Big house builders need to reassure on growth

In these income-starved times of record-low interest rates and depressed bond yields it is hard to believe that a FTSE 100 stock would barely move when the management team affirms dividend plans that equate to a 7.7% yield for 2017.

But shares in Taylor Wimpey yawned at exactly such an announcement at the end of last month (28 February), mirroring the insouciant response received by Persimmon the day before.

On that occasion, the York firm declared it would expand its capital return programme by an extra 25p a share for 2017, topping up the £1.10p payment already planned and taking the dividend yield toward 6.5%.

Yet the stocks are struggling to make much progress despite such largesse, having recouped much if not all of the ground lost in the wake of the Brexit vote last June and growth may be the reason why.

Price bonanza

The good news is that the big seven house builders who have been listed for the last decade generated 23% more sales and 55% more profit in 2016 than they did at the previous peak in the cycle in 2007.

House builders’ sales and profits are booming

Source: Company accounts. Covers Barratt, Berkeley, Bovis, Persimmon, Redrow and Taylor Wimpey

In addition forward visibility is apparently excellent.

Combined order backlogs (or forward sales figures) come to £12 billion against £5.3 billion a decade ago, enough to mean two-thirds of aggregate sales forecasts of nearly £18 billion are already in the bag for this year (barring an unforeseen spate of cancellations).

Meanwhile their balance sheets are in terrific shape, with an total of £1.9 billion in net cash between them, compared to £3.7 billion in net debt back in 2007 (a sum that was largely the result of the Barratt-Bowden and Persimmon-Westbury acquisitions).

Market psychology

This cash position means Persimmon, Berkeley, Barratt and Taylor Wimpey are all running generous capital return plans for shareholders, via ordinary dividends, special dividends or (in the case of Berkeley) possible share buybacks.

Yet the house builders shares are making heavy weather of moving higher despite all of this good news.

One possible explanation is growth. There may be a nagging suspicion somewhere that this is about as good as it is going to get, given labour shortages, questions over the UK economy and even the (admittedly distant) prospect of interest rate rises from the Bank of England.

And, so goes the theory, if this is as good as it is going to get, then all it can do is get worse. And if it is going to get worse, then the shares are going down at some stage and it’s time to exit gracefully while the going is still good, according to this particular line of market psychology.

For the moment the house builders’ shares are neither rising nor falling particularly. The dividends yields are providing support on the downside so perhaps for fresh upside to present itself the builders need to show some growth, to provide insurance against cost increases, boost dividend cover and reassure that the housing market remains in good health.

The reason the market is seeking reassurance on growth is simple. Despite the bumper sales and profits, the house builders completed just 2% more houses in 2016 than they did in 2007 – the revenue and earnings upside has largely come from price increases.

Rising prices rather than surging volumes underpin the builders’ profit renaissance

Source: Company accounts. Covers Barratt, Berkeley, Bovis, Persimmon, Redrow and Taylor Wimpey

In fairness, Bellway, Berkeley and Bovis did complete more dwellings in 2016 than they did in 2007, but Bovis made such a mess of it, leaving itself with a £7 million customer compensation bill in its unseemly rush, that this may be of little consolation, at least in that particular case.

Although record-low interest rates and Government initiatives such as Help to Buy (and now the Lifetime ISA) may help to keep the pot boiling, they are stoking demand, not supply.

There has to be a risk that average house prices eventually reach a level whereby buyers will struggle to afford them, no matter what external help they get (barring perhaps the bank of Mum and Dad).

This may explain why house builders continue to rail against a complex and slow planning permission process.

It may also explain why analysts are only pencilling in limited sales and profit growth for 2017, especially as most of the builders expect cost increases to run in the low single-digits this year, potentially limiting operating margin and profit upside.

It is this scepticism about growth and fears whether Brexit or high prices or record-levels of consumer debt that could crimp housing demand that leave the big house builders on generous yields and low earnings multiples – as the lowly valuation is the market’s way of saying it doesn’t entirely trust the earnings forecasts.

House builders come with discount valuations and premium yields relative to the whole UK market

Source: Digital Look, consensus analysts’ forecasts

The net cash balance sheets provide ample support to the dividend forecasts and in theory the builders could meet their lavish cash return plans in the event of an unexpected downturn by stopping buying land.

But it is buying land cheaply during downturns that provides margin and profit upturns during the subsequent recoveries (something Tony Pidgeley at Berkeley has demonstrated with particular skill time and again) so this decision may not prove as straightforward as it seems if and when the time comes to make it.

This is not to say the builders are destined to see their shares suddenly falter, although weakness in mortgage approvals figures or house prices are both possible trigger points here.

Meanwhile it may take further confidence in future completion volumes for them to really power higher.

Such confidence could come from delays in interest rate rises or new Government initiatives on planning or financing, so investors with exposure to this sector for growth or yield will need to keep abreast of developments on all of these fronts.

Russ Mould, AJ Bell Investment Director