The UK house building firms’ shares have enjoyed a great run since their credit-crunch induced plummet at the end of the last decade. That’s exactly what we hope cyclical sectors will do in the up-leg of macro-economic cycles.
Don’t become complacent with the house builders, though. Right now, the sector is flashing a warning and we, as shareholders, should listen.
House building is as cyclical as it comes, and the fortunes of firms such as Taylor Wimpey (LSE: TW), Persimmon (LSE: PSN) and Barratt Developments (LSE: BDEV) rise and fall according to the swell generated by economic tides.
That’s fine after a cyclical bottom has been reached. Once the house builders’ share prices move up from a nadir, thus indicating the downtrend is over, the ride on the next up-leg can be breath taking. Look how the house builders’ share prices performed recently:
Those gains are impressive, and we haven’t even considered investor income from dividends over the period, which were also good for part of the time.
The share price performance of these firms elevated all three into the FTSE 100 index recently. The last time that happened was at the end of 2007 — just before last decade’s financial crisis, which catalysed a catastrophic plunge in business performance and share prices for the house-building firms.
Should we be wary now?
Yes. The big share-price rises for the house builders probably already happened in this macro-economic cycle, and valuation-compression seems set to drag on share-price progress as the cycle unfolds.
The stock market figured out cyclicality long ago and tends to mark the valuations of cyclical firms downwards as year-on-year profits rise. Why does it do that? Well, for profits and share prices to fall in the down-leg of a macro-cycle, they must first reach a peak. Ergo peak profits presage a calamitous plunge. The market tries, and fails, to adjust for the expected down-leg by keeping P/E ratings and other valuation measures low.
Yet, despite that valuation-compression effect, we still seem to see a dramatic plunge in share prices with the down leg, and we never really know when that plunge will arrive. That means cyclicals such as Taylor Wimpey, Persimmon and Barratt Developments become more and more dangerous to hold as the macro-cycle progresses — it’s akin to playing Russian Roulette, although the difference is we stand to lose our money rather than our lives!
Reasons to be cautious
Business is booming for the house builders, and that’s a cause for concern in itself. They all confidently predict good times ahead, just as they did in early 2007. Of course, they would at the top, or near the top, of a boom, or a cyclical top. It takes that to mark the top. It takes that before we can have a down-leg.
Another cause for concern is the pattern of valuations just now:
|Forward valuation to 2016||P/E rating||Dividend yield|
Those forward valuations are almost ‘square’. When the P/E rating and the dividend yield are roughly the same number, we sometimes refer to the issue as a ‘square share’.
Then last time I remember seeing many ‘square’ shares was in the London-listed banking sector around 2007. Value-oriented investors were salivating, and the banks appeared on ‘value’ lists all over the internet. It was disastrous for those buying into the ‘value’ argument for banks back then.
In the event, the ‘squareness’ of those banking shares ended up marking peak earnings and the top of the cycle. We measured the share-price plunges that followed in the nineties of percent in many cases, and some banking shares still haven’t regained their earlier highs, and probably never will.
Many different factors could pull the rug from the house-building sector. Base interest rates remain at historical lows, but will they forever? Affordability and mortgage availability tend to cap house prices. Right now interest rates remain low, but what damage would base interest rates at, say, 5% do to the housing market?
House prices can move in a different cycle to general economic growth — they can fall as the economy grows. That adds to my concern that we never really know when the top will arrive for the house-building firms.
I could be wrong about where the shares are going in the house building sector, but valuation compression will surely drag on investor total returns from here, regardless of whether share-price collapse is just around the corner or not.
To me, the house building sector feels like a dangerous place to invest right now, so I'm looking at these five shares, which make good candidates for further research and remain strong and well placed in their less cyclical sectors.
The Motley Fool analysts identified these London-listed market leaders as enduring long-term investments.
Kevin Godbold 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.