Ryland, MDC Stand Out as Worthy Fixer-Uppers

Residential real estate has been cooling for almost two years now, dragging home builders' shares down with it. The Dow Jones U.S. Home Construction Index, which serves as a proxy for the sector, has tumbled by half since peaking in July 2005, battered by a seemingly endless procession of bad news. Just today the Commerce Department said housing starts fell in May, while on Monday the builders' sentiment index compiled by the National Association of Home Builders slid to its lowest point since 1991.

Yet patient investors with a stomach for volatility have at least a couple of opportunities to buy low. There's also one stock that, if insider sentiment is any indication, is screaming to be sold.

As counterintuitive as it may seem at the moment, there's a good case to be made for some home builders. Indeed, Citigroup analyst Stephen Kim is actually bullish on the entire sector, positing that the short-term buying frenzy in the first half of the decade overshadowed a long-term shift in industry fundamentals.

"The linchpin to our bullish stance on the public home builders remains our conviction that a widespread, entrenched supply constraint emerged in the home-building industry in the mid-1990s — in the form of a bottleneck in the land development pipeline," Kim has noted repeatedly in his research. "Anti-sprawl sentiment has kept housing starts over the past 15 years well below prior record levels, despite obviously strong demand."

That pushed growth rates and margins for elite builders dramatically higher since the mid-90s, and Kim believes there's no going back.

"Intriguingly, the home-building stocks have continued to trade as if their strong results are entirely due to ephemeral factors, such as low interest rates and speculative demand, which are currently evaporating," he writes. "While unnaturally high demand did provide a boost to the builders' 2004 and 2005 results, we believe this effect was minor compared to supply constraints."

Consequently, Kim thinks home builders' stocks will appreciate aggressively late in the third quarter and stage a strong rally in the fourth in anticipation of an eventual housing recovery.

If you find that thesis persuasive, Ryland looks like one of the better plays in the space, given its valuation and fundamentals. Shares are off 25% year-to-date to $41.12 as of Monday's close. That puts the stock's price/book ratio at 1.2, well below its five-year average of more than 2.0, according to Reuters data. In the last 52 weeks the stock has dropped 7% vs. a 23% gain for the broader market.