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Why U.S. home building stocks look cheap Add to ...

After three years of falling home prices and sagging sales, the U.S. home building industry is finally beginning to look like a bargain.

Stocks in the sector look particularly cheap from a Canadian perspective. With the loonie trading around parity with the U.S. dollar - and overvalued by about 20 per cent based on measures of each currency's buying power - there is good reason for investors on this side of the border to diversify into U.S. assets.

Granted, any turnaround in U.S. housing will take time to unfold. By some counts, the total number of homes for sale, including so-called "shadow inventory" of likely foreclosures, amounts to about 20 months worth of sales - more than three times the norm.

Despite the swollen backlog, there are at least eight reasons why patient investors may want to consider investing in the downtrodden sector.

Pent-up demand: Economists at the National Association of Home Builders (NAHB) estimate that there are "2.1 million missing but expected households that have been delayed due to the Great Recession." These are people in their twenties and thirties who are still living at home with their parents, and individuals who have doubled up with roommates.

The NAHB study adds: "As the labour market improves, these potential households will be unlocked, helping to reduce the excess supply of housing - perhaps faster than many analysts expect."

Fed's focus on unemployment: An unemployment rate of about 9 per cent is one of the biggest factors holding back demand for U.S. houses. But the Federal Reserve has declared it is now focused on providing the stimulus required to bring down joblessness and boost the housing sector.

Inflation hedge: With the amount of stimulus being unleashed by U.S. policy makers, inflation could gather momentum once the slack in the economy is taken up. Real estate usually fares well in inflationary environments.

Population growth: Jeffry Chmielewski, a private investor and former hedge fund manager, notes on the seekingalpha website that the steep drop in home construction from 2008 to 2010 brought the number of housing starts during the 2000s back in line with the historical tendency for housing starts to track population growth.

If the U.S. population grows over the coming decade at the historical rate, 13 million to 15 million new houses will be required by 2020. With inventories of new construction at all-time lows, housing starts "will need to double or triple in order to keep up with population growth," Mr. Chmielewski estimates.

Housing stocks still out of favour: Sentiment on home builders' stocks remains pessimistic. For example, the Motley Fool community gives home builder stocks their lowest rating, one star. For contrarians, that's good news.

Record affordability: U.S. housing has never been as affordable. In the fourth quarter of 2010, the NAHB/Wells Fargo's Housing Opportunity Index signalled that 74 per cent of all homes sold nationwide were affordable to families earning the national median income of $64,400 (U.S.). That is the eighth consecutive quarter above 70 per cent. Until the recent streak, the index never had been above 70 per cent.

Home builders in better shape: "The balance sheets of home builders are in their best shape in years," says William Mack, a former Standard & Poor's equity analyst who now manages individual investment accounts. "The average builder has cut its net debt by roughly $1-billion since 2006 peak levels" through lower inventories, reduced operations, tax refunds and secondary share issuances.

The process of writing down land holdings appears just about complete. In fact, Mr. Mack says, the majority of existing land inventories now consists of land purchased in the past two years at relatively reduced, or distressed, prices.

Many of the smaller builders went out of business during the recession, leaving the larger builders to benefit disproportionately from any upturn.

Mean reversion: Residential construction in the U.S. has accounted for about 5 per cent of gross domestic product since the 1970s. The percentage in 2010 is estimated to be around 2.5 per cent. If activity reverts to the historical mean, home builders will profit.

Then there is the NAHB/Wells Fargo Housing Market Index, which tracks current sales, expected sales and traffic at more than 300 U.S. builders. The index ranges between 0 and 100 and registered a reading of 16 in February. By comparison, the index came in at 72 at the peak of the market during the summer of 2005. Again, a reversion to the mean would boost home builders.

If the contrarian case for U.S. home building stocks appeals to you, consider the SPDR S&P Homebuilders The exchange-traded fund is up from its early 2009 lows, and could climb much higher assuming the housing sector fixes its imbalances over the coming years.

Charging a gross expense ratio of 0.35 per cent, the home builder ETF tracks two dozen equally weighted companies tied to the U.S. housing sector. Included are home builders such as NVR Corp., and retailers such as flooring company Armstrong World Industries Inc.

Disclosure: Author owns units in the SPDR S&P Homebuilders ETF.

This article first appeared on Globe Investor Gold.

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