This year, it has been easy to be a contrarian about the homebuilders (NYSEARCA: XHB). The stocks are rallying on strength, driven by a rapidly diminishing backlog with an outlook that includes a sharp downturn in business. It looked for a long time like the homebuilders were rushing toward a revenue and earnings cliff, yet the stocks continued to rally. Now, Warren Buffett is getting into the picture, and the question is why?
The answer is normalization within the market and robust cash flow. The backlogs continue to decline, but signs within the data suggest a bottom is in play. A percentage of the economy has to move or buy a house or is unencumbered by rising rates, and that is sustaining business.
With the availability of existing homes falling to record levels and the shortage of homes profound, these trends could sustain the homebuilders, their cash flow, and capital returns for quite a few years.
What do the homebuilders offer besides cash flow? These stocks pay reliable dividends and repurchase shares and have been working to reduce debt, improve book value, and drive shareholder equity. That’s what the team at Berkshire Hathaway sees and is driving these stocks higher.
The point today is that the homebuilders have pulled back from recent highs and offer an opportunity to get into the market.
Toll Brothers Leads The Way Higher
Toll Brothers (NYSE: TOL) Q3 report is the first for the group and suggests strength will continue into the end of the year. While backlog is down 30% YOY, there was a significant uptick in new contracts signed, which points to a floor for the market. The rise in contracts is partly due to the temporary ebbing of interest rates, which is a risk. Interest rates are rising and will continue to be a headwind for the market. Regardless, Toll Brothers' revenue grew by 8% to outpace the analysts' expectation for a decline by 1200 basis points, and guidance is solid.
Margin widened at the gross and operating level to deliver a 51.6% increase in net income, a strength that is expected to hold for the foreseeable future. This led to a 58% increase in GAAP earnings aided by share repurchases. The company used its cash flow to pay its 1% yielding dividend and repurchase shares with ample leftover funds.
Repurchases more than double the dividend yield are not expected to end soon. Another tailwind that is blowing this stock and the group higher is the analysts. The trend in consensus price targets is bullish, with 8 revisions showing up immediately after the release; all contain price target increases, and the consensus is double-digits above the current price action.
KB Home And Lennar Are Set Up To Outperform
The analysts have raised their KB Home (NYSE: KBH) and Lennar targets (NYSE: LEN), but the bar may still be low. The results from Toll Brothers echo and are a continuation of trends set in Q2, which include outperformance, an increase in YOY net new orders, share repurchases, dividends, and balance sheet improvement.
KB Home and Lennar will report Q3 earnings in mid-September and may begin to rebound before then. The analysts rate both at Hold verging on Moderate Buy with price targets that have been trending higher and are about 10% above the current action. Assuming the Q3 results align with Toll Brothers, the analysts should resume the upward revisions and drive these markets higher if the rebound hasn’t begun by then.
The Technical Outlook: The Home Builders ETF Is In Rally Mode
The Home Builders ETF is in rally mode and on track to retest all-time highs. The market is recovering from a minor correction that shaved about 5% off the price. The correction could deepen to a full 10% but will likely find support at the long-term EMA in that scenario. If not, the market should resume the uptrend soon and could break out to new highs on solid results from Lennar and KB Home next month.