Third-quarter earnings wrapped up for the publicly traded home builders Nov. 10 with D.R. Horton reporting fully diluted earnings per share of $2.24, handily beating analyst consensus expectations of $1.76. This was a common theme for the industry, as the builders posted better-than-expected operating results across a number of metrics, including net new orders, revenues, and profitability.
Yet despite the solid results, the housing-related stocks underperformed the broader market over earnings season (defined as the time period from Oct. 19 to Nov. 10), as the S&P Homebuilders Exchange Traded Fund (XHB) declined 2.6% compared with a 3.5% gain for the S&P 500. While it is always difficult to interpret stock market moves over the short-term, the analysts and investors I spoke with following the results offered a few explanations.
Strong year-to-date performance. Heading into earnings season, home building was one of the best performing industry sectors in the S&P, with the XHB gaining 18.4% versus a 4.1% increase for the S&P 500. The outperformance was even more pronounced from the trough of the COVID-19 sell-off in March with the XHB rebounding 118% from its lows compared with a 50% improvement in the broader market. Investors quickly realized that the home building industry would be one of the winners coming out of the pandemic, as the combination of record-low mortgage rates, scarce existing-home inventory, and a heightened sense of urgency to own a home drove buying activity sharply higher. By the time the third-quarter earnings season rolled around, investors had largely already given the builders credit for the improved operating environment, bidding many of the stocks up to their 52-week highs. As a result, the third-quarter results became a “sell on the news” phenomenon with many short-term traders taking profits by selling their positions.
Interest rates move higher. Home building stocks have historically had an inverse relationship with the benchmark 10-year Treasury yield—i.e., when the yield moves lower, builder stocks move higher, and vice versa. Investors understand that the majority of buyers finance the purchase of a home and that rates have a significant impact on buying activity as well as affordability. Over the course of earnings season, investors started to price in the likelihood of another COVID-related stimulus package from the government, giving rise to inflationary fears, which in turn pushed bond yields higher. As a result, the yield on the 10-year treasury rose 16 basis points from Oct. 19 to Nov. 10, representing a 20% increase. While this increase did not materially alter mortgage rates, the sharp percentage move higher spooked some investors into believing that this could be the beginning of the end of the historically low interest rate environment.
Community counts move lower. While investors and analysts had cheered the better-than-expected selling environment occurring in the summer and into the fall, they soon came to realize that there is a downside to running at such high absorption paces: faster-than-expected community closeouts. On several third-quarter earnings conference calls, management teams warned of declining community counts as the combination of elevated sales paces and a pause in land development and acquisition activity at the start of the pandemic was resulting in a lag in community count replenishment. While this phenomenon should prove to be short term in nature as builders eventually bring more communities to market, investors likely lowered their order growth assumptions for the industry.
Costs creep higher. Another issue facing the builders as a result of the strong market is the rise in input costs. The sharp increase in home building activity has put a strain the availability of labor and materials in most markets, which has pushed building costs higher. Several management teams spoke about focusing more on price versus pace going forward in an effort to pass these costs on to the home buyers. While the home builders have been successful in staying ahead of cost inflation so far, there is a growing concern among investors that we may have hit the peak in terms of profitability.
Despite these near-term concerns, most analysts and investors agree that the long-term outlook for the industry remains favorable. The lack of existing single-family home inventory coupled with the rise of millennials aging into their prime home buying years creates a supply-demand imbalance that will not be solved any time soon. This thesis remains intact despite some of the issues that arose during third-quarter earnings season, and I suspect most patient, long-term investors maintained their positions in the stocks.