Lennar: Staying Bullish On This Homebuilder Stock Amidst Real Estate Boom

Residential real estate is in the midst of a major bull run, with10-year annualized return, but substantially less than returns over the past three years.

Market-Implied Outlook For LEN/h2

I have calculated the market-implied outlooks for LEN for the next 4.8 months using options that expire on May 20, 2022 and for the next 12.8 months using options that expire on Jan. 20, 2023. I selected these two expiration dates as these were the closest to the middle and end of 2022.

The standard presentation of the market-implied outlook is in the form of a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Source: Author’s calculations using options quotes from E-Trade

The market-implied outlook for LEN to May 20, 2022 is generally symmetric, although the peak in probability slightly favors negative returns. The annualized volatility calculated from this distribution is 35.2%, quite high for an individual stock.

This distribution gives a 1-in-5 probability that LEN will lose 17% or more over the next 4.8 months and a 1-in-5 probability that LEN will gain 17% or more over the same period.

To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Source: Author’s calculations using options quotes from E-Trade

This view shows just how closely the probabilities of positive and negative returns of the same magnitude match up (the solid blue line and the dashed red line are very close to one another), although the probabilities of negative returns are slightly higher for the higher-probability outcomes (the left third of the chart above).

Theory suggests that market-implied outlooks will tend to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. Considering the potential for such a bias, the market-implied outlook for the next 4.8 months looks neutral to slightly bullish.

The market-implied outlook through 2022, calculated using options that expire on January 20, 2023, more strongly favors negative returns (the red dashed line is well above the solid blue line for the range of possible outcomes). This is a slightly bearish outlook. The annualized volatility calculated from this distribution is 37.6%.

Note: The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from E-Trade)

The market-implied outlook to the middle of 2022 is neutral to slightly bullish, shifting to slightly bearish for the outlook to early 2023. The expected annualized volatility is 35.2% for the mid-year outlook and 37.6% for the full year. This is consistent with there being greater concerns about rising interest rates as the year progresses.

Summary/h2

Lennar has done very well in recent years. A number of factors have aligned to drive demand for homes.

The prevailing low interest rates and, more recently, COVID have been very good for homebuilders. With increasing inflation and the Fed signaling a less accommodative stance for 2022, along with record-high real estate prices in many US cities, the potential for a slowdown in the market is increasing.

The Wall Street consensus for the next year continues to be bullish, with expected 12-month total return of about 18.3%. Even with the uncertainties, as reflected in the high expected volatility, this is an attractive rate of return.

As a rule of thumb for a buy, I look for an expected 12-month return that is at least ½ the expected annualized volatility. LEN just manages to meet this criterion. The market-implied outlook for LEN is neutral to slightly bullish in the first half of 2022, but shifts to slightly bearish for the full year.

Considering LEN’s modest valuation, current economic conditions, and the two types of consensus outlooks, I am maintaining my bullish view for LEN for the time being. I plan to revisit this analysis around the middle of 2022, given the uncertainty in interest rates and the shift in the market-implied outlook to slightly bearish for the full year.

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