Post-Bubble Recovery Trade Could Allow Income Investors to Book 37% a Year

Home prices have been depressed for years after one of the biggest asset class bubbles in history burst. In many hot real estate markets, inflated home prices dropped to a mere fraction of their peak prices, leaving investors holding illiquid assets that they couldn’t sell, but also couldn’t afford to keep.

Banks and mortgage companies foreclosed on many of these homes and then tried to unload them on an already saturated market — further pressuring prices and adding a tremendous amount of supply to a market that exhibited virtually no demand.

Of course, individual real estate investors were devastated. And another area that was dramatically affected was the homebuilding industry. From the large-cap home construction companies to the myriad of independent contractors, business essentially dried up and many of the less capitalized companies were forced to shut their doors.

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With fewer homebuilders still in operation, the surviving businesses are now much healthier — and poised to take advantage of a dramatic rebound in the housing market.

As we discussed a couple of months ago with our Blackstone Group (NYSE: BX) trade, private equity buyers have been spending billions buying up distressed homes, remodeling them, and then renting the properties to tenants.

With billions of dollars in demand hitting the market at once, the supply/demand tide is now shifting. Quality homes for sale are becoming harder and harder to find, and homebuilders are once again breaking ground on new projects.

For the month of March, the National Association of Realtors reported the highest level of pending home sales in more than three years, underscoring the rising demand for residential real estate.

Toll Brothers: Rapid Earnings Growth

One of the best homebuilder opportunities is Toll Brothers (NYSE: TOL). The company has already turned the corner and is reporting positive earnings, with tremendous growth in its future.

Analysts currently expect the company to earn $0.74 per share for fiscal 2013, ending in October, down from $2.86 in fiscal 2012. However, earnings per share (EPS) for fiscal 2014 are expected to nearly double to $1.41. As growth companies demonstrate the ability to generate strong earnings increases, investors will pay a much higher premium to own the stock.

Over the next few months, I expect TOL to continue to trade higher as the housing market experiences both seasonal strength (spring and summer are typically strong periods for building), as well as a cyclical rebound in line with the supply/demand imbalance for homes.

Materials Shortage — A Blessing and a Curse

There has been a bit of press lately about a materials shortage for construction companies. As demand picks up, the availability of lumber, concrete and other building materials has tightened.

This means that some builders will have a hard time sourcing the materials, and prices for building supplies will likely increase. Obviously, this represents a challenge for builders and may pressure overall profit margins. But there are some positives to these shortages as well.

First, a shortage of materials naturally gives the large-cap competitors an advantage. This is because large companies like Toll Brothers have established relationships with the materials suppliers and often have long-term supply contracts in place. So, a shortage may actually give Toll Brothers a leg up on its competition.

Second, the supply shortage is just another data point confirming that the housing rebound is for real. If demand for new materials is so strong that lumber mills and concrete plants are running out of product, then we know we have a legitimate rebound on our hands.

Finally, as covered call traders, we know that volatility actually adds to our profitability. So with the supply news causing homebuilder stocks to pull back a bit, we’re actually getting a better entry price on the stock, and better premium for the option contracts we are going to sell.

So, let’s take a look at the setup and how we can generate 37% a year with this type of trade.

Setting Up the Toll Brothers Covered Call Trade

Toll Brothers is currently trading near $35.37 as it builds the right side of a relatively volatile base. The stock rallied sharply at the end of April on analyst upgrades, but this week, it has pulled back just a bit, giving us an attractive entry spot.

TOL Stock Chart

Today, we’re going to buy TOL near $35.37 in 100-share lots. Then, to add our covered call income overlay, we’re going to sell the TOL June 35 Calls near $1.90.

Remember, we want to sell one call contract for every 100 shares of stock that we buy. The net cost per share for this trade would be $33.47.

Now, assuming TOL remains above $35 through the option’s expiration date on June 21 (45 days from now), we will be obligated to sell our shares at $35. This represents a profit of $1.53, or a 4.57% gain during that time period.

If we continue to set up trades like this throughout the year, the 45-day gain represents a 37% return over the course of a year.

On the risk side of the equation, we’re actually protecting our capital with a breakeven price of $33.47. This means the stock could drop more than 5% and we would still not experience a loss.

As demand for residential real estate continues to pick up, homebuilder stocks should do very well. Depending on how TOL works out, we may add additional exposure to this industry during the next several weeks.

As always, I love hearing from you. Please drop me a note at Editors@ProfitableTrading.com and let me know how you are implementing these trades in your account.