Sector Screener: two bargain housebuilders amid the gloom

Housebuilders are in the midst of a hugely challenging period. High inflation that still stands at more than three times the Bank of England’s 2% target has prompted borrowing costs to soar to their highest level since 2008.

Rising mortgage rates, alongside a cost-of-living crisis and an increasingly uncertain jobs market, have caused a sharp decline in demand for new homes. This is expected to translate into fewer housing completions for industry incumbents in the short term. House prices have also experienced a modest decline; falling by 4.6% over the past year. This is likely to further weigh on the sales and profitability of housebuilders.

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Despite this challenging near-term outlook, the FTSE 350 household goods and home construction sector has risen by 13.6% year to date. This puts it firmly in the top half of the index’s best-performing sectors. Although the sector is a somewhat hotchpotch mix of companies that includes consumer goods firm Reckitt Benckiser (LSE:RKT) and several smaller consumer-focused businesses, it is dominated by housebuilders.

The sector’s recent performance suggests investors have already factored in the tough near-term outlook faced by housebuilders, and are beginning to look ahead to a recovery. Indeed, the current cycle of above-target inflation, rising interest rates, lacklustre economic growth and a cost-of-living crisis now appears to be in its latter stages.

Past performance is not a guide to future performance.

An improving industry outlook

The Bank of England’s recent decision to leave interest rates unchanged at 5.25% may represent the start of an era of less-hawkish monetary policy. After all, the “Old Lady of Threadneedle Street” expects inflation to meet its target in early 2025. Given that interest rate rises take time to have their desired impact on inflation due to time lags, it is likely that a slower pace of monetary policy tightening is ahead.

According to the central bank’s August Monetary Policy Report, the market currently expects interest rates to rise modestly over the coming months to peak at around 6% before descending to 4.5% by the third quarter of 2026. A fall in interest rates between now and then, alongside the International Monetary Fund’s prediction of a sustained long-term decline in Bank Rate, as weak productivity and an ageing population force policymakers to enact greater economic stimulus, means mortgages, and new homes, will become more affordable.

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Falling interest rates are also set to positively impact economic activity levels. The UK economy, while continuing to stutter in the short run, is set to expand by 1% next year versus a growth rate of 0.4% in 2023. While the unemployment rate has moved 0.5 percentage points higher to 4.3% over the past three months, it is expected to peak at 4.8% over the coming years. This is low by historical standards and suggests demand for new homes is likely to be buoyant, as consumers benefit from the effects of low inflation, falling interest rates and improved economic growth.

A fundamentally sound sector

Alongside rising demand for new homes, a lack of supply is set to catalyse the financial performance of housebuilders and boost the return of the household goods and home construction sector.

Indeed, over recent decades, the number of new homes being built has consistently failed to keep up with population growth. For example, the UK’s population has risen by an average of 380,000 people per year over the past 20 years. In the same period, around 179,000 new homes have been built on average per year.

Since the housebuilding industry is dominated by a relatively small number of major operators with large land banks and who enjoy high barriers to entry, the UK’s supply of new homes is unlikely to significantly rise until market conditions improve. This is likely to limit house price falls in the short run, and lead to a further imbalance between supply and demand over the long run, creating an attractive operating environment as the economy’s prospects strengthen.

Clearly, housebuilders have been negatively affected by challenges such as cladding-related issues, which resulted in an additional 4% residential developer tax being applied on their profits, as well as the uncertainty of potential changes to planning laws.

However, in many cases they enjoy solid financial positions which include vast amounts of cash and very modest debt that ensures they have the means to survive bouts of industry-related difficulties. And with housebuilders trading on extremely low valuations, the margins of safety on offer are exceptionally wide vis-à-vis other sectors. This means there are currently several attractive investment opportunities for long-term investors within the household goods and home construction sector.

Past performance is not a guide to future performance.

Bellway

Bellway (LSE:BWY) currently trades on a forward price/earnings (PE) ratio of around 7 in spite of a 12% rise in its share price over the past month. This suggests investors have more than sufficiently factored in the tough operating conditions highlighted in its recent full-year trading update.

In the 2023 financial year, the firm’s revenue declined by over 3%. This was due to a 2% fall in the number of completions and a 1.4% drop in the average selling price of each property.

• ii view: Bellway flags weak demand and a move to cut jobs
• Read more articles by Robert Stephens here

Operating profit margins, meanwhile, slumped by 2.5 percentage points to 16% as rampant build cost inflation persisted. This, though, is set to ease as the pace of price rises across the economy slows. The firm is also taking measures to cut costs, such as through headcount reduction, to ease the impact of high inflation on profit margins.

In the short run, the company expects completions to “decrease materially”. However, its net cash position of £232 million means it is well placed to overcome market difficulties that are likely to prove temporary as the UK’s economic outlook improves. And with a land bank that stood in excess of 100,000 plots as at the time of its half-year results in January, it has the capacity to meet a significant rise in demand over the coming years.

Redrow

Similarly, Redrow (LSE:RDW) offers a favourable risk/reward opportunity for long-term investors. It ended the 2023 financial year with a net cash position of £235 million that provides ballast as it navigates challenging market conditions.

Indeed, the firm expects revenue and earnings per share to decline by 21% and 55%, respectively, in the 2024 financial year. Already, sales per outlet have fallen from 0.61 in the first ten weeks of the 2023 financial year to 0.34 in the same period of the current year. It also expects to reduce dividends per share from 30p to 14p in the current year, which means it has a prospective yield of around 2.7%.

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Despite its downbeat near-term outlook, investor sentiment towards the company has improved recently. Its shares have risen by 12% in the past six months, for instance, as investors look beyond temporary industry-related problems. With a forward PE ratio of around 12.6, it continues to have capital growth potential that is set to be triggered by an improving operating environment.

When precisely this will occur is impossible to accurately predict. But with solid finances, low valuations and sound market positions, both Redrow and Bellway are well placed to capitalise on favourable industry dynamics and an improving economic outlook. Ultimately, the doom and gloom that currently surrounds the housebuilding industry will dissipate to act as a catalyst on their sales, profitability and share price performance. 

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.