As regular readers of my columns and followers of my share recommendations will be well aware, I have a keen interest in the sector. Indeed, I have no fewer than four live buy recommendations on the following companies: Barratt Developments (BDEV: 345p), Taylor Wimpey (TW.: 108p), Bovis Homes (BVS: 750p) and Inland (INL: 45p). In all cases, prospects are little changed from when I last updated the investment case. In fact, if anything, they are even rosier than before.
However, following a surge in share prices last year and into the first quarter of 2014, some investors have been taking money off the table in the past couple of months. In hindsight, that has proved the correct short-term move given that prices of these companies have come off between 10 and 20 per cent in the same period. However, that should not detract from the merits of holding these shares for medium-term gains. Indeed, I included both Barratt and Taylor Wimpey in my 2014 Bargain share portfolio in early February for this very reason. I also maintain my upbeat view on Inland even though shares in that company have more than doubled in the 12 months since I included them in my 2013 Bargain share portfolio. My target price of 60p, a third above the current share price, remains unchanged and I can only reiterate the buy case made by my colleague Jonas Crosland last month ('Inland still too cheap', 3 April 2014). My positive stance is built on sound foundations, too.
The UK housing market
In my opinion, it is difficult to see a scenario whereby the housing market outside London has peaked out. In most regions prices are well below their 2007-08 highs, and have only just started to gain momentum. The London market, as has been well documented in the press, is a law onto itself with the combination of a chronic undersupply of new housing, a rising population and investor demand from overseas resulting in ever increasing prices. The natural consequence of this is that the ripple effect from the capital will in time spread into the Home Counties and beyond, as London buyers cash in their chips and take advantage of the widest relative valuation gap between the Capital and the regions on record. It's clear from price trends and reports from housing analysts and estate agents that this is now happening.
It is also clear that with the UK economy recovering strongly, and interest rates at record lows, those that are able to borrow to fund their purchases are feeling far more comfortable now than a couple of years ago. That confidence is unlikely to dissipate any time soon. If anything, it will become self-fulfilling as the media jumps on the housing market bandwagon and induces homebuyers to take the plunge before prices run away from them. Even the Royal Institute of Chartered Surveyors (RICS) has indicated that the current housing market boom has potential to run until 2020.
Mortgage and interest rates
True, the government's 'Help to buy' mortgage guarantee schemes and the Bank of England's Funding for Lending programmes have proved a major fillip in both improving the ability of home buyers to make their purchases, and in turning on the taps of mortgage lenders to provide them with the finance at rock bottom rates. But equally, a scan of available mortgages on the market today highlights that there is now better availability of funding for home buyers outside these schemes at higher loan-to-value ratios than was the case a few years back when only buyers with 40 per cent plus deposits could access the best rates. It's hardly a surprise either, as mortgage lending is one of the most highly profitable earners for banks and building societies. That's because the security offered in the UK housing stock reduces the capital required to back up this lending and, in turn, generates a higher return on capital on a risk-adjusted basis for financial institutions.
Lenders can also exploit the distorted impact on the yield curve of record low Bank of England base rates and Libor money market rates, by borrowing short term and lending at much higher mortgage rates to borrowers on three, five and 10-year fixed rates, so creating a sizeable and very profitable 'yield' gap. That is unlikely to change in the next nine months as the earliest indications are that UK interest rates will not rise until sometime late in the first quarter of 2015. Even then, expect the rate setting Monetary Policy Committee under the guidance of Canadian governor Mark Carney to adopt a conservative approach when they finally press the button on increasing the Bank's base rate. That's because there is still uncertainty among economists whether or not the UK economic recovery is strong enough, and sustainable enough, to withstand far higher rates.
I adhere to that line of thinking because, although UK employment is well above 30m, an all-time high, and unemployment is well under the 7 per cent target rate needed for Bank base rate to rise, the impact of five years of financial repression has taken a chunk of cash from the pockets of millions of consumers' and mortgage payers' net disposable income. This cash would otherwise have been used to fund higher mortgage rates. For the most stretched, the first rate rise will prove a tipping point into financial misery. Given that the consumer generates two-thirds of the UK's GDP, the MPC are all too well aware of the risk of killing the recovery at too early a stage by depleting the resources of hard-pressed mortgage payers.
It's well worth noting that millions of borrowers are currently on variable rate mortgages with partly state-owned financial institutions. These are generally priced at around 3 per cent, so even a 0.25 per cent rise in interest rates would result in a 12.5 per cent increase in monthly interest payments. Factor in the effect of five years of financial repression, and these borrowers are now far more sensitive to rate rises than ever before because they simply don't have the comfort of enough surplus disposable income.
It will also be on the minds of the members of the MPC that the longer they leave the first move in interest rates, the fewer there will be in this unfortunate financial position. That's because inflation has been falling sharply which will relieve some of the pressure on the most hard-pressed. It may seem a strange situation to have a housing market booming in certain parts of the country and an economy set to be the fastest growing in Europe, but the Bank of England is in a quandary as to whether to raise rates to dampen the enthusiasm. But that's exactly how it looks from my perspective.
In any case, if there are genuine worries about a 'bubble' being inflated in London house prices, then this could be easily addressed by dampening both domestic and investor demand by lowering loan-to-value ratios on properties in the Capital. It may also remove some of the speculative excess from overseas investors targeting London residential property as a one way bet. This way the regions can continue their housing market recovery on the back of an improving UK economy without being penalised by an interest rate rise too early.
So having taken all the above factors into consideration, it's my view that the current market recovery has quite some way to run assuming, of course, a non-intrusive political outcome at the next general election in a year's time.
The question therefore is how much of this good news story is already in the price of the homebuilders whose shares have fallen despite the very positive newsflow in the past couple of months. The answer is not enough.
Undervalued
A spate of trading updates has confirmed that the combination of rising prices and increased output is feeding through to sharply rising margins and profits. For instance, Taylor Wimpey expects its current year operating margins to rise between 200 and 300 basis points from 13.6 per cent in 2013, and to post further gains next year. According to analysts at Brewin Dolphin, the company's margins could peak out at 19 per cent by 2016, slightly less than for Persimmon (20 per cent) and Berkeley Group (23 per cent).
And with less capital being deployed on land banks which were replenished at rock bottom prices a few years ago, the builders are in a sweet spot whereby land is being converted into cash in a booming market and is being returned to shareholders. The average-owned land bank of the FTSE 350 homebuilders is around 5.5 years at current build rates, and these holdings exclude strategic land which is under option or awaiting planning consent. This explains why Brewin Dolphin have a current year forecast dividend yield of 3.5 per cent on the FTSE 350 homebuilders, rising to 5.3 per cent in 2015.
It also means that if markets remain firm, these longer land banks will provide companies with an extended period of higher margins, something I feel is not being reflected in the current valuations. Indeed, the FTSE 350 homebuilders are currently trading on around 1.7 times book value and priced on around 10.5 times forward earnings estimates. Barratt's is the lowest rated on just 1.1 times book value and, although Taylor Wimpey is higher rated on 1.6 times, the company is returning £250m of capital back to shareholders this year and next and plans to make significant further cash returns in 2016.
It also seems lost on the housing market jeremiahs that there is a chronic imbalance between new supply coming onto the market and demand across the UK, and not just in the hotspot in London. This is not going to change in the coming years, and this imbalance could even be accentuated if prices continue to rise, as this will fuel the demand side even more. In fact, new housing starts were only 120,450 last year, only two-thirds of the last peak in March 2006.
In the circumstances, I feel the correction in the share prices of all four of my sector picks is overdone and if you are willing to take anything other than a very short-term view, all are worth buying at the current levels.
■ Due to a technical glitch, the complimentary postage offer for IC readers purchasing my book Stock Picking for Profit ended prematurely last week. Subject to availability, the offer has been extended to 26 May for all internet orders placed at www.ypdbooks.com. Please use offer code ICOFFER when ordering online. The book is priced at £14.99, plus £2.75 postage and packaging. Telephone orders placed with YPDBooks (01904 431 213) will continue to incur the £2.75 fee. I have also published an article outlining the book's content: 'Secrets to successful stock-picking'
