Chasing Value: "Home Prices Are About to Bottom"

I would say that the market has bottomed -- but not everywhere, and with little assurance that it will stick. My colleague Gary Shilling, however, disagrees and posted this two days ago, Housing Woes Not Nearing an End.

The market will certainly turn eventually. When it does, what investment opportunities might be worth a look?

The two leading home remodeling and construction outlets are competitors Home Depot (HD) and Lowe's Cos. (LOW). Home Depot closed last Friday November 12 at $31.44, hovering between it's 52-week low of $26.35 and its high of $37.03. Lowe's with a closing price of $21.69 seems to be dancing closer to the bottom of its 52-week range of $19.35 to $28.54.

Lowe's earnings grew 17% for the quarter, topping estimates, and Home Depot is expected to show improvement as well in its quarterly report later this week. The question will be how much more can they increase earnings by reducing expenses and tighter inventory control.

Looking at a few choice metrics Home Depot has the better dividend yield at 2.97% vs. 1.84%. Lowe's has a slightly better PEG ratio 1.0 vs. HD's 1.17, but both indicate there is value here. As might be expected, Lowe's has the lower P/E ratio near 14.0 vs. 15.5 for HD going forward. In both cases the P/E's are working themselves lower still.

At this point, even though I am a dividend hound, I might favor Lowe's over Home Depot since it is farther off its 52-week high, potentially giving it more room to run.

Based on other considerations, however, there is some value here for both companies. They both have have manageable debt, very low P/S ratios around 0.75, and are still growing. If there is one area that gives the nod to Home Depot, besides yield, it would be the double-digit return-on-equity of 14.34 vs 9.54 for Lowe's. Although, to be truthful, the disparity might be explained by the fact that Home Depot is leveraged more.

Because I do not believe we will have a double-dip recession, I think both stocks are safe investments. However, I do not believe the stock prices can advance faster than the economy -- and few think the economy will improve very fast at all.

Since the time of that Barron's cover story investors have been asking themselves if it is safe to dabble in the home builders. They have been beaten down but that does not necessarily make for a bargain. Let's look closer at a few.

• K.B. Homes (KBH)
• Lennar (LEN)
• Toll Brothers (TOL)

Then again let's not. All three still have too much debt, negative P/E ratio's, a patchwork quilt of projects under way, negative ROE and the rest is a guessing game. There is no question that as a contrarian investor you want to be zigging when everyone else is zagging. This is not the time as I think investors in the home builders are still flailing in the wind. There are arguments pro and con for taking a shot when things are bleak, but there are just too many other opportunities to make a move here.

Long-time readers may recall that I have taken strong positions many times in the midst of crises. I could rationalize buying Merck (MRK) during the Vioxx debacle, bought financial stocks amidst crushing economic news, found value during the recent scandals around Goldman Sachs (GS), and BP (BP), and made money each time. Unfortunately I cannot come up with a story here to give me any confidence in the housing stocks.

Never one to give up without a fight, I did find one way to make money in the housing stocks, but not by buying the stocks. For this opportunity I had to look at LEAPS, in the world of options to find possible value with a story I could believe in. Two of the three stocks, KBH and LEN offer 2013 LEAPS.

The rationale for LEAPS being worth consideration is that we are now three years into the housing bubble burst. It took about five years to get there, since past Fed Chairman Alan Greenspan began his interest rate reductions in 2002 which current Fed Chairman Ben Bernanke has continued. If it takes at least as long to make any sort of recovery than the soonest the housing stocks might see a sunrise is more than two years from now in 2013.

In examining the KBH 2013 (January) LEAPS I found you could receive around $7.00 for selling a $17.50 put. This amounts to an annualized return of 31% (7 / 10.5 x 12 / 26 months) if the stock option expires because it is has reached or exceeded the strike price. In the case where it does not and is "put to you", your break even price is $10.50, a significant discount to Friday's closing price of $12.43. That seems like a very good margin of safety.

The same story holds true for LEN 2013 LEAPS offering $10.10 for selling a $25.00 put. Again there is a 31% annualized return (10.10 / 14.90 x 12 / 26 months) if the option expires; your break even being $14.90, a discount to Fridays closing price of $16.05.

One more thing to juice up this deal. I usually take the premium I get at the time of the trade and buy a conservative dividend paying stock like Duke Energy (DUK) currently paying a 5.45% yield during the LEAP holding period. In the case of KB Homes and Lennar it would push the returns up about 2.5% passing 33.5% -- now that is a housing story you might be able to build upon.

Sheldon Liber is the CEO of a small private investment company and the principal for design and research at an architecture & planning firm. He writes the columns Chasing Value™ and Serious Money. Disclosure: He currently owns shares and/or options of BP, DUK, and MRK,