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Alpha alert for housebuilders

Simon Thompson believes the back drop is favourable for a first-quarter sector rally
January 3, 2018

It’s a sign of the times that the hot topic at drinks parties I attended over the festive period wasn’t Brexit, nor the country’s obsession with house prices, but cyber currencies. In fact, some fellow partygoers even received an e-wallet in their Christmas stockings chock full of computer code. Not that the recipients had a great understanding of their gift to be honest, which is why they turned to me to explain exactly what Santa had left them.

It caused more than a ripple of excitement when I pointed out that Santa had not only been generous, but shrewd too. In one case, he had spotted a short-term trading opportunity in cyber currency, Ripple, just before it surged ten-fold during December. Whether Ripple will be a cyber currency winner is not the point of this article, nor is whether or not its $100bn valuation is justified. Of far more interest to me is the fact that investors are willing to bet on cyber currencies in the first place, a consequence of the debasing of fiat money by the world’s leading central banks, all of which have pursued ultra-easy monetary policies for the past nine years, and adopted negative real interest rates. These zero interest rate policies have not only forced investors up the risk curve in search of income, but tempted some to speculate on alternative assets in a global financial system awash with liquidity: cyber currencies being just one beneficiary.

Bearing this in mind, it will be interesting to see how some of these alternative investments fare if the US Federal Reserve starts draining liquidity from the monetary system faster than market participants anticipate. That’s not an unrealistic possibility given that the Republicans' recent tax reforms could boost the US economy by as much as 0.8 per cent of GDP per year, according to economists. In my view, a faster rate of tightening of US interest rates poses the greatest risk to financial markets this year, and one that I am keeping an eye on as it has the potential to lead to a spike in volatility, equities included.

A short-term play

For now, though, it’s reasonable to expect the general market backdrop to remain relatively benign, and one supportive of playing my first-quarter housebuilders trading strategy. It’s proved a standing dish of the stock market, with the sector rising 32 times in the first three months of the year since 1980, falling just six times, and posting an average gain of 11.4 per cent, or 8 per cent more than a FTSE All-Share tracker.

Moreover, since I first discovered this phenomenon while carrying out quantitative research 14 years ago ('Time to take stock', 14 Nov 2003), the trend has strengthened with the ‘alpha’ – the excess return earned over an index tracker – increasing to 10 per cent on average in the first quarter since 2004.

Also, when the trade fails to work, the losses are manageable. For instance, despite the sharp market sell-off in the first six weeks of 2016, the average loss on the FTSE 350 housebuilders' shares was just 1.8 per cent when I closed my 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 tendency of this strategy to generate 'alpha'.

It's worth noting that only twice since 1980 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 almost 12 per cent. In other words, it's pretty rare to see the sector underperform in this specific three-month period even when the general market falls. Furthermore, when the sector rises in the first quarter, expect outperformance; it has outperformed the FTSE All-Share in all bar three of those 32 ‘up’ years, posting an average gain of around 15 per cent, a return three times greater than from a FTSE All-Share tracker. Last year was no exception, with the 10 FTSE 350 housebuilders rising on average by almost 14 per cent in the first quarter, or more than four times that of a FTSE All-Share tracker.

 

Table One: 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
201713.93.110.8
Quarterly return10.80.710.0
Up years 322832
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; 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); and recommended the same trade on 4 January 2017 and closed it on 4 April 2017 ('Taking Q1 profits and running gains', 4 Apr 2017).

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 well. True, shares in the housebuilders surged last year, but the sector pulled back in the autumn, so setting up the possibility of a return to last year’s highs if newsflow from the forthcoming corporate results season proves favourable. I expect it will.

Secondly, the sector is still enjoying benign conditions: mortgage rates are close to multi-year lows, so underpinning affordability; the rate-setting monetary policy committee of the Bank of England is cautious on raising interest rates due to its negative ‘Brexit’ economic outlook, and given that import price inflation from the devaluation of sterling post the EU referendum is now unwinding; and housebuilders' profits continue to reap the benefit of cheap land acquired during the recession.

Thirdly, demand in the housing market is underpinned by a raft of government initiatives, record UK employment levels and net migration, so creating a supply-demand imbalance supportive of new housing starts.

Fourthly, and importantly, valuations are attractive. The ten FTSE 350 housebuilders are priced on an average of 9.2 times forward earnings for the 2018 financial year, and offer a prospective dividend yield of 5.7 per cent based on forecasts from brokerage Peel Hunt. A price-to-book value ratio of 1.9 times also seems quite reasonable for companies underpinned by rock solid and unencumbered balance sheets and reporting an impressive post-tax return on equity of 20 per cent plus.

 

Table 2: FTSE 350 Housebuilders' key financial data    
CompanyPrice (p)Mkt cap (£bn)Forecast price-to-book valueProspective dividend yield (%)Forward PE ratioForecast net cash (£m)Year-end 
Barratt6506.61.86.79.9£940mJun-18 
Bellway3,5804.41.73.78.9(£3m)Jul-18 
Berkeley (note one)4,2095.72.13.78.7£367mApr-18 
Bovis11841.61.58.612.6£81mDec-18 
Countryside Properties3501.62.02.910.2£76mSep-18 
Crest Nicholson5471.41.57.27.1£6mOct-18 
Galliford Try1,2801.12.17.87.6£25mJun-18 
Persimmon2,7358.42.84.910.1£1202mDec-18 
Redrow6472.41.53.48.1(£57m)Jun-18 
Taylor Wimpey2036.62.17.59.2£611mDec-18 
         

Source: EPS, dividend, price-to-book values and net cash estimates all based on forecasts from Peel Hunt.

In the circumstances, I feel that current sector valuations are supportive of a first quarter rally ahead of and during the forthcoming corporate reporting season when the major players are set to report bumper results, strong cash generation and hefty dividend hikes. It therefore makes sense to buy a handful of shares in the FTSE 350 players to exploit the tendency of the sector to rally at this time of year. 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.).

Small-cap sector plays

I have no reason to alter my positive stance on the four small cap companies I follow with housebuilding and land development activities: Inland Homes (INL:62p), Telford Homes (TEF:421p), Urban&Civic (UANC:293p), and Henry Boot (BOOT:319p).

Henry Boot announced yet another bullish trading update in the autumn ('On the money', 24 Oct 2016), vindicating my bullish view on the company’s prospects. Following an accelerated completion of transactions, and the successful delivery of major development schemes through the second half of last year, analyst Guy Hewitt at broker FnnCap raised his revenue expectations from £373m to £395m to support a 15 per cent upgrade in pre-tax profit to £51.6m. On this basis, expect EPS to surge by a third to around 28.5p for 2017, and the payout per share to be hiked by 14 per cent to 8p, implying the shares are being priced on a modest 11 times likely earnings and offer a decent 2.5 per cent dividend yield.

I would flag up too that Henry Boot continues to backfill its opportunity pipeline and work on deals for 2018, thereby replacing those executed earlier than expected last year. So, with the earnings risk skewed to the upside, and the shares trading on a deep discount to broking house finnCap’s sum-of-the-parts valuation of 398p, I continue to rate them a buy.

The same is true of Inland, a leading brownfield regeneration specialist and housebuilder with a focus on the South and South East of England. In a first half trading update this week, chief executive Stephen Wicks revealed that his company’s “housebuilding programme is at a record level, with over 500 homes currently under construction and a healthy pipeline of new development projects in place for the coming months, supporting our positive outlook". He also noted that Inland has entered a 50/50 joint venture to develop a site for 95 houses in Ipswich with an estimated gross development value of £16m.

Land sales are going well too. In December, Inland completed the sale of 146 plots in Birmingham to Crest Nicholson, conditionally exchanged a contract with the same company for the sale of a further 87 plots on an adjoining piece of land, and sold 58 plots in Uxbridge, Middlesex to a private investor. The combined value of these dispolas is £12.7m.

Trading on eight times likely EPS for the financial year to end June 2018, offering a 3.3 per cent prospective dividend yield and priced on a 40 per plus discount to EPRA net asset value estimates of 105.25p, based on forecasts from analysts at equity research firm Hardman and Co, there is value on offer. I maintain the positive stance I outlined when I last updated my view ('On an earnings beat', 3 Oct 2017), having first included the shares in my 2013 Bargain Shares portfolio at 23p ('How the 2013 Bargain Shares fared', 7 Feb 2014). Buy.

Value opportunities with momentum

I also note that shares in Urban&Civic, a listed property group specialising in strategic residential land developments, have risen by 12 per cent since I advised buying ahead of the full-year results at the end of November ('Trading plays', 9 Oct 2017). As expected the company’s EPRA net asset value (NAV) posted a decent uplift, rising from 284p to 304p a share.

However, this only tells part of the story because surveyors’ valuations embedded in that EPRA figure incorporate a thumping discount on the actual open market prices of land parcels Urban&Civic is achieving at its 1,432 acre freehold site at Alconbury Weald, incorporating Cambridgeshire's Enterprise Zone; and at the 1,170 acre site in Rugby. Marking land to open market prices adds almost £100m to the company’s net asset value, a sum worth 68p a share. I fully expect the rerating to continue as further land is sold off and the hidden value in the accounts is crystallised. Buy.

My final play is London housebuilder Telford Homes. It’s proved a cracking investment with the share price rising almost 50 per cent since I spotted the potential less than 18 months ago ('London property trading play', 22 Aug 2016). I last advised running profits at 397p in the autumn ('A trio of small-cap plays', 16 Oct 2016), since when the share price has risen 8 per cent to 420p and is now heading back towards the May 2017 high of 439p. I reckon there is a decent chance of a chart break out.

The company continues to de-risk its £1.5bn plus development pipeline of 4,000 new homes by entering into build-to-rent funding arrangements with large institutional investors, while at the same time targeting the lower end of the London property market where there are chronic housing shortages. This strategy de-risks the forward sales pipeline, accelerates profit recognition, drives a higher return on capital as Telford no longer needs to fund these developments, and reduces gearing levels as capital is released from its land bank and working capital.

Indeed, chief executive Jon Di-Stefano noted at the recent interim results that Telford is bang on track to deliver pre-tax profits in excess of £40m for the 12 months to end March 2018, having secured over 95 per cent of anticipated gross profit already. Moreover, it has already secured two thirds of the gross profit needed for pre-tax profits to exceed £50m in 2018/19. Rated on less than 9 times Equity Developments EPS estimates, falling to 7.6 times 2018/19 forecasts, priced on a miserly 1.2 times March 2019 forecast net tangible assets, and offering a 4 per cent prospective dividend yield, Telford’s shares rate a trading buy with a chart break-out on the cards. Buy.

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com for £14.99, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source. Simon has published an article outlining the content: Secrets to successful stock picking