Published: November 23, 2009

Today's home sales report might not have caught your eye, but the news is good and worth reviewing for investors looking for potential market-beating gains.

Existing-home sales in October jumped a record +10.1% from the previous month. Sales are up +23.5% since their October 2008 low, which also marks a record for a year-over-year increase.

The National Association of Realtors, which released both numbers, said government action was the driving force behind the surge: Buyers were rushing in to take advantage of Uncle Sam's first-time home buyers' credit before it was set to expire October 31.

The median sales price in October was $173,100, a -7.1% drop from a year ago, pressured by heavy sales of lower-priced first homes. Depressed prices for foreclosed homes also played into the lower median price, as buyers bottom-fed on bargain-basement properties lenders were eager to get off their books.

Another bit of good housing news: Supply. The inventory of existing homes is down to seven months. That's hardly a glut: A six-month supply is considered optimal. The reduced supply -- combined with another government action -- spells opportunity.

The government action was the extension and expansion of the homebuyers' credit earlier this month. Washington is the most powerful financial force on the planet, and wise investors position themselves to leverage Uncle Sam's actions in their favor. Every time a public dollar is spent, a private profit is realized.

Here is what investors need to know about the new tax credit:

The credit is available on any contract signed by April 30, 2010, even for buyers who have owned a home before. The income limit has been raised to $125,000 ($225,000 for couples) from $75,000 a year ($150,000 for couples). If income exceeds the threshold, the credit is reduced but still available. A 2010 purchase can be claimed on a filer's 2009 return. Purchases made in 2009 can be credited on an amended 2008 return. Caveats: Taxpayers must live in the home for three years after buying it. And homes sold among family members don't qualify, nor do homes that cost more than $800,000.

Point Two: Rates are still super-low.

Bankrate.com pegs a 30-year fixed-rate mortgage at 5.03%; an adjustable-rate mortgage drops the borrowing cost to 4.06%. At that extremely low rate of interest, married borrowers who buy a median-priced $178,000 home and file jointly will not beat the standard deduction! ($173,100 times 5% = $8,655. The standard deduction for couples is $11,400.)

These low rates, combined with the tax credit, which can be used to bolster a down payment, means a home purchase makes immediate financial sense for millions of buyers who otherwise might have needed a few more years to save.

More buyers taking advantage of low prices, low rates and the tax credit will significantly reduce supply during the next five months, when the new homebuyers' credit is set to expire.

Taken in concert with the long view in mind, these facts clearly mean it's time to seek value in a corner of the market that hasn't ridden the rebound: Homebuilders.

None of the three major homebuilders is making money. None of them has made money in a while, and none is forecast to post in the black any time soon. The market has evidently written off the future of these companies, at least for now.

Which is interesting. Because the data show that these companies are fully capable of posting profits. And certainly this is not an industry that failed, like Wall Street or Detroit, but one that was crunched in a housing bubble that it had no role in creating.

These are the top three homebuilders:

Pulte Homes (NYSE: PHM, $9.50). Pulte is a $3.6 billion participant in an industry that has seen its annual revenues drop to $6.3 billion in 2008 from $14.7 billion in 2005. The company's income statement has seen better days -- it's expected to post a loss of -$4.25 per share this year vs. a loss of -$0.56 last year. The builder is completing about 21,000 units a year, less than half the homes it completed in 2005, when it earned $1.5 billion.

Pulte's balance sheet is strong: With some $3.3 billion in equity, Pulte trades at almost no premium to its net asset value. And while Wall Street is hesitant to put any value on the home-building industry, only 7.4% of shares are short, amounting to only about two days' volume. This puts it squarely in the middle of the S&P 500 and in such company as Kraft, hardly a stock most investors would be worried about owning.

D.R. Horton (NYSE: DRI, $10.66). Horton trimmed down and posted a loss of $545 million for the year ended September 2009, an improvement over its gut-checking $2.6 billion loss the year before. Horton is notable for its relatively wide net profit margin: Net earnings amounted to 7.9% in 2006 and 10.8% the year before, handily beating its peers. Horton is worth $3.4 billion, or roughly 2.8 times its 2006 profit.

Here again, the balance sheet is clean. A billion-dollar profit like the one it turned in 2005 or 2006 would give this company a return on equity of nearly 50%. It's important for investors to realize the relative ease of that level of earnings: 20,000 additional homes would likely put Horton well into the black. That's roughly one-half of 1% of the 3.57 million homes currently for sale. As inventory wanes, capturing another 0.56% of the supply may prove doable with low rates and incentives. About 10% of Horton's shares have been shorted, or roughly three days' volume. This implies a little more investor angst than with Pulte. Some may argue there is less value to Horton, as it already trades at 1.4 times net asset value. The S&P average is 2.2.

Lennar (NYSE: LEN, $13.65). Lennar typically trades at about 15 times earnings, but investors don't seem to think this is in the cards anytime soon. Twelve percent of its shares are short, Wall Street is ascribing no value to its business and the consensus forecast is for a loss of -$2.98 a share this year, reversing a teeny two-cent-a-share profit in 2008. On the plus column, its balance sheet is every bit as strong as Horton's.

Now for the opportunity

Investors who can see the economy rebounding may consider now the time to buy. Traders who understand cycles might buy these stocks in bad years while keeping in mind what they can do in good years. Low rates and incentives will bring these companies through the downturn, and near-term forecasts may start to rise as more analysts price in the extension of the tax credit. Until the market does the same thing, investors can buy rebound results at recession prices and see outsize gains. Remember, a +100% gain in year two beats the market for two years even if the return was flat for the first twelve months.

Value investors looking at homebuilders must consider the huge discounts these stocks represent. These three have clean balance sheets and, in two out of three cases (Pulte and Lennar), command no premium for a business that in normal years can turn billions of dollars in profit.

Short interest shows that optimism for these issues is only partly contrarian, as it's easy to find lots of other companies the market is far more willing to bet against. The best buy among these three is likely Pulte, with its leading market position, low price-to-book ratio and strong balance sheet.

Long-term investors with moderate risk tolerance should consider these shares a long-term buy. Traders with a shorter term in mind might want to wait a little: The good news about housing today didn't do much for homebuilders, but flagging sales in November -- following October's strong showing -- likely will have a negative effect and push share prices down temporarily, which could make these homebuilders a very nice stocking stuffer -- and right in time.

Andy Obermueller
Chief Investment Strategist
Government-Driven Investing