Valuations are cheap and dividends are generous
Thursday 17 Jan 2019 Author: Tom Sieber

We are turning positive on the housebuilding sector on the basis that shares in the biggest companies are currently too cheap to ignore. Some are offering dividend yields in double-digits which are supported by strong balance sheets.

In our view the robust financial positions enjoyed by the sector heavyweights means they can afford to keep paying generous dividends even if house price ease back. Many of the housebuilders are sitting on significant amounts of cash which puts them in a very strong position.

We believe share prices will rise to reflect increasing market confidence the promised dividends will be paid.

We are most positive on the high-yielding trio of Barratt Developments (BDEV), Bovis Homes (BVS) and Taylor Wimpey (TW.) which are also trading on relatively attractive price-to-net asset value (NAV) ratios.

Sentiment towards the sector is beginning to improve but on valuation grounds it is still trading at a level comparable to that seen immediately after the savage sell-off it endured in the wake of the 2016 EU referendum result.

That means investors have a chance to buy stocks that are cheap and also offer considerable income appeal.

HOW ARE HOUSEBUILDERS VALUED COMPARED TO THE IMMEDIATE AFTERMATH OF THE BREXIT VOTE?

Housebuilders tend to be valued against their assets using the price-to-book metric – also known as price-to-net asset value (NAV). However, the price-to-earnings (PE) ratio still provides a useful yardstick of how the sector is being priced now compared with history.

The FTSE 100 housebuilders’ average PE, according to Refinitiv data, is 7.7-times against 7.5-times in July 2016.

Even on a more traditional price-to-NAV basis housebuilders trade at a similar level as they did in July 2016 based on data from Canaccord Genuity. Its universe of housebuilders are trading at 1.27-times NAV today against 1.24-times at the sector’s low point on 8 July 2016. In general, housebuilders are deemed too expensive when they exceed 2.0-times.

It is important to stress that the outlook isn’t entirely rosy for the housebuilding space. The pressure on earnings that we highlighted in our 5 July 2018 feature Housebuilders: farewell mega profits? remain but the difference now is that the sector has sold off heavily from the highs seen in summer 2018. 

What we said last summer:

‘Get out, wait until the market has had time to price in lower earnings and there has been a natural rotation for investors out of the sector; and only then potentially consider buying back if valuations have dropped to really attractive levels’

WHY ARE WE SAYING TO BUY AGAIN?

We believe the challenges facing the housebuilders – the main one being their ability to achieve the required growth in average selling prices to compensate for rising build costs – are now factored in to their market valuations.

That said, investors should not rule out further volatility until there is greater clarity on Brexit. Being a sector with an almost entirely domestic bias it would likely suffer if the EU separation outcome is worse than the market expects.

According to analysis from Canaccord Genuity at the end of 2018 the sector was ‘broadly’ pricing in a 5% fall in house prices and 10% fall in volumes. ‘If the actual outcome for 2019 is at or close to current consensus expectations, we would expect a sharp value rally,’ it says.

Consensus expectations are for modest (1% to 2%) increases in volume and pricing. Sentiment could also improve on a resolution to Brexit which we believe would be viewed favourably by the market.

Against this backdrop, the traditional spring selling season could be an important catalyst for share prices and next month a series of trading updates from the sector will offer some insight into the outlook.

Investors may have to react quickly and sell shares in housebuilders if either the Brexit outcome is very damaging to the economy, and/or if future trading updates suggest a material slowdown in the market.

In the rest of this article we take a look at the sector’s largest constituents, ranking them by their price-to-net asset value, dividends and balance sheets.

We also summarise the latest commentary from housebuilding stocks to give a picture of how they are seeing the outlook for their respective businesses.


THE SECTOR IS SITTING ON A LOT OF CASH

Having recently restrained investment in land – they previously bought a lot at cheaper prices in the wake of the financial crisis – many of the sector’s largest constituents are sitting on very large cash piles.

While this drags on returns, it does provide a buffer against any downturn while also underpinning companies’ plans to pay out generous dividends. Of the names included in the table, Bellway (BWY) is forecast to have the lowest net cash position.


COMPANIES HAVE PROMISED BUMPER DIVIDENDS

You need to take a step back and understand what high yields are really telling you, as many of the housebuilders offer dividend yields far in excess of most other FTSE 350 stocks.

A general rule of thumb with investing is to be cautious of dividends over 7% or 8%. Such high yields are often the result of a falling share price as the market doubts earnings forecasts.

In times of strife, dividend forecasts are sometimes downgraded much later than earnings as analysts want to be truly certain that any financial or trading problems are only short-term, so it makes yields look more attractive than they actually are.

To give you an example, let’s say Company X is expected to pay 10p dividend and its shares are trading at 200p, so the yield is 5%.

The shares then fall as the market believes Company X is having financial and operational problems. If they drop to 100p and the dividend forecast is kept the same at 10p, the shares now yield 10%.

Some investors may look at the 10% yield and snap up the stock in hope of generous income. Sadly Company X then admits to various problems and suspends the dividend, meaning the yield is now 0%, much to the annoyance of anyone expecting 10%.

We believe housebuilders are in a different situation. Their high prospective yields are boosted by special dividends which are extra rewards on top of normal dividends. Companies tend to pay special dividends if they have excess cash to their business needs. They are rarely paid year in, year out, and should always be seen as nice bonuses rather than something to expect on a regular basis.

Housebuilders in general currently have lots of cash at their disposal. Forecasts suggest that in most cases dividends are easily covered by cash flow per share.

Many companies in the sector have also been explicit about their dividend plans:

– Taylor Wimpey recently (9 Jan) committed to paying £600m in dividends in 2019.

– Bovis is part way through a commitment to pay out £180m to shareholders in the three years to 2020, making a first £60m payment in November 2018. The company is also in a turnaround situation under industry veteran Greg Fitzgerald after getting itself in a mess at the end of 2016 with a major profit warning and strong criticism over build quality from purchasers.

– Persimmon (PSN), which is forecast to be sitting on more than £1bn in net cash, has committed to return surplus capital of at least 235p per share to shareholders each year for the next two years ending 2020, and 110p per share in 2021. Its chief executive Jeff Fairburn was forced out in November 2018 amid backlash over his £75m bonus. The company had failed to put a cap on a long-term incentive plan agreed in 2012.

– In February 2018 Barratt committed itself to returning a further £350m in special dividends, with one payment being made in November 2018 and the other promised for November 2019.

– High end operator Berkeley (BKG), despite not offering such a significant yield, is paying out plenty of cash in monetary terms too. It has committed to extend its annual return of £280m a year to 2025, beyond the previously stated end point of 2021. This commitment will be fulfilled barring a ‘material deterioration in the operating environment’. These words are a reminder that dividends could still be affected by a pronounced housing market downturn despite the strong balance sheets in the sector.


VALUATIONS LOOK REASONABLE ON A PRICE-TO-NET ASSET VALUE BASIS

Using price-to-net asset value as a guide, housebuilders are cheaper than they have been for some time, although not as cheap as they look based on price-to-earnings and dividend yield.

Persimmon is the notable outlier, trading at more than two times assets. This could reflect its existing large land bank, diversified exposure across the UK and a relatively low average selling price – meaning it is not as exposed to the more vulnerable premium end of the market. Redrow (RDW) is the only firm on this list trading at exactly net asset value.


WHAT ARE COMPANIES SAYING ABOUT TRADING?

Here is a summary of the most recent outlook statements from the sector:

– Barratt Developments (in October 2018) – The company has made a strong start to the year, and is confident of good financial and operating performance.

– Bellway (in October 2018) – Strong order book, Brexit could hit consumer confidence during busy spring selling season, unchanged conditions should allow company to increase output in the year ahead.

– Berkeley (in December 2018) – A good start to the year resulting in increased full year guidance and reaffirmed for next two years, based on current market conditions, but short-term outlook clouded by Brexit and operational headwinds in London and South East.

– Bovis (in November 2018) – Good progress against medium-term targets, on course for record profit in 2018. 

– Persimmon (in January 2019) – Profit for 2018 to be modestly ahead of market forecasts. Positive outlook statement.

– Redrow (in November 2018) – London market subdued thanks to Brexit and stamp duty changes but trading in line with expectations.

– Taylor Wimpey (in January 2019) – 2018 results will be in line with expectations. Too early to give definitive view on 2019 but forward sales indicators are strong, with reference to wider political and economic uncertainty.


THE FIVE FACTORS UNDERPINNING THE SECTOR’S GROWTH – AND HOW THEY COULD BE AFFECTED BY BREXIT

The impressive returns achieved by the housebuilding sector in recent years have had five main foundations. Investors need to consider if these supportive factors will persist and how they might be impacted by the UK’s exit from the European Union.

Supply/demand dynamics

A possible population decline if immigration falls in the wake of Brexit could tip the scales somewhat but is unlikely to alter the fact that the country is still not building enough houses to keep up with demand.

A Government report published in December 2018 noted: ‘Estimates have put the number of new homes needed in England at between 240,000 and 340,000 per year, accounting for new household formation and a backlog of existing need for suitable housing.

‘In 2017/18, the total housing stock in England increased by around 222,000 homes. This was 2% higher than the year before – and the amount of new homes supplied annually has been growing for several years – but is still lower than estimated need.’

Government support

The launch of the Help to Buy scheme in 2013, providing a 20% government loan on top of a buyer’s 5% deposit on a new-build property, has been very supportive to the sector.

Industry body the Home Builders Federation noted that in the first five years of the scheme’s operation 136,657 first-time buyer households had purchased a new-build home with support from a Help to Buy equity loan, representing more than four in five of all completions up to that point.

Help to Buy has been extended out to 2023, albeit on tighter terms, and the need to build more homes to meet the anticipated demand should mean, though does not guarantee, a supportive approach from across the political spectrum regardless of what happens with Brexit.

Price rises

The supply/demand situation has helped house prices recover rapidly from the financial crisis, however the market has stalled recently, and this has been linked to the uncertainty around Brexit causing potential purchasers to sit tight.

Rising prices had made it easier for housebuilders to absorb increases in build costs.

Although warnings of a 30% house price crash in the event of a no-deal Brexit from the Bank of England were dismissed as too extreme in some quarters, they were at least an indication of how significant disruption to the economy might affect the market.

Such a situation could also force housebuilders to write down the value of their land holdings, which in the financial crisis put a big dent in profits and affected housebuilders’ ability to pay dividends. One difference now is that housebuilders’ balance sheets are much more robust than they were a decade ago.

A robust jobs market

Unemployment levels are at multi-decade lows, even if wages have stagnated. While a disorderly Brexit could result in job losses in some areas, the potential reduced availability of workers from overseas could support employment and wages for those already in the UK.

Availability of cheap mortgages 

A combination of low Bank of England base rates and a highly competitive market has led to widespread availability of cheap mortgages for prospective buyers.

If a no-deal Brexit led to a significant deterioration in sterling, the Bank of England might be forced to push up rates to deal with the resulting inflation. Given the restrictions on banks in other areas, mortgages are likely to remain an attractive product for them to sell.


WHAT IS THE PICTURE IN THE WIDER HOUSING MARKET?

The good news for home buyers is that the seemingly relentless rise in house prices over the last 10 years seems to have petered out.

According to building society Nationwide the average house price in December 2018 was £212,281 or just 0.5% higher than a year earlier. This was the slowest pace of growth since the start of 2013.

A survey by Halifax reported an average house price of £229,729 in December 2018 which was just 1.3% higher than a year earlier, while the average selling price from Land Registry records has been flat at £231,000 for four months.

Mortgage borrowing was steady at around £12bn a month last year according to the Bank of England, and figures from UK Finance show first-time buyers taking an increasing share of mortgage lending through the course of the year.

On the minus side, the latest RICS survey shows a steep fall in new buyer enquiries even though more agents are reporting sellers lowering their price expectations.

As with all aspects of consumer spending, confidence has a large role to play. In December 2018 the widely-watched GfK confidence index hit -14, its lowest level since July 2013, generating a slew of negative commentary.

To put that in perspective, -14 is roughly half way between the survey’s highest reading of +10 in June 1987 and its lowest reading of -39 in July 2008.

However, the ‘major purchases’ index, which asks consumers whether they think now is the right time to spend, ticked up to +2.

That is six points above the December 2017 level, suggesting that people’s confidence in their personal finances is improving.

With house prices holding steady, interest rate rises on hold, a lack of new and existing homes for sale and a return of consumer confidence, maybe 2019 will see more buyers coming into the market.

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