It’s time to sell out of the housebuilding sector – here’s why

Newly-built home © Getty Images
Housebuilders: boom will inevitably turn to bust

If you bought shares in a housebuilder three years ago, you’re probably feeling pretty happy now. Shares in several leading firms have doubled or trebled since then.

And with house prices still rising, you may be planning to hang on to your shares for some time to come.

I think that would be a mistake. You need to remember that this isn’t a ‘buy and hold’ sector. Housebuilding is a very cyclical business. Today’s boom will inevitably turn to bust at some point. And because stock market investors normally look ahead, share prices often start to fall before the good times have ended in ‘the real world’.

So that raises two questions: is now the time to sell out of housebuilders? And are there some more attractive sectors out there?

Why people like housebuilders

Let’s start by looking at the positives for housebuilders.

The big plus point is there’s plenty of unmet demand for housing, especially in southeast England. Yet the number of new housing starts is still well below the peak level it hit in the last cycle, according to broker Brewin Dolphin. As a result, builders can sell new homes at premium prices.

What’s more, Rics (the Royal Institution of Chartered Surveyors) thinks that house prices will carry on rising until 2020.

Even better, a modest relaxation of planning rules in 2012 means that housebuilders have more scope to boost the number of housing starts if they want.

And you could argue that many housebuilders don’t look that expensive – they’re largely trading on price/earnings (p/e) ratios of ten or 11.

Trouble is, because housebuilding is so cyclical, firms in this sector normally trade on lower p/e multiples than the stock market as a whole. (A company is less attractive to investors if there’s a strong chance that profits will fall in the future, as is so often the case with housebuilders – in other words, they’re less willing to pay a high price for £1 of earnings, because they can’t be confident that those earnings will still be there next year.)

Look below at the valuations for some of the best known stocks.

Share price Current NAV Price/Book Prospective p/e
(Dec 2014)
Barratt (LSE: BDEV) 382p 228.5p 1.67 11.61
Berkeley (LSE: BKG) 2387p 1031p 2.31 10.94
Bovis (LSE: BVS) 800p 604.2p 1.32 10.7
Galliford Try (LSE: GFRD) 1188p 455p 2.61 12.6
Persimmon (LSE: PSN) 1371p 671.4p 2.04 11.3
Taylor Wimpey (LSE: TW) 109p 69.5p 1.56 11.1

 

If you look at the price/book column, you can see that Galliford Try’s share price, for example, is more than twice as high as its net assets – including its land. Granted, that’s partly because Galliford also has a separate construction business. But all of these builders are on price/book ratios that look high to me.

I’m also worried that Rics may be over-optimistic on house prices. When interest rates start to rise, we may see some forced sales of homes as some people can no longer afford their mortgage payments.

Lenders have also been forced by the regulator to tighten their rules on how much they can lend to homeowners. These new affordability criteria were only implemented last month, so they may begin to make an impact soon.

But the most important point is that developers are starting to cut back on their landbanks, according to Brewin Dolphin. The broker says that developers are positioning themselves to make plenty of money in the short term, but not to be too vulnerable if the bubble bursts.

In other words, the housebuilders’ bosses fear that the good times will end in the next two or three years, and they don’t want to get caught out. Indeed Brewin thinks that 2016 is most likely time for a big slowdown in housebuilding. It’ll be a year after the election and interest rates will almost certainly be moving up by then.

Bigger payouts aren’t compensation enough to hang on

As these companies invest less money in land, they’re starting to return more money to shareholders. Some builders have drawn up long-term capital return plans with schedules for increased dividend payouts and share buybacks.

Thanks to these higher payouts, Brewin Dolphin reckons that income investors can stick with the housebuilders for a while yet. But growth investors – who are more interested in gaining from rising share prices – should consider getting out.

But I think that even the income investors should consider moving their money elsewhere. Although dividend payments may continue to grow for a while yet, a bad bust would trigger dividend cuts later this decade. You can probably get more sustainable dividends in other sectors – tobacco, pharmaceuticals and consumer goods spring to mind.

And as Brewin says, if you’re looking more for a mix of growth and income, the case for switching out of housebuilders is all the stronger. Once again, pharmaceuticals could be a better bet, and I also think some small-caps look like an attractive, if riskier alternative. (I highlighted some decent small-cap stocks to buy earlier this year. If you’re not already a subscriber, sign up for a free trial and you’ll get four free magazines plus access to our full web archive where you can read the article.)

Of course, another option is to use some of your sale proceeds to boost your cash balance. There’s no shame in holding some cash when a bull market is five years old and several housebuilder stocks have trebled.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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