Homebuilding stocks tend to be very sensitive to both mortgage rates and economic strength. It is unusual for both of these considerations to be positive at the same time, but they are now. On top of that, demand for housing has surged because of Covid-19. Now is a good time to invest in this industry.
Economic Conditions Favor Homebuilders
Interest rates have been on a secular downtrend since the early 1980s, but with the onset of the Covid-19 pandemic the Federal Reserve pulled out all the stops in their effort to juice the economy through low rates. Historically, the Fed limited its activities to the short end of the Treasury yield curve. However, after the Great Recession the Fed began a policy of “quantitative easing,” buying not only Treasuries, but also mortgage-backed and even corporate bonds in an effort to push down longer-term interest rates. In the wake of Covid-19 the Fed has spread its bond buying further out the yield curve than ever before.
The result, as shown in the graph below, is that the average 30-year fixed-rate mortgage is at an all-time low.
Source: Federal Reserve Bank of St. Louis (https://fred.stlouisfed.org)
Interest rates normally tend to increase in response to news that the economy is stronger than expected. However, with the Fed aggressively pushing down on interest rates, the normal price setting activity in the bond market is being thwarted. At some point the signs of economic recovery will be impossible to ignore and even if the face of political opposition the Fed may be forced to throttle back on its extraordinary monetary stimulus. But at present, any change in Fed policy looks like it will be several years out.
Meanwhile, homebuilders are benefitting from both historically low mortgage rates and mounting signs of economic recovery. Both factors contribute to a growing demand for housing.
In addition, the desire for more physical distance from others in the wake of Covid-19 has spurred a growing demand for roomier living spaces. It is uncertain how much of this shift in demand for real estate will persist once the pandemic is a distant memory, but for the time being, homebuilders are experiencing very high demand for their product.
I am an investor in ETFs. I like their diversification of stock-specific risk, their low expense ratios, and their tax efficiency. At present, there are five U.S. homebuilding ETFs, as shown in the table below:
|Ticker||Fund Name||AUM ($Mil)||Expense Ratio||21D Avg Bid-Ask|
|ITB||iShares U.S. Home Construction ETF||1,994||0.42%||0.02%|
|XHB||SPDR S&P Homebuilders ETF||1,386||0.35%||0.02%|
|NAIL||Direxion Daily Homebuilders & Supplies Bull 3X Shares||380||0.99%||0.18%|
|PKB||Invesco Dynamic Building & Construction ETF||162||0.59%||0.16%|
|HOMZ||Hoya Capital Housing ETF||40||0.30%||0.26%|
Only the first two are of interest to me, and I suspect, to most investors. The other three have some combination of higher expense ratios, wider bid-ask spreads, leverage, or extremely low AUM (an indication of fund closing risk). Consequently, I will focus on only iShares U.S. Home Construction ETF (ITB) and SPDR S&P Homebuilders ETF (XHB).
Comparisons Between ITB and XHB
Certainly, ITB and XHB sound like they would be highly similar, and indeed, they are. Perhaps the most significant difference between the two is the fact that ITB tracks a capitalization-weighted index whereas XHB uses an equal-weighted index. ITB has 45 holdings compared to 35 for XHB.
The sector weightings between the two are somewhat different, as shown in the following table:
Top 10 Sectors
|5.9%||Appliances, Tools & Housewares|
|3.5%||Communications & Networking|
|4.6%||2.9%||Construction & Engineering|
|12.3%||14.4%||Construction Supplies & Fixtures|
|3.5%||19.5%||Electrical Components & Equipment|
|1.3%||Forest & Wood Products|
|0.2%||7.7%||Home Furnishings Retailers|
|10.6%||11.7%||Home Imprvmnt Prod & Svcs Retailers|
Homebuilding is by far the largest exposure for both, but it is much more dominant for ITB than XHB, which tends to have much higher weightings in housing-related industries of various kinds.
Top 10 company weights are also quite different as shown in the table below:
Top 10 Holdings
|4.9%||Carrier Global Corp.|
|14.4%||3.8%||D.R. Horton, Inc.|
|4.2%||Floor & Decor Holdings, Inc. Class A|
|4.1%||Home Depot, Inc.|
|4.2%||Johnson Controls International plc|
|12.4%||Lennar Corporation Class A|
|4.2%||Lowe's Companies, Inc.|
|5.3%||Mohawk Industries, Inc.|
|3.3%||Toll Brothers, Inc.|
|4.6%||Trane Technologies plc|
|4.3%||Trex Company, Inc.|
ITB is more concentrated, as expected with a capitalization-weighted index, and the top 10 holdings comprise 64.0% of the portfolio, compared to 44.5% for XHB.
Is sum, ITB might be described as a “purer play” on homebuilding, while XHB includes many more related industries and companies.
The graph below analyzes the historical return differences between these two major homebuilding ETFs. Based on the history of the trailing 36-month total return correlations, the two seem to be very close substitutes. However, all equities and (particularly) equity funds tend to have very high correlations to each other because of their shared exposure to the overall stock market. The risk-adjusted returns below have statistically controlled for the portion of return due to either 1) equity market risk or 2) interest rate risk. These risk-adjusted returns show much lower levels of correlation.
As shown in the bar graph below, ITB has both a higher stock market beta and a higher sensitivity to interest rate changes. These betas are measured using exponentially-weighted multiple regressions where both risk factors are captured simultaneously. Exponential weighting gives more weight to the recent past, which tends to make these risk betas more robust estimates of future behavior.
Whether these two homebuilding ETFs are different enough to warrant investing in both is debatable. I have used one or the other at times, and at other times, as at present, I have invested in both.
ETF Factor Analysis
I am a “quant.” I select investments based upon their characteristics, and the returns that those characteristics have generated over intermediate-term (36 months) and long-term (10 years) trailing time periods. I measure the payoffs to these characteristics using cross-sectional regression analysis within a universe of similar securities. For sector and industry selection, I make comparisons across 86 sector and industry ETFs. ITB and XHB are two of the 86.
The weight of credible academic evidence indicates that the most powerful and persistent factor anomalies have to do with three broad types of characteristics:
I typically use 2-4 different factors within each of these three categories to quantify the degree of exposure of each ETF to each factor and measure its historical payoffs. FactSet provides “look-through” analysis of ETFs based upon data for the individual ETF stock holdings.
For value, the most powerful factor within the sector and industry ETF universe is EBIT/EV or earnings before interest and taxes compared to enterprise value, which is the sum of market value of equity and book value of debt. It is a broader measure of value than the more common P/E, and is more uniformly applicable across sectors and industries with widely varying capital structures.
As shown in the bar graph below, both ITB and XHB have excellent value, and are among the top sector and industry ETFs in terms of EBIT/EV.
Momentum: Analyst Estimate Revisions
One of the most powerful indicators of momentum among sector and industry ETFs is estimate revision diffusion (%up - %down) for earnings estimates of the current and next fiscal years. The trend in analyst estimates of future earnings is a very good leading indicator of future earnings and stock price. As shown in the bar graph below, ITB and XHB have the top two highest loadings on this factor, indicating excellent momentum in the underlying business fundamentals of their portfolio companies.
Profitability is one important aspect of fundamental quality. I measure profitability based upon return on invested capital (ROIC). It has proven a powerful cross-sectional indicator of future relative performance. Contrary to the impression that homebuilding is a capital-intensive industry with weak margins, as indicated in the bar graph below, the homebuilding ETFs rank very highly in terms of their profitability as measured by return on invested capital.
Quality: Interest Coverage
Another vital quality indicator is financial strength. I measure it with cash flow coverage of interest expense. Before the Great Recession, homebuilders were often highly leveraged, holding “land banks” of developable lots in their inventory that were financed with debt. The severe financial distress experienced during 2008-2009 forced a more conservative approach in the industry. As shown below, today homebuilders have the highest quality balance sheets of any industry as measured by operating cash flow to interest expense.
- The current environment is very favorable for homebuilders:
- Mortgage rates are at all-time lows
- The economy is recovering
- Demand for housing is booming
- Two homebuilding ETFs have massive AUM, low expense ratios, and low bid-ask spreads:
- iShares U.S. Home Construction ETF (ITB)
- SPDR S&P Homebuilders ETF (XHB)
- Both have very favorable factor characteristics:
- Value: high EBIT/EV
- Momentum: upward revisions of analyst earnings estimates
- Quality: profitability as measured by ROIC (return on invested capital)
- Quality: financial strength as measured by operating cash flow/interest expense
- Now would be a good time to buy either ITB or XHB or both