The U.S. housing market's golden age is coming to an end, says Stephen Kim, a senior managing director and veteran housing industry analyst at Evercore ISI. What lies ahead is considerably less golden. Consumers are anxious, builders have excess inventory, and mortgage rates recently hit 7.28%, up from 5.98% at the beginning of the year. Demographic trends also bode poorly, as household formation is poised to decline in coming years.

Home builders' shares reflect this dour outlook, with most trading at or below book value. The stocks could get a lift, says Kim, if companies stop producing so many homes and doling out incentives, and focus instead on boosting profitability.

Will that happen? Kim shared his views and favorite stocks with Barron's in two interviews in September. Read on for the edited details.

Barron's: Home-building stocks performed poorly over the past year. At this point, is all of the bad news baked in?

Stephen Kim: Demand for new homes has weakened because mortgage rates have moved higher, although that isn't the only factor. Consumer sentiment has been persistently weak. An unprecedented number of people in the top third of the nation's income distribution are worried that they are going to lose their jobs in the next five years. If you don't have a job, you don't care what the mortgage rate is, because you aren't going to buy.

We are forecasting that the price of existing homes, as measured by the FHFA House Price Index, will move down 1% to 2% or so a year for the next few years. Production will remain low as builders try to adjust to the weak demand environment.

This isn't an attractive fundamental backdrop for the builders. The only thing they have going for them is their valuations, which are inexpensive at around book value. Builders' valuations reflect the negativity in most cases. Lennar is trading around book value. Most of the small-cap builders are trading at discounts of more than 20% to their tangible book value. That historically has been a good sign of maximum pessimism.

While the stocks' valuations are cheap, most lack a catalyst for improvement. I don't think this is the right time to buy this group, but don't be surprised if, sometime in the next six months or so, I change my view.

What might prompt that change?

We don't expect the conditions in the industry to get materially better until one of two things happens, although both would be great. The first is that builders have to build less. In each of the preceding two winters, the builders overproduced, which led to a frustrating spring and summer when they had to discount more than expected. We think they finally learned a lesson. At this point home builders are fairly despondent; they are cutting back on production.

I want the builders to stay reserved, quiet, and unhappy for the next several months. That will leave them with a lower level of inventory next year, and then we'll see what demand looks like. What I don't want to happen is something that causes demand to perk up, and then the builders get overexcited into the late fall.

The second thing that could happen is that mortgage rates could come down. Mortgage rates probably need to get below 6.50% for the demand picture to improve materially, and that seems far away. Predicting the trajectory of mortgage rates is arguably much harder than predicting what will happen with the stocks.

Hopefully, we will get a little of both things: The builders will stay depressed for the next few months and enter the spring with lean inventories, and mortgage rates will offer some relief. Then, demand can start to pick up. That would allow home-builder profit margins to carve a bottom in 2027.

How can home builders thrive in the longer term if household formation is shrinking?

Household growth is the main driver of the need for home-building. The U.S. long had about 1.25 million household formations and about 250,000 home demolitions a year. That creates the need for about 1.5 million housing starts annually. That household formation number is going to drop significantly, to 755,000 in the 2030s and 420,000 in the 2040s. Soon, deaths will outnumber births in the U.S.

But builders' performance depends on their capital allocation. Home-building has never been a growth industry. You can achieve growth from market-share gains, but housing is a cyclical industry. This isn't about every company growing by 10% a year. It's more about disciplined capital allocation and share repurchases.

NVR, for example, has bought its shares back over a long time. A lot of the large public home builders have done that. Toll Brothers has bought back about 50% of its shares outstanding since 2015. The builders can lean more into share buybacks. In a market that isn't growing rapidly, you allocate less capital to land acquisitions and more to share repurchases.

Are there any home-building stocks you like right now?

We aren't recommending the group as a whole, but PulteGroup and Toll Brothers are our favorites. We have an Outperform on those stocks. Our target price on Pulte is $154, and our target on Toll Brothers is $184. [Pulte was trading for about $112 a share on Oct. 7., and Toll Brothers, for about $134.]

Both companies have been benefiting as many baby boomers continue to buy nice, relatively large houses. Higher-end buyers don't have as much sensitivity to mortgage rates. They have more ability to absorb the extra costs. I wouldn't say the higher end of the market is strong, but it is healthy. There's the idea that everybody downsizes when the kids leave. Well, not really. There's something nice about having your kids, with their families, come back to stay with you.

PulteGroup and Toll Brothers' margins [at a recent 25% and 23.9%, respectively] are sufficiently high that cash flow is still strong. Their leverage isn't high. They have been deploying their cash to repurchase shares, and aren't investing for growth's sake.

Being able to balance a strong return on equity, or at least a sufficient return on equity, with low leverage and high-enough margins creates a case for revaluing the stocks. We value the larger-cap builders on a price/earnings basis, although we keep an eye on price-to-book value, as well. Our price targets imply that Toll Brothers will sell for 13 times next year's earnings, and Pulte, for 14.5 times, up from a recent 10.9 times and 9.75 times, based on our forward estimates.

What would an industrywide revaluation look like?

If home-building stocks get revalued, price/earnings multiples could rise to the midteens, or the mid- to high teens for the largest builders. That hasn't happened yet.

The stocks have long been regarded as uninvestible for long-term money management because the companies don't return in excess of their cost of capital on a predictable long-term basis. As a result, they often trade at book value, or the value of the land they own, and sometimes they trade below book. These are liquidation valuations.

Arguably, the largest companies have changed enough over the past 35 years to support the idea that they should be trading on a price/earnings basis. That idea started to gain purchase with investors three years ago. Based on almost every metric, including market share or leverage, they are better companies than they used to be.

Builders needed to do two things to gain a higher valuation. First, they had to become more land light, although that wasn't sufficient. They also needed higher margins. The industry's profit margins were too low in the mid-single digits. If you don't make enough money, it doesn't matter whether you are asset light.

Margins are weak today, and we don't know when they will bottom. We were hopeful that they would bottom this year, but now we aren't so sure, with mortgage rates having moved up.

You downgraded Lennar to Underperform late last year, a prescient call given the stock's 25% decline this year. What has driven Lennar lower, and what do you make of Berkshire Hathaway's accumulation of a $2.2 billion stake in the company?

Long-only investors have a much longer time frame than my one-year target price. They also tend to focus on the quality of management. Such investors are probably familiar with [Lennar CEO and Executive Chairman] Stuart Miller's long history of success in the industry and his ability to navigate housing cycles, acquired over four decades.

Lennar has maintained its volume at a more steady pace than other builders, during a time when demand has really weakened. That volume comes at a steeper margin price than we have seen historically. Therefore, Lennar's margin trajectory has been more steeply downward than peers.

Lennar's margins are likely to suffer due to the idiosyncratic nature of its land deals. [Lennar buys land through purchase agreements with land banks such Millrose Properties, a Lennar spinoff.] Not all options carry the same financial cost. Some, particularly those written by land bankers, carry more restrictive terms and are more costly.

Because of the way Lennar has structured its land holdings, we think the financing cost alone will add more than 100 basis points [one percentage point] of margin pressure. That makes us more cautious about Lennar relative to peers. We value the company at estimated tangible book in the next 12 months, or at $78 a share.

Are any companies immune to the weak environment for new construction?

Our top pick is Owens Corning, a roofing supplier. Roofing is an interesting subsector. Usually, people don't think about the roof unless they have to, and then it's an emergency. Demand related to new construction isn't a driver. Storms are.