One of the secrets of making money in stock markets is timing. And if you can establish a grasp of anticipating interest rate expectations, there is money to be made in buying and selling house building stocks. Let me explain.
In early October last year we called the top in the housing market in the Fleet Street Letter. This wasn’t a particularly controversial call, despite the fact that some pundits were ‘calling wolf’ some three years earlier. And since October, house price increases in the UK have indeed ground to a halt, with average house prices, according to Nationwide Building Society, rising by less than 2% in the seven months since last September.
Where we stuck our necks out was by saying that the construction and building materials sector would not be severely marked down by the peaking of the housing market. In our view, the constant worry of a fully blown house price crash unjustifiably weighed on the valuations of house building companies; in fact, these stocks had more upside. Year in, year out they delivered double-digit earnings growth and rewarded shareholder patience with increments in dividend payments above 20% in some cases.
Yet the markets ignored these solid fundamentals. Instead, they priced these companies as if they were about to undergo a repeat experience of the late 1980s. Back in October last year analysts warned that housebuilders were ‘not as cheap as you think’. Their weakness, it was reported, was that the sector remained heavily geared to the movements in UK house prices; as such, there would be a severe contraction in earnings as house price inflation disappears and as cost inflation continues.
Analysts therefore concluded that investors should be selling rather than buying into any rally in the construction and house building sector because the companies were on undemanding p/e ratios.
We disagreed with this view. The housebuilding sector is a different animal from what it was in the late 1980s, and the companies that have survived have learnt from that sobering experience. The number of housebuilders has more than halved since 1989. Bigger companies with lower gearing are controlling a higher proportion of the market, while tight planning restrictions have left market supply constrained.
Back then we held a couple of housebuilding stocks: Galliford Try and Redrow. In addition, we were bold enough to produce a new recommendation, Ben Bailey, just at the time when media hype was focused heavily on the downturn in the housing market.
Our contrarian view paid off. By mid-February this year Galliford Try had increased by 14.5% since early October last year and Redrow was 20.8% higher, notwithstanding dividend payments of nearly 2% and over 2.5%, respectively.
Changes in interest rate expectations had been on our side during these months. Throughout this period the Bank of England Monetary Policy Committee (MPC) had unanimously agreed to keep rates at 4.75% from September 2004 to January 2005. Consequently, the markets, with no intimation as to what direction the next move in rates would be, opted to forecast that rates would be unchanged for the rest of this year.
We argued at the time that the longer this game of cat and mouse continued, the more the markets would be tempted to view that the next move in rates would be down. By January this year the markets expected UK rates to end this year around 4.75% instead of over 5% back in October. This development underpinned gains in the housebuilding sector.
But by early February there was a greater risk of a sizeable correction in these stocks, perhaps if the Bank of England sprung a surprise and hinted at a further rate hike. Balancing risk and reward, we decided to take profits in Galliford Try at 59.25p and Redrow at 429p in early February ahead of the release of the minutes of the February MPC meeting.
Indeed, it was at this meeting that one Bank of England MPC member, Paul Tucker, broke the five-month spell of unanimity over the course of rates and voted for a 0.25% point hike in rates. We hung on to Ben Bailey shares through its interims on 1 March before cashing in a 26% profit in six months, selling the shares at 511.5p.
Interest rate expectations were becoming more negative from February. By early March the markets were discounting rates at close to 5.25% by the end of the year, implying two further rate hikes. Not surprisingly, housebuilding shares were marked down on this development.
With house prices moving sideways, a further interest rate hike would be a body blow to the housing market. So Galliford Try, Redrow and Ben Baily retreated to lows of 53.5p, 346p and 430p respectively. This represents a retracement from our exit prices of 10%, 19% and 16%, respectively.
With corrections on this scale, is it worth venturing back into house builders now? The answer partly hinges on the outlook for UK interest rates and in this respect there has been a transformation in the market’s interest rate expectations over the last couple of months. Two months ago the markets were expecting two 0.25% point hikes in rates this year; now they are looking for a cut by December.
In the May inflation report the Bank of England expressed surprise at the speed at which retail spending had slowed down and cut its economic growth forecast for this year to 2.6%, compared with the Treasury’s prediction of 3% to 3.5%. The Bank also accepted that the slower economy meant that inflation pressures had fallen. The markets took this as a hint that the next move in rates would be down. This perception was reinforced by news that in the May meeting Paul Tucker no longer favours a hike in rates.
This more benign interest rate outlook will not be enough to rescue the ailing UK retailing sector, which, as we argue in this issue, will have to look overseas for growth opportunities. However, the feeling that the housing market will not now be dealt another body blow will improve sentiment among housebuilders, which are all on undemanding ratings.
By Brian Durrant, the Investment Director of The Fleet Street Letter.