Bet the House

This article was originally published by Zacks.com.

Maybe you have heard of the recovery in housing. It's been a heavily played story over the last few months, and we got confirmation of it recently when we saw the homebuilders report solid earnings.

The following graph shows how the story has taken hold, but clearly still has some room to run.

Let's take a closer look at the direct and indirect housing plays that investors can use to prosper from the recovery in housing.

The direct play is costly

One example of good recent earnings from the home builders is Toll Brothers (TOL), which has reported two consecutive positive earnings surprises. The April 2012 quarter saw the company post earnings of $0.10 per share, and that was $0.06 more than the Zacks Consensus Estimate of $0.04. This translates into a 150% positive earnings surprise. The following quarter saw another $0.08 beat or a 44% positive surprise.

Those beats are what investors want to see, but they come with a price. Expectations keep building higher and higher as the recovery continues, and the valuations for the home builders have moved in lock step. TOL traded at 40 times earnings one year ago and is now trading at nearly 80 times trailing 12 months.

With homebuilders reporting positive quarters, if you are feeling that the stocks have either moved up too much or the valuations are now stretched, you are not alone.

We have looked over a few industries that are benefitting from the recovery and could provide investors with a better valuation profile and help diversify risk. Several of our strategists have found stocks that benefitted and continue to benefit from the recovery.

Building blocks

When home builders begin construction they need raw materials. There are several companies that supply the basic materials — wood, steel and glass — but we want the companies that are primed for solid earnings.

There are a number of construction companies that have shown a solid history of positive earnings surprises and have seen recent earnings estimates increases. These stocks are benefitting from the recovery in housing as demand for their products allows for price increases. These same price increases are helping to expand margins, which in turn produce higher earnings.

One advantage to the construction supply stocks is that they are likely to give a warning signal if the market turns around. Any slowdown in growth from these players could signal a slowing for the homebuilders, so these stocks can be used as a “canary in a coal mine.”

Following the money trail

Home buyers may not find the current process of buying a home as easy as it was in the bubble days, but the low interest rates are certainly helping things out. These low rates are stoking the flames of demand for new homes.

Specialty mortgage players are in a sweet spot, as rates are low and new home construction prices continue to improve. Like many financial companies, these stocks tend to pay a handsome dividend, but picking the best of breed can be difficult. Simply looking for a high-dividend-paying mortgage company may lead you to a path of pain.

The best play is to look for steady growth in earnings and a lower divided. The payout ratio is a key indicator of the health of a company that offers a dividend. The best payout ratios in the financial space are in a range of 30% to 50%. This allows for the company to retain earnings for growth and still pay out a handsome dividend.

Just as the construction stocks can be a canary in a coal mine, the mortgage companies will give an earlier warning. People need to apply for mortgages before new homes are purchased, so when these stocks cool off, it could be a signal to reduce exposure to the housing play.

New age recovery

In the new information age, there are many plays that allow for participation in the housing recovery. There are a number of websites that assist home buyers in locating new homes. While one company in this space recently went public, there are a few others that might be more attractive to investors.

These plays take advantage of the boom in the housing market from the technology and advertising markets. When new home buyers are shopping for and purchasing a home, ancillary players, like insurers home services (security systems) and other companies, want to be in front of those consumers. They can do that by advertising on the websites that help shoppers find their new homes.

This market is much more fickle and can turn on a dime if the advertising market dries up or a new technology supplants the existing applications. The best companies in this space are the ones that are growing revenue and are profitable. Some even have exposure to the mortgage origination space.

Conclusion

There are several ways to play the housing market recovery. Loading up on the builders alone could be costly from a valuation perspective and would limit diversification. Spreading the risk out across the suppliers of raw materials, providers of mortgages and new age technology plays would help investors bring home better risk adjusted returns.

Brian Bolan is a Stock Strategist for Zacks.com.

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks nor Intellisphere will assume any liability for losses from investment decisions based on this information.