Last week’s autumn statement from chancellor Jeremy Hunt painted a gloomy picture of the outlook for the UK economy and house prices. And yet big FTSE 100 house builder stocks have maintained a mini-revival since making multi-year lows in September/October.
What’s going on? House builders are some of the most cyclical businesses around, their fortunes strongly linked to the health of the economy.
Could it be the stock market had previously overdone its ‘pricing-in’ of the gloomy outlook? And that builders’ shares have passed the worst and are at the start of a major recovery?
Recession
There’s no sugar-coating the state of the economy. GDP contracted by 0.2% in Q3 (July to September). A further fall is sufficiently certain in Q4 for the chancellor to have warned that the UK is already in a recession.
In forecasts published alongside the autumn statement, the Office for Budget Responsibility (OBR) said it expects the economy to further shrink through 2023, before gradually returning to growth in 2024.
This chimes with forecasts by the Bank of England that suggest the recession could last two years all told. It would be the UK’s longest since the 1920s — although not the deepest, if the OBR’s projection of a total contraction of 2% is on the mark.
Housing market
The OBR’s latest modelling also suggests house prices could fall by 9%. This is in line with Nationwide’s central scenario of an 8%-10% decline — although the building society’s worst-case scenario projects a slump of 30%.
Mouth-watering prospect
Against this backdrop of woe, the share prices of big-volume house builders have made gains from their early autumn lows. Persimmon is up by 14%, Barratt Developments by 24%, and Taylor Wimpey by 26%.
These gains may seem impressive, but here’s the thing. If their shares were to get back to their previous highs, Barratt’s would rise by a further 105%, Taylor Wimpey’s by 116%, and Persimmon’s by 131%. Potential returns of this magnitude could be a mouth-watering prospect.
Valuation pitfalls
Valuing house builders on the most commonly used measures of price-to-earnings (P/E) and dividend yield can lead investors astray.
At the peak of the cycle, builders’ P/Es often seem temptingly undemanding and their dividend yields enticingly generous. In other words, they appear ‘cheap’ on a conventional reading of these valuation measures.
At the bottom of the cycle, when profit margins and earnings have collapsed, P/Es are high (or off the scale if the company has swung to a loss), and dividends have been slashed or suspended. In other words, they appear ‘expensive’ on a conventional reading.
A good barometer
There’s another valuation measure I find more useful for house builders. Namely, price-to-book (P/B). This asset valuation measure sticks to the script: it’s high at the top of the housing cycle and low at the bottom.
For example, at the top of the cycle before the 2008/9 recession, Persimmon reached a P/B of 2.5. This meant investors were paying £2.50 for every £1 of the company’s assets. At the bottom of the cycle, Persimmon’s P/B fell to 0.7, meaning you could buy £1 of its assets for just 70p.
At the top of the latest cycle, the P/Bs of Persimmon and its peers exceeded their highs of the previous cycle. Not too surprising, because the economy was pumped with the stimulating drugs of money-printing and low interest rates. And on top of that, builders enjoyed a special supply of crack-cocaine in the form of Help to Buy.
Where are we now?
The top of the cycle’s behind us. Are house builders’ current P/Bs at the kind of discount levels that signalled the bottom of the last cycle?
Persimmon’s P/B is now 1.2, compared with 0.7 in the 2008/9 recession. Barratt and Taylor Wimpey both currently have PBs of 0.9 — a discount to their assets, although not as big as the discounts in the 2008/9 trough.
What does it mean?
I think the house builders’ share-price rises of recent weeks have been something of a relief rally from the turmoil caused by ex-chancellor Kwasi Kwarteng’s ill-fated mini budget.
If past cycles are any guide, builders’ PBs and share prices could yet fall lower before the advent of a new growth phase.
Having said that, the companies’ balance sheets are stronger than they were going into the 2008/9 recession. And their current PBs are a lot more attractive than when — as recently as last year — buyers of these blue-chip stocks were coughing up £2-£3 for every £1 of their assets.
