10 housebuilder shares: best value, momentum, margins, and dividends

There are three tables for the price of one this week as stock screen expert Ben Hobson investigates which housebuilding stocks are a screaming buy and which ones are overpriced.

After years of easy economic conditions, the home construction market was hit by severe headwinds in 2022. But could a brighter outlook make this notoriously cyclical sector a better prospect for investors this year?

When it comes to benchmarks of UK economic health there are very few stock market sectors quite as closely watched as home construction.

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Activity and confidence across the industry is naturally important to anybody who owns (or wants to own) their own home. But its impact is felt throughout the economy. Little wonder that construction is scrutinised by everyone from mortgage lenders to politicians.

In boom times, big builders make big profits, attracting investors with strong price momentum and highly attractive dividend yields. But when the outlook darkens, share prices quickly retreat, and that’s exactly what we saw last year.

In the first nine months of 2022, the FTSE 350 Construction & Materials index fell by 28.6%. After more than a decade of low rates, modest inflation and a supportive economy, a lot changed.

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High and rising inflation drove up costs across the industry and put pressure on consumer spending. Meanwhile, rising interest rates made mortgages less affordable for hard-pressed borrowers.

Mortgage costs are set to get even trickier for new buyers, with the imminent closure of the government’s Help to Buy equity loan scheme set up in 2013. It’s unclear what impact this will have on sales of new homes.

Put together, it’s no surprise these headwinds have affected builders. According to the latest S&P Global/CIPS UK Construction PMI survey, a sharp decline in house building in January marked the fastest fall in construction output since May 2020.

However, an interesting finding in the latest data is that construction firms are growing in confidence. Some reported that “the general economic outlook appeared to have improved”, while others cited “tentative signs of a turnaround in sales enquiries”.

This upbeat talk tallies with a sense in some quarters that the market is starting to price in brighter economic times ahead. That is reflected in the fact that FTSE 350 construction and materials shares have rallied by 29.2% since last October.

Momentum building for home constructors

This week, I’ve taken a look at 10 shares in the home construction sector, which include all the major housebuilders plus a couple of smaller industry players such as Watkin Jones (LSE:WJG) and MJ Gleeson (LSE:GLE). Let’s start with a look at the signs of improving price momentum…

Data: SharePad.

The 12-month relative price strength of these shares gives you a sense of the concern that swept the sector last year.

Persimmon (LSE:PSN), the largest operator by market cap, has underperformed (adjusted to the performance of the All-Share) by a staggering 40% in that time. Price-wise, Berkeley (LSE:BKG) has performed the best because its shares recovered sooner and quicker than the rest.

On a three-month basis, things look much brighter. We’ve seen near-20% rises in shares like Vistry Group (LSE:VTY) and Taylor Wimpey (LSE:TW.) recently, which suggests the City sees signs of optimism.

Margins are above average for now

But what about financial health, both now and in the future? Housebuilders can see their profits plunge when recessionary forces are at play, so care is needed. This list is sorted by operating margin:

Data: SharePad.

Current forecasts suggest that almost every firm in this list will see sales grow in the year ahead. But that’s not necessarily flowing through to forecast earnings growth, which is much patchier.

The good news is that current profit margins appear solid and generally above 10-year averages, with a couple of exceptions. It could be that inflationary pressures aren’t yet showing up in the financials of these firms, but solid double-digit margins should offer some protection when they do.

Measuring the profit efficiency of builders can be tricky with so many moving parts affecting this industry. However, Persimmon’s return on capital employed (ROCE) of 25.4% indicates that it is a sector-leading business in terms of profit generation. Single-figure returns at firms such as Bellway (LSE:BWY) and Crest Nicholson (LSE:CRST) could mean their financial strength requires more investigation.

A solid eight out of a possible nine on the Piotroski F-Score of balance sheet health is a positive for Persimmon, Taylor Wimpey and Vistry. By contrast, MJ Gleeson and Watkin Jones achieve only four positive checks. That suggests smaller firms are going into this uncertain phase in weaker shape.

Construction shares are cheaper than usual

Given everything we know about economic headwinds, recent price trends and resilient profitability, are these housebuilders cheap?

Data: SharePad.

It’s worth remembering that valuations should take into account what these firms own, and what they are building, as well as what they are earning.

Price to net tangible asset value per share (P/NTAV) can help with this. It is quite a strict measure that compares the share price to the value of the company’s tangible assets (minus its liabilities).

A P/NTAV of more than ‘1’ indicates that the share is being valued in excess of its asset value. That’s what you would expect given that these companies generate strong earnings in good times. And when you look at the 10-year averages, housebuilders do trade on P/NTAVs of well in excess of 1.

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But currently, all of them are trading well below their averages, with many on P/NTAVs of 1 or less. Here you can see a strong sense of scepticism on the part of the market. That’s supported by very modest price/earnings (PE) ratios and very solid forecast dividend yields (another valuation clue), particularly among the more profitable companies.

Deciding whether these cheaper valuations are justified would take further investigation on a share-by-share basis. But from a screening perspective, evidence suggests that the whole sector remains on a much cheaper valuation than usual over the past decade.

What now for housebuilders?

Part of the appeal of home construction shares is that they are capable of big re-ratings when economic conditions allow. They are almost always heavily sold off when everyone is worried but then the first to recover when markets start to see through the uncertainty.

The on/off debate about whether the UK will now even experience a recession this year is clearly exciting parts of the market. Shares in the sector have performed well in recent months, but caution is needed. It is far from clear whether the current inflation and interest rate cycle has passed the worse or whether there is more bad news to come.

For now, these screening results suggest that the strongest momentum in the sector is being enjoyed by bigger, more profitable and financially resilient players. Whether that continues will have a lot to do with what happens to the economy in the months to come.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.