in the past 12 months, which now make UK property far more attractive to overseas purchasers even after factoring in the higher level of stamp duty.

Fifthly, I would highlight the fallout from former chancellor George Osborne's misguided reforms of the taxation system of the buy-to-let market which come into effect in April, impacting as many as 400,000 private sector landlords, according to the National Landlord Association. By reducing the proportion of finance costs that can be offset against a landlord's rental income for tax purposes, thus increasing the tax take for the Treasury, this is likely to reduce the supply of rental properties in certain parts of the country where leveraged landlords are unable to increase rents and decide to sell up instead, but will undoubtedly drive up rents in other areas where the rental market is far tighter as landlords will try to recoup their lost income from tenants, so boosting gross yields on their properties. And because almost half of all buy-to-let properties are unencumbered in the first place, this could actually enhance yields for landlords where the market is tight.

In addition, the 3 per cent stamp duty surcharge on second homes is unlikely to dampen demand from cash-rich buyers if the yields on offer are attractive, potential for rental growth is underpinned by tight supply and the returns on alternative investments are meagre, as has been the case for the past eight years.

Bearing all these factors in mind, I feel that the risk premium embedded in the valuations of the housebuilders is too high and if newsflow remains positive then expect a modest unwinding of this premium. So with the housebuilders set to report bumper results, sound order books, strong cash generation and hefty dividend hikes, then the odds are skewed towards a continuation of the sector rally from post-EU-referendum lows.

I would therefore recommend buying a handful of shares in the FTSE 350 players to exploit the tendency of the sector to rally in the first quarter. The companies are: Barratt Developments (BDEV), Bellway (BWY), Berkeley (BKG), Bovis Homes (BVS), Crest Nicholson (CRST), Countryside Properties (CSP), Galliford Try (GFRD), Redrow (RDW), Persimmon (PSN) and Taylor Wimpey (TW.).

 

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