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Cogent Investing: Members Report Sample

Context: Cogent Investing’s premium subscription service includes two reports a month. In these reports we typically include

  1. In-depth analysis on one stock idea;
  2. Discussion of recent news on any company in our portfolio; and
  3. Commentary on recent market movements and whether we’re changing the mix of stocks and defensive assets in our portfolio.

The report below on homebuilder NVR is an example of the in-depth analysis on one stock. We originally published this research on November 21st, 2018.

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NVR’s stock performing well as headwinds fade

Published Nov 21, 2018

NVR continues to grow profits well

We call NVR the best homebuilder in America because the firm has consistently delivered excellent financial results for the past twenty years.

NVR has high earnings growth (see chart below), a robust balance sheet, and a risk-averse business model as they outsource land development activities to their business partners. NVR has been profitable every year since adopting this risk averse business model in the early 1990s – including during the financial crisis.

These strengths are why NVR is one of our core holdings, and we view NVR recent share price volatility as an opportunity to buy, not a reason to sell.

NVR’s stock is down 30% in 2018

NVR’s stock had an excellent year in 2017, rising more than 100%. This rise was not fully justified by growth in NVR’s intrinsic value, however, as the firm ended the year priced at ~20x earnings, well above its normal level of 15-16x.

The sell-off came, inevitably, with rising mortgage rates leading to sharp drop in the first six weeks of 2018. We view that sell-off as justified, as it took the heat out of NVR’s stock and returned the firm’s valuation to more normal levels of 15-16x earnings.

But the market has become even pessimistic on NVR’s prospects since then, which we believe is simply not justified. NVR’s stock fell sharply at the end of July after new order growth fell to +6%, and then sharply again in October as the market focused on the prospects of interest rates rising further still.

We understand why the market has reacted the way that it has in each of these instances, as NVR’s new order growth is likely to slow for the next few quarters. We’ve shown the reason why several times before: the chart below shows that: higher mortgage rates cause some buyers to delay their house purchase, which reduces NVR’s new order volumes.

These share price moves give us an opportunity

While we understand why the market has sold NVR stock as mortgage rates have moved higher, that doesn’t mean we believe the moves are justified. They’re not. Each move has been directionally correct, but in aggregate they’ve pushed NVR’s price (and valuation) down too far.

This is the source of our opportunity. NVR’s stock hit its lowest valuation since the financial crisis in late October, which was 10.8x earnings. The firm has recovered some ground since then and is now valued at 12.7x earnings. But this is still ~20% below its’ normal level in absolute terms (second chart above) and relative to the market (chart below).

NVR’s stock price has recovered somewhat in recent weeks, and we believe this recovery can continue as the headwinds facing the firm begin to fade. This should lead to shareholder returns >15% p.a. for investors patient enough to hold for the 1-2 years for this idea to play out.

Large builders all seen to face the same challenges

NVR isn’t the only homebuilder whose stock has suffered in 2018, of course. Most large homebuilders have seen their valuations drop to post-financial crisis lows, as they’re all facing the same headwinds – at least in theory.

Many homebuilders have seen their valuations drop well below 10x earnings. This is very cheap, and several of them probably make good long-term investments from here. We’ll stick with our focus on NVR, however, as it is a much higher quality & more resilient business than the other firms. We’re confident NVR will continue to prosper even if we’re wrong in our view that the housing market will recover from this temporary slowdown – but we cannot say the same about the other firms.

The rationale behind this sell off is that mortgage rates are rising, so new homes sales will fall, and this will cause some builders to sell some homes at a loss as they need to meet their financing obligations.

Headwinds logic makes sense at a national level…

This logic has some merit at a national level. Higher mortgage rates have led the “pending home sales” metric, which measures forthcoming new home sales nationally, to fall over the past year.

This slowdown in demand will cause some builders to face financial difficulties, especially if they are levered financially and forced to sell homes at a loss to meet their debt obligations.

…but headwinds logic makes little sense for NVR

This logic fails when applied to NVR, however, at least over the long-term.

We agree that rising mortgage rates will have a short-term impact on NVR’s new order growth, and we’ve already seen it slow to 2.4% annual growth in Q3 2018. But we need to remember that:

  1. The slowdown in order growth is driven by rising rates, not high rates in absolute terms, so this headwind will annualize and fade from Q2 ’19.
  2. NVR has consistently grown orders faster than the pending home sales index, growing 45% since 2001, vs. 5% for builders nationwide.
  3. NVR has shown that slowing order growth does not mean falling profits. NVR’s new orders fell in late 2013 but operating profits didn’t fall in 2014, and net income barely budged (see first chart).
  4. NVR has no land assets they need to sell or any financial leverage, so they’re not forced sellers of any properties, and are unlikely to make a loss in any year (they didn’t in the financial crisis).

We believe NVR will continue to prosper, and that their current slower rate of order growth is just a short-term blip in their long-term success.

Amazon’s HQ2 will boost demand in NVR’s heartland

Amazon recently announced that they’ve selected Long Island City, New York, and National Landing, Virginia to be their two new headquarters for the firm (in addition to retaining Seattle). Amazon has promised to create at least 25,000 new jobs with an average wage above $150,000 in each location, which will be a large source of housing demand over the next 10 years.

This is a great result for NVR, which is based in Northern Virginia and conducted ~25% of their business in the Washington DC area in 2017.

We expect this incremental demand will show up in NVR’s new order data from early next year – which lends support to our view that NVR’s new order growth will return to trend by the middle of next year, and that NVR should return to its’ normal valuation of 15-16x earnings over a similar timeframe.

We’re buyers of this dip

We believe the headwinds that have dragged down the homebuilding sector in 2018 are unlikely to have a major impact on NVR’s profitability over the next year, and very little impact, if any, over the long-term. NVR’s stock has performed well in the past month, but it remains very cheap and we expect this strong recent performance will continue.

We believe NVR will generate 15-20% returns over the three years, which means this is a great opportunity to buy more shares of this fantastic firm.

 

Disclosure: Warwick Simons owns shares of NVR.

 

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