Imaginima

Thesis

Demographic trends are seen by many analysts as playing an important role in economic growth and, therefore, stock market returns over time. The performance of the housing sector is also affected by variations in population growth. In this analysis, I explore the demographic factor regarding the growth prospects of the home building industry, proposing DR Horton, Inc. (NYSE: DHI) as an attractive choice for investors to exploit favorable medium-term trends.

Short-term fear and bad memories rule homebuilder stocks

Spreading fears of an impending recession, combined with rising borrowing costs (interest rate hikes) and input cost inflation (rise in building material prices) have led the residential construction industry to register significant losses since the beginning of the year. Despite very modest valuations across the sector, homebuilders are down -28% year-to-date compared to -15% for the S&P 500.

Even though the industry has seen some growth in recent years – +65% 5-year price return for (XHB) – the 2008 housing bubble and subsequent crash still haunts investors’ memories, making them hesitant to engage in actions in the industry. As a result, today, especially since the recent major market pullback, almost all stocks in the sector are trading at a deep discount.

Chart
XHB data by YCharts

Demographics: Exploring the Demographic Driver for Homebuilders and Stocks

Although more headwinds may emerge in the short term and recent performance indicates deteriorating investor sentiment, over the next decade a major catalyst will lift industry performance.

As population growth changes over time, some generations are much larger than others. When a large generation enters its prime years of productivity (28 to 50), economic growth and stock market returns have historically exhibited significant upward trends.

Generations

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Millennials are one of the most important generations in recent memory and the good news is that they are now entering their prime years of productivity and home buying. As millennials enter their 30s to 50s, they are expected to peak in productivity in 2029.

As shown in the graph below, provided by Fundstrat, stock market performance over the medium term is correlated with the size of the population group aged 28-48. In fact, the period when two other major generations (the World War II generation and baby boomers) reached their peak productivity years coincided with very strong stock market growth. Depending on other macroeconomic factors, the cumulative annual growth from 2022 to 2029 is expected to be between 8% and 20%.

Demography vs market

Fundstrat Global Advisors

Every market cycle is a demographic cycle. Especially when it comes to industries revolving around the housing market. Returns from the residential construction sector are expected to outpace those of the broader market, due to its discretionary nature (strong performance during periods of economic growth). Additionally, a generation moving towards its peak productivity years translates into greater home buying activity.

Home builders are therefore very likely to outperform the market over the medium term. Given the very low valuation levels across the sector, the downside potential becomes limited, providing a rare opportunity for asymmetric return risk.

In the long term, short-term market movements become rather unimportant, except for the entry opportunities they may provide when stock prices fall.

It’s also important to remember that US households are arguably one of the most sequential owners of equity investments, whether through retirement programs or brokerage accounts. People between the ages of 30 and 50 are likely to invest because they earn more. In this sense, a large demographic group between these ages is exerting upward pressure on stocks. According to US News, in 2019 about 53% of American families held investments in the stock market, a sharp increase from the 32% who owned stocks in 1989.

Why DR Horton specifically?

Within the homebuilder industry, analysts and investors have been able to identify a number of well-positioned companies. So what really makes DR Horton a great candidate to capitalize on the demographic catalyst?

Financial performance: DR Horton has grown its revenue to 22.7% and 18.50% CAGR over the past 10 and 5 years respectively. Operating profit also increased significantly, at 10- and 5-year annualized rates of 42.3% and 36.0%, outpacing sector and industry growth rates. Profitability is also strong, with a gross margin of 30% in 2021, when most companies in the sector are aiming for 22-25%.

Size and Competitive Forces: DHI is the largest homebuilder in the United States with a market cap of $25 billion and revenue of $27.7 billion (fiscal year 2021). The company also maintains the largest market share in its 5 largest markets, including Houston, DFW, Atlanta, Phoenix and Austin.

Geographical positioning: DR Horton operates in some of the most dynamic real estate markets in the United States, including Texas, Florida, Arizona and others. Population growth and internal migration trends are particularly beneficial in these parts of the country.

Various product offerings: DHI maintains a diverse catalog that includes entry-level, move-out and luxury homes. Since most of the company’s revenue comes from low-cost homes, the company should be more resilient in the event of a recession or a downturn in the real estate market.

Dividend growth: Although the current yield of 0.95% is not impressive, DHI is a good choice of dividend growth for long-term investors. Dividends have grown at a CAGR of 11.03% over the past 5 years and the payout ratio remains low.

Valuation: add to upside potential

The risk-reward outlook for exploiting the demographic catalyst within the homebuilder industry further improves considering the attractiveness of DHI’s current valuation. While posting strong growth and substantial profitability, the stock is trading close to liquidation value, which is not only absurd, but also a limiting factor on the downside.

Currently, DHI is trading at a P/E FWD of 4.3x, a P/S of 0.75x and a P/B of 1.3x. Compared to market and industry averages, the stock looks very cheap. Even compared to the company’s historic 5-year P/E multiples, DHI currently sits at a lower multiple from 2020 levels. This is after posting record earnings in 2021, and as analysts s expect another year of net income growth in 2022. P/S and P/B ratios are also at or near 5-year lows as well.

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Risks for the thesis

As with any other investment proposal, especially in times of uncertainty, there are several risks that need to be considered. A short list of factors that could negatively affect the thesis is offered below.

Rising inflationary pressures: In the scenario where inflation does not subside, we must anticipate a contraction in the margins of house builders. Rising material prices, labor and transportation costs will reduce operating margins.

Significant increases in interest rates: Despite recent interest rate hikes by the Fed, rates remain, for now, at relatively normal levels in a historical sense. Currently, the 30-year fixed mortgage rate is around 5%. Further increases will likely affect housing affordability and cause consumers to postpone buying a home.

The US economy is entering a major recession: Spending on new homes is discretionary and demand elastic. In the event that consumer income declines significantly, unemployment rises, and sentiment deteriorates further, home purchases could decline significantly, affecting sales growth and profitability.

Final Thoughts

Even though the Demographic Catalyst may not be reliable in predicting market performance in the short term, and therefore is not useful for short-term focused investors and traders, in the medium term it projects asymmetric upside potential. . The homebuilding sector and DR Horton are in my opinion the best vehicles to exploit the general growth trend that is expected to affect performance over the next decade.