May 2022 - Why is Fletcher Building trading on a single digit PE?
It’s no secret that 2022 is proving a challenging year for investors. And not just for equities, Deutsche Bank analysis shows that US 10-year Treasuries have just posted their worst start to a year since 1788 (!), with scope to get worse, if interest rates keep grinding higher. The share market is having a large wobble with most major indices closing in on 20% drawdown territory. And that’s an average of the markets move, clearly many companies have performed far worse than that average. One of the major victims has been the early-stage technology companies that were gorging on cheap capital supplied by zero interest rates, many of those are rapidly fading away and may be gone for good. Capital suddenly has a price and as a result is rapidly becoming far more rational.
However, some of the companies that are being hammered right now are real businesses that will endure, even though current price action is suggesting that they have been permanently impaired. A good case in point would be homebuilders, around the globe these businesses so far in 2022 have been treated like toxic waste.
A great example of this current distain for homebuilders is Lennar. This American business has been in operation since the 1950s, it listed on the NYSE in 1983 and is a member of the elite corporate club that is the S&P 500. It has paid a dividend continuously for 42 years, even in the depths of the US housing crash that was at the epicentre of the GFC. However, this year it’s share price has dropped nearly 40%. As mentioned this in itself is not unique given the volatility of 2022 but Lennar stands out from the crowd in that it is now on a price to earnings multiple of 4. That’s a very low multiple for a substantial and profitable business. Another facet of this years sell off is that it has actually increased earnings guidance by around 10% since the start of the year. Either the market is getting the share price way wrong, or Lennar’s earnings are going to collapse because solid businesses do not trade on a PE of 4 for very long.
Chart showing an impressive 42 years of continuous dividend payments
It’s hard to know for certain why investors have been selling homebuilders like Lennar with such determination, but the biggest factor is almost certainly rising mortgage rates. In the US this year mortgage rates have risen to 5% which is making houses less affordable. US house prices had been rising, doubtless due in part to the very low cost of financing, and now they are easing. The Lennar share price is strongly implying that house prices are going to drop a lot further and that Lennar is likely to sell less houses at a lower price in the future. Essentially another crash in house prices similar to the GFC period. This doom and gloom outlook has been causing share price weakness in companies around the globe that are exposed to demand for residential properties, even our own Fletcher Building which has underperformed the S&P/NZX50 so far this year.
However, there is actually a strongly supportive fundamental coming down the line for US homebuilders. The key determinant of demand for houses in the US is the birth rate 30 years ago because 30-year-olds are the new entrants onto the home ownership ladder. The chart below shows how the birth rate in the US has moved over time. It starts high as it captures the Baby Boomer period from 1945-1964, which led to massive demand for new builds through the 1980s. It also shows that the run up in hoses prices prior to the GFC was not supported by strong demand from 30-year-olds. Population growth had dipped below 1% through the 1970s which was a key factor in the sharp fall post 2008, the demand was weak. This time though, while we are seeing prices ease from their recent peaks, the demand for houses should be much greater – the Millennials are coming! And there are a lot of them, you can see it’s the first meaningful jump in the birth rate since the Baby Boomers.
Chart showing 70 years of US birth rates
Source: Macrotrends & United Nations
This surge in 30-year-old buyers should be a significant tailwind for US homebuilders for the next decade. It could be that investors are overly focused on the short-term impacts of rising mortgage rates and that homebuilders such as Lennar shouldn’t be trading on a PE of 4. Meanwhile Fletcher Building appears to have suffered from this souring of sentiment towards homebuilders. This is probably why the share price has been down in 2022 despite consensus earnings upgrades. For more detail on how the relationship between share price and earnings revisions work you can refer to this previous article https://www.nbr.co.nz/node/230071 Ultimately this situation will resolve with either the share price recovering or consensus earnings forecast falling.
Chart showing the recent bi-furcation between earnings revisions and share price
While Fletcher Building hasn’t been savaged as badly as US homebuilders, while half of its revenue in New Zealand come from residential, a chunk of that will be renovations and repairs, and none of its revenue in Australia comes from residential, it is estimated to be trading on a price to earnings ratio of 9x forecast earnings. That’s not 4x cheap but its still cheap and cheaper still when compared to the broader New Zealand market where the average PE is 20x. There can be little doubt that the fizzy top is coming off house prices here, but there remains a very healthy pipeline of activity due to capacity constraints creating a back log of work. It will be fascinating to see how house prices respond to changing affordability and changing underlying demographics. In the US one part of the puzzle is already baked in, the coming wave of Millennials that will be looking to buy a house over the next decade. In New Zealand that part is less clear, our demand for housing is driven by migration. If there turns out to be a pent-up surge of migrants heading to New Zealand from China, Europe and the US, we might just see house prices stabilise around current levels.