In this episode of Industry Focus: Energy, Motley Fool analyst John Rotonti joins host Nick Sciple to discuss the hot U.S. housing market and its low inventory, and why he thinks NVR (NYSE:NVR) could be a top-performing stock over the next five years.
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This video was recorded on May 20, 2021.
Nick Sciple: Welcome to Industry Focus. I’m Nick Sciple. This week, I’m excited to welcome on Motley Fool analyst John Rotonti, to discuss the U.S. housing market and the homebuilding stock he just can’t stop talking about, which is NVR. John, welcome back in the podcast.
John Rotonti: Thanks for having me, Nick. Really excited to talk housing and NVR, one of my favorite long term themes.
Sciple: Yeah, I pulled a quote off your Twitter, John. Folks should go follow him, JRogrow on Twitter. You said, “I think NVR can be one of the best performing stocks over the next five years.” Let’s talk about that. Why do you believe that?
Rotonti: Thanks, Nick. A lot of times I’ll find an investment and my thesis will basically be, “XYZ company is a really good business, trading at a pretty good value.” That will be the thesis. With NVR, I think there is an undeniable long term theme, macro trend that I’m really excited about, and a really good business. You get the best of both worlds. I have housing, which is, like I said, a long-term trend that I’m really excited about, and there’s one homebuilder that I think leaps and bounds above all others, and that’s NVR.
Sciple: Since you mentioned that, with the overall housing market, there’s a micro story with NVR, and we’re going to break our discussion up that way. Let’s start off with the macro point of view. Anybody that’s been following the housing market knows it’s been hot. In particular, the last year prices have shot up through the roof. What’s going on with housing? What’s driving the macro forces behind what we’re seeing in the market?
Rotonti: There are several bullet points here. I think the first big one is that housing inventory is at an all-time record low of two months. There are currently two months worth of homes available for sale in the U.S., and that’s an all-time record low. That’s a structural problem because people want to have roofs over their heads. They want to start families, they want to start households. There’s maybe many reasons, but one of the big reasons is that the U.S. has been underbuilding new homes for a decade now. Another stat is we’ve been building about a third fewer homes than we did for most of the late 20th century.
The Wall Street Journal recently put out numbers from Fannie Mae or Freddie Mac, one of those two, but basically says that were 3.8 million homes short in the U.S., so roughly four million homes are needed in the U.S. So this is a major structural problem. Homes are, not only for most people, or for many people, their largest financial asset, their biggest investment, but it’s also where they raise their families and create some of their best memories. It’s part of the American dream and we don’t have enough houses to go around here in the US. That’s the big one.
No. 2, mortgage rates in the U.S. are extremely low right now. I’m not saying housing is extremely affordable, because existing homes, the markets are so hot in some cities more than others. But this is also great for NVR, Nick, because existing homes are so expensive that new homes are more affordable. That’s a big driver of that, and the fact that existing homes are so hot, new homes are more affordable, that gives homebuilders some pricing power. It gave them the ability to raise their prices to come up somewhat on terms with existing home sales, which are just too expensive right now. We have not enough homes, existing homes that are too expensive, mortgage rates at 3% for a 30-year fixed. That is generational low. It’s not as low as we got at some point last year, but relative to averages of 5% or 6%, depending on what time frame you’re looking at, mortgages are extremely affordable, 3%. When you take inflation into account, that’s literally almost free money.
Another major tailwind is millennials, the largest age cohort in U.S. history. They’re entering their prime home buying years. If you add up, Nick, that we are under-built by almost four million homes and that the largest cohort of millennials are entering their prime home buying years, I think we can have a longer than normal housing cycle. Homebuilding is cyclical. I think we’re going to have a longer than normal upcycle. Now, the thesis is not dependent on that. NVR is one of these companies, and we can get into this later, that is literally praying for a downcycle. I’m serious. We can get into why, but if there is an upcycle, NVR will go with the trend and keep up with the industry. If there’s a downcycle, NVR kicks it into high gear, takes a bunch of shares, buys back a bunch of cheap stock, and plants the seeds for the next decade of future growth. There are a lot of tailwinds here, Nick.
Sciple: Right. If you look at a chart with housing investment, it really fell off a cliff in 2008 with new home inventory. You mentioned a multiyear low, and at the same time, the population just keeps ticking up. If you look at millennial homebuyers just now entering the portion where if you want to have the house with the yard and the kids and all those things, there’s a structural reason you need to do that. You mentioned housing is on the absolute bottom of Maslow’s hierarchy of needs. One of the most inelastic expenses you have out there. You combine this big upswing in demand as the millennials enter their prime home buying, home purchasing years at the same time where we have a structural shortage in supply, basic economics tells you that that’s a good market for the folks selling that good.
Rotonti: Yeah, Nick, and you mentioned something that I should have mentioned. You said if you want to have a home with a yard. There is some strong evidence that households are moving out of densely populated cities in a COVID world, because they want more space to work, learn, exercise, and play at home in a socially distanced way. They want that yard to be able to get outside. They want some space between them and their neighbor, versus being in a high rise where you have neighbors close to you on both sides, above and below you, shared AC vents, shared circulation of air. They want to be able to work from home, play from home, learn from home in a socially distanced way. Redfin CEO, Glenn Kelman, last year said, he is expecting something, and this is a quote, “Close to an exodus from really large cities.” In the January 2021 Barron’s Roundtable, Henry Ellenbogen, one of my all-time favorite investors said this, “One of the most fundamental trends that will come out of 2020 is that America will spread out. The first suburbanization trends started in 1810. I would argue we’re now in the 5th phase and it is going to be as powerful, if not more so, than the first four.” So there’s some strong evidence, even if we start making our way back into the office that people are moving to the suburbs.
Sciple: Absolutely. Just from an affordability point of view, when you look at the tick up in first time homebuyers, it’s in the cities where you’re seeing that issue pop up because that’s where there’s the affordability problems. I already suspected pre-pandemic that folks were going to have to move out of cities like San Francisco because you just can’t afford to live there, but then you pour gasoline on top of that with every workplace on the face of the planet that has the means to do so adopting remote work as much as they can.
Sciple: We tell the story of rising demand in a market where anywhere you look, there’s a shortage of homes. Where does NVR play into this? Why do you think NVR is the company that is best positioned to take advantage of this misalignment between supply and demand?
Rotonti: NVR is the fourth largest homebuilder in the U.S. It has built in 14 states clustered along the East Coast and into the Midwest. Housing is an essential business, it serves a crucial need, it’s a major driver of the U.S. economy and the American dream. Excuse me. I didn’t mention this, just residential fixed investment, building new homes every year is about 4%-5% of U.S. GDP, so really important to the U.S. economy. If you do 4% of 22 trillion, that’s like almost a trillion-dollar business. Is just building new residential investment every year. It’s a really simple business. If you look at their 10-K, the first section of every 10-K is the business, theirs is three pages long or 3.5 pages long. Simple business. Here’s what they do. Most home builders buy land, put that land on their balance sheet, and then develop that land, and then build on that land. NVR does not do that. That is capital-intensive and when you layer on a capital-intensive business model of buying and owning land, developing land and then building on that land, keeping that all on your balance sheet, when you layer that capital intensity in a really cyclical industry, the two Cs, cyclical and capital-intensive, you can get into trouble.
Sciple: Because there’s debt involved there too.
Rotonti: Exactly. NVR actually, it came public in a leveraged buyout back in 1987, filed for bankruptcy in 1990. Key moment in it’s life, it filed for bankruptcy because it had this traditional home-building business model, cyclical with a lot of debt and a lot of capital intensity. Filed for bankruptcy, ever since then completely changed its business model, Nick, to become a unique asset-light business unlike its major competitors. It does not own or develop land. It doesn’t keep that on its balance sheet. Rather, it secures lot purchase agreements, which are basically an option or the right to buy a finished lot by just putting down 10% of the finished lot price. By not forking over all of that cash at once and instead using these options, NVR can reserve the land on which it wants to build while maintaining a ton of liquidity. That’s the most unique thing about its business model, that it doesn’t own and develop land, which is part of the homebuilding culture, rather it has this asset-light model.
No. 2, it also tries to be the market share leader in each of the markets it participates in, not nationally. If you look at the rest of the industry, they brag about being the national market share leader or in the top three. NVR doesn’t care about that. They want to be No. 1 or No. 2 in each market they participate in because when you can cluster your workers together, your subcontractors together, when you can maintain the closest relationships with local land developers and local subcontractors, you can become efficient, you can create productivity and efficiencies. Their goal is to be the market share leader in each of their markets, these clustered markets along the East Coast. They also vertically integrate. Seven of their factories are within 90% of their communities. Basically, they build the home off-site. The four walls of the home, all built off-site. Staircases, all built off-site. Interior walls, built off-site, brought there on a truck and then just stood up and nailed together. It’s vertically integrated prefab stuff. They have fewer home models, so it’s easier to keep track of their home models. Lot of stuff that makes them more efficient. The cool thing is you would think, “Hey, they use these options, why don’t other home-builders use options?” It’s because home-builders love the adrenaline and the excitement of owning land and selling it at a huge profit in upcycles, Nick. It’s almost like wildcatters in the oil industry. They love that adrenaline rush of being able to make huge profits in upcycles from owning land. NVR doesn’t care about that, they’re fine growing slower in upcycles and then using downcycles to enter new markets. When everyone else in the industry is struggling literally to survive, they enter new markets. NVR in the global financial crisis, in the housing crisis, they entered six new markets and they bought back unbelievable amounts of cheap stock.
Then if you look at how they performed, this differentiated business model that we just talked about enabled NVR to be the only publicly traded homebuilder to remain profitable every year during the worst of the global financial crisis. Its return on invested capital never dipped below 12% in the worst of the global financial crisis. That’s more than the home industry builder average today. Their lowest of their low is higher than the industry average today. By the way, homebuilders are making a lot of money today because it’s been an upcycle for the last decade. Still their lowest of their low, better than industry average today. Then Ensemble Capital recently put out a note on NVR and they said, “Despite NVR’s land-light strategy success, the industry’s use of land options remains lower than it was during the housing boom in 2004-2006.” They’re not moving toward NVR’s land-light asset-light business model. The industry is sticking to the asset-heavy own the land and pray model.
Sciple: Is there a disadvantage to this model? I guess you don’t have as much upside in the bull markets, but you said you would trade that for more stability throughout the cycle.
Rotonti: Totally. NVR maintains massively high returns on invested capital and profitability across a cycle, Nick. That is not the case for the industry. Let’s put some numbers on this. NVR, the only company with net cash and a lot of it, Nick, $1.2 billion in net cash. Every other player has large amounts of net debt. Altman Z-score, it’s a measure of the likeliness a company will file for bankruptcy. The higher the better. The industry averaged 3.7, NVR 8.
My point is, Nick, the differentiated business model, the uniqueness of this business model, it shows up in the corporate fundamentals. A lot of investors will say, “Oh, I have this unique business, it’s so rare, it can’t be replicated.” No, that’s not true. Show me when it shows up in the numbers. NVR, it shows up in the numbers. Industry average ROIC last five years, 7.8%, NVR’s, 30.6% last five-years. Industry average ROIC last 12 months, 10.5%, NVR’s, 38.7%. The trade-off Nick, if these are last five-year numbers when the industry has been hot, you will see NVR grow slower than the industry in an upcycle. Revenue, five-year CAGR for the industry, 12.4%, NVR 8.4%. Net income for the industry, 27% basically, NVR, 19%. But still NVR buys back stock, so it’s growing it’s earnings-per-share at 21%. This is growth and it’s amazing growth at ROICs of 38%. There’s nothing like this. It’s in a class of its own.
Sciple: I think that makes a lot of sense. One of the things you said earlier that I think is maybe interesting to double underline for investors, you talk about how NVR defines the market region by region, whereas you hear other folks defining the market nationally. If you think about common sense, real estate is a very local market, but defining the market in that way. How do you think about that as an investor from an analytical point of view and when you see this company taking a different approach than others, does that make your antennas go up?
Rotonti: No. The industry doesn’t know what it’s doing. They basically survived the global financial crisis. NVR went through with 12% returns on capital, and was profitable every year. If you look at some of NVR’s markets, they have 20% or 30% market share in D.C. for example, Baltimore, Maryland, some places in Pittsburgh, high […] market share. It’s got serious market shares in its market. Nationally, 2% market share or thereabouts. My point is, it’s got a long, long, long runway of growth when it decides to leave the East Coast. It’s no further West than Indiana, Ohio, and Illinois. Everything else touches the East coast basically. When it decides to go to the other two thirds of the country, it’s just got a massive runway of growth.
The other thing is during these downcycles, Nick, that’s when it turns up the speed. It’s patient during upcycles and then very aggressive and adaptable during downcycles. During the GFC global financial crisis, it entered six new markets, when, like I said, everyone else is struggling to survive, and it bought back massive amounts of cheap stock. In December 2010, I’m using that date because 2008 and 2009 were really bad parts of the downcycle. Coming out of the downcycle at 6.2 million diluted shares outstanding in 2010. Bought 10% of its stock in 2011, bought in 9% of its stock in 2012, and bought back another 10% of stock in 2014. More recently, it’s only been buying back two or three% of shares per year because its stock price is much higher. But when its stock price got crushed with the rest of the industry, it used its profitability and its cash flows that its competitors did not have to enter new markets, six of them, and to reduce the shares outstanding by nine or 10% every year during the worst of the financial crisis.
Most businesses do the exact opposite, Nick. They invest when times are great, they buy back stock when its stock is expensive. NVR’s ability to shift its speed up and down based on market conditions, it’s part of its culture. You can’t do that. It’s got to be ingrained in that corporate DNA. Most companies are grow, baby, grow until something bad happens. Not NVR. Really, really patient in up markets, and then puts the pedal to the metal in down markets, whether it’s entering new markets, making acquisitions, which they don’t make a lot of, they’ve only made three in 20 years, or buying back stock at bargain, basement, fire sale, stupid prices.
Sciple: That raises the question, John. We look at the stock today, it’s about 10% off its all-time highs. We’ve told the story about we’re in a structural undersupply in the housing market. What are you looking for over the next five years? Where do you think the company can go?
Rotonti: I think, personally, that it can be one of the best-performing stocks in the next five years. Let me tell you why. NVR was one of the best-performing stocks in the last 30 years. I’m sure you all have seen this chart here on Twitter from Charlie Bilello. It’s the best performing 30 stocks over the past 30 years. It’s No. 17 on this list. In its most recent proxy, it provides this chart. On a 20-year basis, this is from the proxy, total shareholder return of 3,201% was nearly three times the total shareholder return of the next highest in the peer group and nearly eight times the 409% average of the Dow Jones U.S. Home Builder Index. By far and away, the single best player by far in another galaxy. But here’s the thing, Nick, in the last year, it was last on that list.
Last, because the industry is selling expensive properties that they’ve had on their balance sheet for a while, that’s the game they play. NVR, despite being, you said, 10% from its all-time high has underperformed the industry over the last year. This translates into a stock price that to me makes no sense. It’s trading at a 7% free cash flow yield. What I’m doing here is I’m using numbers from new constructs. These are the most rigorous, most conservative measures of free cash flow you will find, but it’s trading at a 7% free cash flow yield, Nick, which is its highest. For yields, higher the better, higher the cheaper. Here’s its free cash flow yield, 6.5%. 2016, it was in the 4%’s, then it dropped down to the 3%’s, 6%, 5%, and 5%, the highest it’s been in five years. P/E ratio of 14 times, Nick. The market’s trading at 21 times. For these numbers, here’s return on invested capital up into the right. Here is free cash flow margin up into the right. Yet, it underperformed the industry in the last year, trading at a 7% free cash flow yield. That means it only has to grow revenue or organic free cash flow, whatever you want to say, 3% to generate a 10% annualized return.
Sciple: When you lay out the track record and the free cash flow yield and all those things, it’s hard to argue against it. I’m going to make you do that, John. What goes wrong in the next five years, if the story doesn’t play out the way you think. What did you miss? What went wrong?
Rotonti: For the stock price, it would be an industry downturn because, like I said, they are praying, Nick, for an industry downturn because that’s when they shift into high gear. That’s when they use their consistent profitability and free cash flow across the cycle to be able to make acquisitions or enter new markets during a downturn. That’s when they plant the seed for the next decade of growth, or they buy back cheap stock to grow earnings per share and free cash flow per share. But their stock will fall with the rest of the industry. If I’m wrong and it’s not one of the best performing stocks in the next five years, it’s because we have a massive housing downturn. I don’t think it will happen. I think we’re having an elongated cycle like I said earlier in the segment, but that would be it.
The next thing I can think of, they do have large market shares in markets like D.C. and Baltimore. I hate to say it. Natural disaster, extreme weather event in one of those areas, that doesn’t let them build for a while. That could be something. The last thing I’ll say is NVR is all about old school. Maintaining returns on invested cap, they’re actually paid on that metric. Maintaining high returns across the cycle and growing earnings per share. They’re not yet seeing the importance of green building and using more green energy building products and stuff like that. There could be more millennial focus on buying from more green builders. That could be something. Yeah, I would say industry downturn or just a shift toward buying for more green builders.
Now, I think NVR could naturally make that shift and start using more green building products, but it’s something I would like to see them do more of. Nick, I just want to say one last thing about NVR. Not only is its business model unique of being asset-light, not owning the land, being vertically integrated, clustering, being market share leaders in regions, not nationally, but they don’t do what other businesses do when it comes to Wall Street and communicating with the Street. So they get far less coverage, Nick. There are Wall Street analysts from the biggest investment banks that cover housing, don’t cover NVR. Why? They don’t hold conference calls quarterly. They don’t do investor days. They don’t give quarterly guidance. They don’t write an annual letter to shareholders as part of their 10-K, and they only report GAAP numbers. Then this differentiated business model doesn’t fit neatly into the home-building industry pattern, so it’s harder to cover. They don’t give guidance. They don’t hold conference calls. They don’t hold earnings calls. So analysts can’t ask them, “Hey, can you help me fill out cell C-13 of my model.” They don’t talk to the Street, Nick. It’s a completely different mentality.
Paul Saville, the CEO since 2005, he was a CFO before that. Top three executives of the company have something like 80 years combined experience in the company. So you have a CFO running a company and just doing it by the book, by the numbers, and they do it better than anybody else. 38% return on invested capital in the last 12 months, industry average,10.5%; four times the industry average.
Sciple: Just for the folks listening at home. This is the second week in a row we’ve brought a company to you that doesn’t do quarterly conference calls. You can’t get this everywhere. John, thank you for your thoughts on NVR. One last question before we let you go. We’ve seen all kinds of volatility in the stock market the past few weeks, crypto as well. We’ve got lots of new investors listening to the podcast who’ve come into the market over the last year. You’ve been investing for a long time. What advice do you have for those folks for dealing with volatility in the market and all this craziness that we see these days.
Rotonti: My No. 1 advice is know yourself, know your risk tolerance, know what you can handle from a volatility perspective. Then set your portfolio accordingly. Have balance between more moderate, stable growers, and then more high fliers, and then position size accordingly. What I do, Nick, is I have larger positions in more stable growth companies, more resilient stable growth companies, and then smaller positions, almost like little gambles, in the next great app, the next shiny app, or something like that. I take positions in those companies, they’re just smaller positions. Then the last thing I’ll say is don’t invest money you may need for the next three to five years. But once you’re above and beyond that, use volatility as your friend. Use volatility as opportunity. If you like the stock 50% higher than it is now and the story hasn’t changed, you should like it more now that it’s 50% cheaper.
Sciple: One of the other points we talked about earlier with these homebuilders, is this idea that some of these homebuilders run a little bit more levered, run a model that gives them a little bit higher returns when things are going great, but it’s a little bit tougher on the downside. NVR is not going to be performing the best in the bull markets, but they’re going to have more resiliency. I think that approach is a great approach to have for your portfolio as well. That ties into some of those things John just mentioned about balancing your portfolio between high-growth and resilient companies, all those things. Those lessons that we talked about of why NVR has done so well, and its approach applies as well to your own personal portfolio.
Rotonti: Yeah, I would agree, Nick. Thank you.
Sciple: John, thank you so much for joining me on the podcast. I hope we can have you on again sometime soon.
Rotonti: Yeah, maybe. I’ve been on your podcast three times. Each time we have a housing-related stock because we did Graco, which makes the paint guns that are used in residential construction, and then we did A. O. Smith, which does residential water heaters for the most part. Now, NVR, the best home builder in America. It’s a theme I love. You can tell.
Sciple: There you got. We’ll have to maybe broaden the pool for next time, John. Until then, thank you for joining me.
Rotonti: Thanks so much, Nick.
Sciple: As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stock discussed, so don’t buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show. For John Rotonti, I’m Nick Sciple. Thanks for listening and Fool on!
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.