Though luxury homes are in demand, small builder stocks with the cheapest valuations are outperforming larger competitors this year.
Within the iShares U.S. Home Construction exchange-traded fund, which tracks builders, materials companies, and home goods retailers, the best performing stock is Beazer Homes, an $885 million builder of energy efficient homes based in Atlanta. At a recent $33.19, the stock's nearly 64% gain has less to do with business and more to do with its impending purchase by Dream Finders Homes for $33.50 a share in cash.
The ETF itself has struggled to break out of its range. The fund is up 3.4% this year as of Thursday's close, according to FactSet.
Behind Beazer, the next top performers are New Jersey-based Hovnanian Enterprises, which is up roughly 40%; Texas-based LGI Homes, which has gained 37% this year, and Colorado's Century Communities, up 21%.
All four share some commonalities, according to FactSet: they are trading near or below book value, a preferred metric for valuing builders, and all have relatively small market capitalizations, with Century's roughly $2 billion market value the largest of the group. A common rule of thumb is to buy home builders at or below one-times book value -- which is the value of a company's total assets minus its liabilities -- and sell at or above two-times book.
Larger builders with more expensive valuations are among those that have lagged behind in comparison. PulteGroup and Toll Brothers, which were up 11.3% and 10.4% this year, respectively, trade at price-to-book value multiples of 1.9-times and 1.7-times on a trailing 12-month basis, according to FactSet. D.R. Horton, the nation's largest builder, is up 4.1% this year with a price to book value multiple of 1.8-times.
The industry's merger fever for builders with relatively cheap valuations has likely been a driving factor for similarly positioned stocks. Japanese builder Sumitomo Forestry agreed to purchase the midsize builder Tri Pointe Homes in February for a 29% premium on the stock's price, and Berkshire Hathaway said in late May it would buy Taylor Morrison at a 24% premium.
Builder consolidation remains a hot topic in lieu of a housing market rebound. After a short-lived bout of enthusiasm around lower mortgage rates at the start of the year, high home financing costs have dulled the industry's appeal.
"Investor sentiment is it still not great," says UBS analyst John Lovallo, who covers home building. "This is an industry that people love to hate, and when rates are doing what they're doing, it makes it easy to hate."
Sales of previously owned homes have remained at low levels, logging a 0.7% gain in July over one year prior, according to National Association of Realtors. The greatest pickup in transactions was among the highest-priced homes, with sales above $1 million rising nearly 15% nationally from a year-ago.
Should it become clear that the worst is over for housing, with inventory levels, building costs, and mortgage rates stabilizing, "we think that there's a lot of upside in the back half," says UBS's Lovallo. If so, builders that have been buying down mortgage rates at the expense of their margin could benefit most.
Investors on the lookout for those signs should keep an eye on housing starts data, a government gauge of new construction, expected on Tuesday.
Toll Brothers will report third-quarter results on Tuesday after the market closes, followed by Hovnanian before the market opens on Thursday.
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