Do Companies Like Galliford Try Plc, Redrow Plc & Barratt Developments Plc Present A Threat To Your Portfolio?

Can Galliford Try Plc (LON: GFRD), Redrow Plc (LON: RDW) and Barratt Developments Plc (LON: BDEV) still drive portfolio returns, or are they a threat to your wealth?

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Housebuilders have featured prominently in the news during recent weeks, with both Redrow (LSE: RDW) and Barratt Developments (LSE: BDEV) both reporting double-digit earnings growth for the 2014 year.

In detail Redrow reported a 56% rise in earnings per share and a 29% increase in return on equity for the year to June 2015, while Barratt also noted a 45% increase in basic earnings per share.

With Galliford Try (LSE: GFRD) set to update the market this week, the housebuilders will probably remain a hot topic for at least the foreseeable future.

Furthermore, with the average price-to-earnings (PE/) multiple at just 12.8x but the average price/ TNAV (tangible net asset value) figure elevated at 2.6x, the valuation outlook is beginning to appear increasingly mixed. With this in mind, it seems like now would be a good time to cover the sector.

Housebuilders are not cheap!

While past performance should never really be taken as a reliable indicator of future performance, there are a couple of things that previous boom-and-bust cycles can reliably tell us about the housebuilding sector.

First and foremost, in the early days of an upturn in the industry, share price appreciation frequently fails to keep pace with what is often a rapid rate of earnings growth. This can lead to persistently lower P/E ratios, despite the fact share prices are rising broadly.

Secondly, in the dying days of a boom period for housebuilders, strong earlier performances from shareholders can often leave investors reluctant to call time on their holdings. This can lead to a slow reaction from shareholders when faced with a deteriorating or a darkening outlook for earnings.

It is this slow reaction that can drive already elevated P/E-based valuations to excesses, as share prices remain elevated despite falling earnings numbers.  

While particularly evident during the 2000-2008 boom-bust, this behaviour calls into question the validity of the usual P/E-based “it’s cheap” mantra of investors.

In fact , I would go so far as to say that given the almost counter-cyclical nature of P/E measures across the sector, they probably aren’t a very good measure of relative “value” for housebuilders at all.

Instead, I prefer to look closely at TNAV (Tangible Net Asset Value) values and the rate of growth in these numbers as part of a wider approach to assessing value or risk. If we use this measure as a suitable basis for comparison, the UK housebuilders are already back where they were at the very peak of the last cycle, with the average price/TNAV value now sitting at 2.6x and some companies trading close to, or above 3x TNAV.

Implications…  

After taking into account the challenges ahead of the sector, including the ongoing impact of the Mortgage Market Review and the potential for 2015/16 interest rate increases to further reduce the UK’s pool of eligible buyers, I am becoming increasingly more wary of the housebuilders.

Furthermore, given the supply and demand disparity facing the market, I also believe there will soon come a time when house prices have to stabilise in order to maintain transaction volumes.

This, I believe, will represent an inflection point where price growth ceases to support earnings growth and the housebuilders are forced to increase build volumes in order to support a flagging financial performance.

Such a move will probably signal the beginning of the first sustained reduction in home prices since the aftermath of the financial crisis.

With all things considered, if I were a shareholder in any of the above companies, I would be inclined to quit while I’m still ahead!

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Skinner has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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