Which homebuilders to buy?

As the housing boom continues, stick with stocks that have the strongest relative strength.

By InvestorPlace May 29, 2013 9:52AM

iplogoBy Ethan Roberts

The U.S. housing market continues to boom, even in the face of a tepid job market and overall economic recovery. The S&P Case-Shiller composite index of 20 metropolitan areas was released Tuesday morning, with the report continuing to exceed analysts' forecasts (see InvestorPlace).


Home under construction (© Corbis)Reacting to the news, homebuilder stocks were initially well up across the board before pulling back later in the session. However, not all were up similar amounts. Beazer Homes (BZH) and Hovanian (HOV) were initially up over 4%, yet Lennar (LEN) was up only about half of that, and has closed negative. The SPDR Homebuilders (XHB) rose about 2% before pulling back.

Last week, KeyBanc downgraded both Pulte Group (PHM) and Ryland Group (RYL) from "buy" to "hold," saying they had already gone up too far. At the same time, KeyBanc upgraded MDC Holdings (MDC), which has been a laggard, from "hold" to "buy." Analyst Kenneth Zener sees MDC as having improving performance. MDC's current price is $39.28, which Zener sees rising to a price target of $46 per share:

We are getting more selective on the builders following the recent rally, with a narrower focus on 1) when land was bought and 2) valuation upside, supporting our upgrade of M.D.C. Holdings, our downgrade of Pulte Group, Inc., and The Ryland Group, Inc, and higher price targets on Lennar Corporation (LEN) and Toll Brothers, Inc. (TOL).

The idea that a stock has run up too much is fine if the fundamentals or technical indicators don't support further price appreciation, and one can await a pullback before buying it. But the notion that one should buy the laggards of a sector simply because it has "more room to run" has never impressed me as being a sound investing strategy. As William O'Neil, founder of Investor's Business Daily and author of "How to Make Money In Stocks," wrote:

If you buy the leading security in the group and your timing is sound, you have a crack at real price appreciation. If, on the other hand, you buy equities that haven't yet moved or are down the most in price, because you feel safer with them and think you're getting a real bargain, you're probably buying the sleepy losers of the group.
One way to assess the strongest stocks in a sector is by comparing each company's performance to the others in the same sector over the past six months. I compared the following eight homebuilder stocks this morning, to see which have performed the best during those time frames. The data is in percentages, and is as of May 24. Negative numbers are in parentheses:


Looking at this table, it is obvious that Beazer Homes and Ryland have had the strongest relative strength in the group. I would not let the one-week pullback in those stocks -- nor the slightly better performance of MDC Holdings -- obfuscate what is readily apparent. Beazer and Ryland should continue to be the stronger stocks of this sector, and the performance of each Tuesday, relative to others in the group off the Case-Shiller report, is further evidence of that.

In other words, always buy the best stocks of a sector rather than the laggards, and you will increase the odds of getting the best performance from that group.

Ethan Roberts does not own shares of any of the companies mentioned in this article.

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