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.

"With no other builders currently likely to adopt Ryland's conservative, consistent capital reinvestment strategy, we expect shares to outperform peers over the next six to 12 months," Reichardt wrote.

Only two analysts offer a price target on Ryland, according to Thomson Financial, but, for what it's worth, their average of $58 implies an upside of more than 40% in the next 12 months or so. Include the dividend and the total return comes to more than 42%.

MDC Holdings (MDC) is another play on valuation and distinctive fundamentals. Shares are down 9% year-to-date to $51.83 as of Monday's close. That puts the price/book at 1.1, a deep discount to its five-year average of 1.6. In the last year the shares are up 1%, lagging the S&P 500 by 22 percentage points.

Argus Research analyst Rashid Dahod rates MDC a Buy. He likes that it's more liquid and less leveraged that many of its peers, and given the right opportunity could purchase additional lots. Moreover, the company has no joint-venture exposure and just enough land to build on for two years. "This stands in contrast to more leveraged builders with much larger supplies of land, in some cases up to eight years' worth of sales," Dahod wrote in a note to clients.

The average of three analysts' price targets for MDC stands at $60, implying an upside of nearly 16%. Throw in the dividend and the projected total return comes to nearly 18%.

On the opposite side of the value spectrum from those buys stands NVR (NVR). Improbably, the shares are actually up, gaining 7% year-to-date to $689 as of Monday's close, lagging the broader market by just a point. In the last year the stock's up 32%, about eight percentage points ahead of the S&P 500. The price/book ratio of 3.1 represents a steep discount to the five-year average of more than five but a whopping premium to the group, which trades near book value.

To be fair, NVR deserves a premium valuation because of some very wise decisions made during the hottest years of the bubble. "NVR is absent from the real problem markets that dog the other home builders, and it followed a much different and very conservative strategy during the boom years," notes A.G. Edwards analyst Gregory Gieber. "These attributes give NVR a unique degree of 'immunization' against the worst of this correction."

But with shares at current levels, that immunization looks likely to wear off. Analysts certainly think so. Whereas they differ on whether Ryland and MDC are Buys or Holds, in NVR's case the debate is over whether it's a Hold or a Sell.

The clincher, though, is insider sentiment. Since late April the company's officers and directors have unloaded nearly $240 million in stock. Most notably, from April 25 to May 3, Chairman Dwight Schar sold almost 260,000 shares for a market value of more than $210 million, according to Thomson Financial. Meanwhile, CEO Paul Saville sold more than $4 million in stock late last month. If the insiders who pursued arguably the smartest strategy throughout the boom years believe the stock's topped out, investors would be wise to move out, too.