As safe as houses

I first discovered the phenomenon while carrying out some quantitative research a decade ago ('Time to take stock’, 14 November 2003). At the time I noted: "On average, you would have made a healthy 8.1 per cent profit over the first three months of the year by investing in the housebuilding sector...and anyone possessing the Midas touch by calling the top in each of those first quarters would have made an average three-month return of 15.7 per cent since 1992." I also noted that the strategy was relatively low risk, because in "only two of the 12 years have produced negative returns".

I identified several specific factors to explain why this phenomenon occurs. "The main one is the reporting season for housebuilders, which starts during late February and early March. As a result, we are guaranteed news flow from the leading players (and generally positive news at that) and, more importantly, the market focuses on the companies' outlook statements. Combine this with general media attention on the spring housing market (this is the time of year most of us prefer to move house), and we have all the ingredients in place for a rerating." It worked a treat because in the first quarter of 2004 the sector surged 19 per cent.

History lessons

As scholars of stock market trends and economics will know all too well, 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's therefore worth noting that the factors I identified driving the sector returns almost 10 years ago are the same ones at work today. Moreover, if anything the trend has become stronger, rather than weaker, even though more investors are aware of the bumper gains to be made.

Table 1: FTSE 350 Housebuilders' first-quarter performance since 2004

In fact, in the past 10 years, the housebuilding sector has produced an average gain of 10.8 per cent in the first three months of the year, which compares favourably with the aforementioned 8.1 per cent first quarterly profit in the period between 1992 and 2003. The risk has diminished, too, because the sector has actually risen in the three-month period in no fewer than nine of the past 10 years. To put that into some perspective, the FTSE All-Share index has struggled to post a positive return in the first three months of the year, averaging a gain of just 0.6 per cent and falling three times in the first quarter in the past 10 years.

Table 2: FTSE 350 Housebuilders' first-quarter performance since 1980

Seeking alpha

This means that the 'alpha' the sector has generated over the market has been an eye-catching 10 percentage points in the three month period since 2004. This is the excess return by investing in the sector after taking into account the performance of the market. If anything, the trend is strengthening. In the past three years, the sector surged by 12.7 per cent in the first quarter of 2011, and by 24.7 per cent in both the first three months of 2012 and 2013. These returns represent eye-watering annual returns which any investor would be delighted with, let alone gains made in only a 13-week period.

Or to put it another way, if an investor had purchased shares in the home builders in the first quarter of 2004; taken profits at the end of March; put the cash under the mattress for the other nine months of the year; and then repeated the process all over again the following nine years; a modest investment of £10,000 would now be worth almost £28,000. A similar investment in the FTSE All-Share index would only be worth £15,000 (excluding dividends) and that's having the advantage of being invested in the market for the whole period.

Table 3 - FTSE 350 Housebuilders' performance in first quarter of 2011

Table 4 - FTSE 350 Housebuilders' performance table in the first quarter 2012

Table 5 - FTSE 350 Housebuilders' performance table in the first quarter 2013

Enhancing alpha

Having advised readers of Investors Chronicle to invest in the sector once again in the first quarter of 2013 ('Foundations for a rally', 10 December 2012), I noted some interesting historical trends half way through the first quarter ('Seeking alpha among the housebuilders', 11 February 2013).

Six weeks into the year and shares in the eight FTSE 350 home builders were showing an average gain of 7.8 per cent calculated on an offer-to-bid basis, a modest 1.1 percentage point outperformance of the 6.7 per cent return on the benchmark FTSE All-Share index at the time. This was very interesting because although past performance is generally no guide to future success, I noted that "of the 20 times when the homebuilders have produced a return of 7.5 per cent or over in the first quarter, not once has the FTSE All-Share beaten the sector in that period in over three decades". So, with markets rallying strongly, it was fair to assume the outperformance was likely to continue from mid-February 2013 to the end of March 2013.

In fact, I discovered that "the average outperformance by the housebuilders has been 13.5 per cent over the three months in those 20 years and, in no fewer than in 11 years, the 'alpha' created was over 10 per cent in the first quarter. Only once in those 20 years, in 1989, has the 'alpha' been less than 1.1 per cent outperformance and, in that year, the sector then went on to rise more than 16 per cent in the three-month period so the trade proved fantastically profitable."

The bottom line was that the sector looked primed to continue outperforming the market in the subsequent seven weeks to the end of March 2013. It did so in spectacular fashion, ending the first quarter up 24.7 per cent. This meant that anyone following my advice when I repeated my earlier buy recommendation on the sector in mid-February 2013 made a 15.6 per cent return in the following seven weeks. In the same period, the FTSE All-Share index rose only 2.4 per cent.

Reasons for the phenomenon

Housebuilding is a highly-seasonal business with newsflow and sales firmly skewed towards the all-important spring selling season. So at this time of year there is increased interest in the sector as investors focus on price trends and the strength of the underlying housing market. And as companies have a firm bias towards reporting financial results in the first quarter - since the majority have calendar or January year-ends - this also brings into focus the merits of the housebuilders.

There is also another reason why the sector outperforms the general market in the first quarter: this time of the year is when investing in 'cyclical' or 'value' stocks - ie. those that are very sensitive to changes in macroeconomic conditions - does well. Moreover, with mortgage rates currently at multi-year lows and housebuilders' profits getting a lift from cheap land acquired during the depths of the recession, the sector is enjoying relatively benign conditions right now. Demand in the housing market is also being underpinned by a raft of government initiatives just as the UK economic recovery gathers pace. This not only creates a favourable tailwind, but also provides a strong likelihood that earnings of the major housebuilders could be inline for analyst upgrades by the time they start reporting financial results early next year.

Playing the trade

Clearly, no trade is guaranteed to produce a profit and the sector is clearly susceptible to general market weakness and profit-taking following the sharp re-ratings enjoyed in the past year. But it's worth noting that only once (in 2000) in the last 33 years has the 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 fell in the first quarter, the housebuilders outperformed the index by an average of 11.9 per cent. In other words, it's pretty rare to see the sub-sector underperform in this specific three-month period when the general market falls. Moreover, when the market rises, we can expect absolute outperformance.

And because I believe the UK stock market will continue to rise in the first quarter next year, then it’s fair to assume the nine FTSE 350 housebuilders will do well too. In fact, I am so convinced that I would recommend jumping the gun and buying them now especially since many investors may well have the same thought come the new year. My aim is to hold the shares for four months until the end of March. The nine housebuilders in the FTSE 350 to buy now are: Barratt Developments (BDEV), Bellway (BWY), Berkeley (BKG), Bovis (BVS), Crest Nicholson (CRST), Galliford Try (GFRD), Redrow (RDW), Persimmon (PSN) and Taylor Wimpey (TW.).

Table 6: FTSE 350 Housebuilders' key financial data

Key points to note:

■ Trend for housebuilders to rally in first quarter has strengthened in past decade.

■ 'Alpha' from holding the housebuilders in the first quarter has increased in the past decade.

■ Monitor relative performance of home builders during the first quarter. When the sector is showing a gain of over 7.5 per cent and outperformance is low and below historic average for the first quarter, housebuilders are highly likely to continue to outperform for rest of three month period. This provides an opportunity to add to shareholdings, or enter new positions.

Finally, I have written two columns today, both of which appear on my home page. In response to recent newsflow, I am currently working my way through a long number of updates on the following recommendations: Bezant Resources (BZT), PV Crystalox Solar (PVCS), Crystal Amber (CRS), API (API), Mountview Estates (MTVW), Daejan (DJAN), Bovis Homes (BVS), WH Ireland (WHI), Netcall (NET) and Pilat Media Global (PGB).

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