The housing sector is surging despite the tepid economy, but we don’t recommend capitalizing on its strength with the conventional sector plays, home-builder stocks. Yes, the group has skyrocketed since the Great Recession, but we’re concerned it has run out of steam.

Our Chief Investment Strategist Linda McDonough sees a better way to profit from housing: Move down the food chain to the firms that supply home builders with construction materials.

A healthy real estate market raises demand for their products, too, and several of these stocks are attractive bargains. Our favorite is Growth Stock Strategist portfolio holding Installed Building Products (NYSE: IBP), a rapidly expanding home insulation supplier and installer whose stock more than doubled the past few years to about $31 a share.

We expect more where that came from, and we’ll explain why shortly. But first, here are some particulars on what’s driving the housing sector.

For starters, June sales of new single-family homes rose 3.5% to an annualized 592,000, the best month for such sales in more than eight years. Plus, new home sales have been trending higher all year, with the June tally clocking in almost 13% above January’s 526,000 annualized rate.

Housing hasn’t peaked yet, though, asserts Ivy Zelman, the Credit Suisse analyst who called the real estate crash that triggered the Great Recession. Zelman, who now has her own firm, predicts double-digit growth in housing starts—initiation of new single-family home construction projects—through 2018.

Her reasoning: Despite recent gains, single-family housing starts are still 35% below normal. And there’s plenty of incentive to keep building because housing demand far outstrips supply, with the nationwide inventory of homes available for sale at a three-decade low. A recent U.S. Census Bureau forecast validates Zelman’s outlook, calling for 10% compound annual growth in housing starts through 2017.

Linda also sees promise in another key indicator of future housing activity—order backlogs at the nation’s four largest publicly traded home builders. These include D.R. Horton, Lennar, Pulte Group and NVR, where annual sales range from nearly $12 billion for D.R. Horton to $5.5 billion for NVR. In all four cases, order backlogs expanded strongly in the second quarter, suggesting business should continue to boom.

Shortage of Homes

Housing is in such short supply because population growth outpaces new construction. According to the National Association of Realtors, construction of new single-family homes, condominiums and apartments totaled 5.6 million units since 2009. During that time, 1.7 million housing units were demolished and removed, yielding a net addition of 3.9 million units.

Yet the population increased about 17 million. At least 3 million new homes are needed to solve the shortage, NAR estimates.

Meanwhile, a dearth of housing is creating hot markets. In the second quarter, home prices rose in 83% of the nation’s 178 major real estate markets. Nationwide, prices are only about 2% below their July 2006 peak, the Wall Street Journal recently reported.

All this creates a superb climate for home builders, who enjoy robust demand and are in a position to charge more for new construction. The four largest expect solid performance for the rest of the year at least. The group in general remains optimistic, too, despite recent weakness in gross domestic product. You can tell this from the National Association of Home Builders/Wells Fargo Housing Market Index, a widely followed measure of home-builder sentiment. In August, the index rose two points to 60, right about where it was a year ago. Anything over 50 indicates positive sentiment.

The trouble is home-builder stocks have risen so much they now lack sufficient reward potential, and D.R. Horton is a prime example. After roughly quadrupling from recession lows, shares of the nation’s largest home builder sell for a 16% premium to the industry average price-to-earnings ratio, suggesting they may not have much further to run.

Cheap Given Growth

At first glance, Installed Building Products may not look like much of a bargain either, with a fairly frothy P/E of 16.2 times next year’s profit estimates versus 12.1 times for D.R. Horton. However, the former has a much cheaper ratio of P/E to growth, a popular valuation statistic known as PEG.

We like PEGs that are less than one because they mean shares sell for a discount to five-year growth forecasts. The further below one the PEG happens to be, the deeper the discount. Installed Building Products has a PEG of only 0.31, indicating a 69% discount to growth estimates. D.R. Horton’s PEG of just over 1 is a compelling sign the stock is fully valued.

Analysts expect Installed Building Products to compound profits an average of 68% annually the next five years. These lofty estimates are feasible, though, as resounding success the prior five years vaulted the company to number two in the market for fiberglass and other types of insulation used in new home construction.

The firm is also a leading supplier of garage doors, gutters and bathroom components. Although focused mainly on new construction, the firm does substantial business in the home remodel and repair markets, too.

Installed Building Products has a history of juicing growth by snapping up successful rivals and already has completed six acquisitions this year, adding a combined $53 million to the top line. Nearly half of this ($24 million) comes from Alpine Insulation, a Wisconsin-based cellulose, spray foam and blown-in insulation specialist acquired four months ago.

Lucrative deals like these should help keep full-year revenue on pace for a 32% spike to $877 million. Earnings are expected to soar 61% for the year to $1.43 a share. We wouldn’t be surprised if the stock hits our $46 price target sometime next year, when sales are approaching $1 billion and per-share profits are expected to exceed $1.90.