Issue #29, Volume #2
This Capital Efficient Homebuilder Is A Good Investment
This is Porter’s Daily Journal, a free e-letter from Porter & Co. that provides unfiltered insights on markets, the economy, and life to help readers become better investors. It includes weekday editions and two weekend editions… and is free to all subscribers.
| The market is going to be volatile over the short term… Ignore the volatility and buy great businesses… This homebuilder is a great business, having transformed itself into a capital efficient, low-debt business… Inflation comes in softer, but consumers remain cautious… |
On Monday, Porter explained that for various reasons – including less foreign ownership of U.S. Treasuries, continued American energy independence, and the Trump administration’s desire to strengthen the private-sector economy – major structural changes are taking place in the global economy. In the short term, the changes are going to cause market volatility. But over the long term, these shifts should make the U.S. economy much bigger, and make U.S. businesses much more valuable. It should also reduce the size of government, and enable tremendous growth in America’s private sector.
He ended Monday’s Daily Journal with this message:
As an investor, how should you handle this?
My advice: just ignore it.
Keep investing in great businesses at good prices, just like you would anyway.
Use the volatility to pick up great businesses when they’re trading at good prices.
On Wednesday, I’ll tell you about one idea I have.”
Today, he shares that idea…
Last weekend, on X (@porterstansb), I outlined why national homebuilder Hovnanian Enterprises (HOV) has become a much better business than most investors understand and why I believe it’s positioned to become a great, long-term compounder. And here, I’m expanding on the idea. (Full disclosure – I own HOV shares.)
Is buying HOV shares a risky investment? Well, it ain’t The Hershey Company (HSY)! But Hovnanian is a well-established business. It was founded in 1959 and has been a publicly traded company since 1983. So, it has some “Lindy” going for it – our Lindy’s List of businesses are those that have excellent economics and long (at least 20-year) track records. Plus, Hovnanian isn’t a hard business to understand: each year it builds around 6,000 new homes in 13 states, generating $3 billion in revenue.
What’s changed about the company over the last few years is probably invisible to most investors. But I know these changes make it a vastly higher-quality business. I first described what was happening at Hovnanian back in 2022, when I wrote about the company in one the very first issues of my newsletter The Big Secret On Wall Street.
Prior to these changes Hovnanian was a “debt dog” – a company that carried so much debt that none of its earnings ever made it to shareholders: all the money went toward paying interest. But that was changing. In fact, in 2021 it generated gross margins of 21%, produced an industry-leading 29% return on assets (“ROA”), and an incredible 53% return on invested capital (“ROIC”). But still, nobody noticed the transformation and the shares were trading for less than four times earnings!
We added it to the Big Secret portfolio at $42.79 per share. And, today, we should be sitting on big returns. But we screwed up. We (stupidly) sold it at the first sign of higher interest rates. Today, we’re getting a second chance. Hovnanian shares are now down more than 50% from their recent peak. And they’re trading for 3x earnings again.
Most investors believe that homebuilders are too cyclical to be safe investments at the beginning of an economic downturn. And when they are heavily indebted businesses, that’s true. But, today, for homebuilders like Hovnanian there’s a new economic reality. Dominant U.S. homebuilder NVR pioneered this new business model in the late 1990s, but most investors don’t understand it.
Doing Homebuilding Differently… And Better
The housing bubble and the resulting mortgage crisis from around 2004 through 2011 was the biggest boom and bust period we’ve ever seen in U.S. housing. This cycle wiped out a lot of homebuilders, but NVR handled the cycle without any stress.
Below you can see NVR’s results from 2003-2015. This was before, during, and after the 2007-2009 housing bubble. Sure, the company had down years, but the question that matters is: how did investors in the company fare? The answer: very well. Average returns on equity for the period were 20%+. And investors buying NVR in 2003, before the cycle, saw shares rise 13% annually by 2015, for 400% total returns – more than double the S&P 500’s 203% return over the same period.
How was that possible? How did a homebuilder deliver outstanding returns for investors despite the worst housing crisis in American history?
The secret: unlike other homebuilders, NVR didn’t face huge write-offs from their land portfolio, because NVR didn’t own huge tracts of land. And it didn’t face big interest expenses on debts tied to their land portfolio – because NVR doesn’t develop land.
NVR’s secret sauce is that rather than invest huge amounts of capital (financed with debt) buying land, the company only buys options on land that it plans to build on in the short term. Who eventually buys the lots? The homebuyers. NVR’s “asset-light” strategy is a complete game changer for investors in homebuilders. This one critical change to its business model – a change that’s largely invisible to customers – makes these asset-light companies vastly better and safer businesses. But investors haven’t figured out the difference between these new financially savvy builders and the rest.
NVR’s financial performance was vastly better than any other homebuilder during the financial crisis because the company didn’t lose billions buying land at the top of the market. NVR’s total write-offs in the period were on options that expired, but it only lost $132 million. Those losses were more than covered by earnings in those years, so it never took any impairment to equity. That’s compared to more than $1 billion in write-offs and large operating losses for all of the other large homebuilders/property developers.
And, following the financial crisis, NVR’s profits quickly rebounded, too, as you can see above – more than doubling from $189 million in 2009 to $383 million by 2015.
Thus, even with a collapse (-57%) in revenue from 2006 to 2009, NVR was able to scale back its operations and quickly resume growth without any material losses.
As a result, NVR remained a world-class business, on average, across the entire cycle. That means it is a very high-quality business: it can consistently generate market-beating returns on equity.
And, today, the market appreciates this about NVR. It has become a “darling” among famous investors with ultra-high-quality, concentrated portfolios (Giverny Capital, Smead Capital, Donald Smith & Co, Joel Greenblatt, and Tom Gaynor). But… investors haven’t yet figured out that NVR isn’t the only high-quality homebuilder.
Homebuilding isn’t magic. It requires good connections with developers, a reputation for building quality structures, and terrific execution.
Hovnanian, with the same strategy and business model as NVR, is trading at around 3x earnings. NVR is at almost 20x.
Since 2019, Hovnanian has dramatically changed its business model, moving from a land-development model (with wholly owned lots) to NVR’s asset-light, land-option model (“Optioned Lots” in the table above measures the percentage of optioned lots the company purchased and developed). You can see this transformation in Hovnanian’s numbers:
Owned lots have declined from 67% of sales to only 27%. As HOV has been able to sell off its real estate, it has reduced debt and massively reduced interest expenses. Net income has increased steadily and the stock price has followed… until its recent correction.
Hovnanian Has A Strong Outlook
Today, with much less debt and dramatically lower interest expenses, I believe Hovnanian, like NVR did during the Global Financial Crisis, will continue to perform well through this rocky economic period, producing great results, on average, across the cycle.
If I’m right and if you assume revenue grows only 5% a year on average for the next seven years, and the share price revalues to a still-cheap P/E of 10, you can see how well Hovnanian’s business and its stock (now priced at just over $100 per share) could perform from these levels.
Obviously, this is only a model. The future will not unfold exactly like this. But the point is, if the future unfolds anything at all like this, on average, over the next seven years, the results for investors in Hovnanian today will be stupendous – annualized returns in excess of 30%.
That’s the job of an investor: to find situations where you can expect extraordinary returns from average business results.
And, if you’ve got a portfolio full of these kinds of great businesses, purchased at reasonable prices, the macro outlook won’t bother you.
That’s good investing.
Three Things To Know Before We Go…
1. Trump takes the trade war to Europe. The Trump administration announced 25% tariffs on all steel and aluminum imports from the European Union (“EU”) this morning. Within hours, the EU retaliated with new import taxes on an estimated $28 billion of U.S. industrial and farm products. The EU also announced new tariffs on a range of consumer goods, including motorcycles, bourbon, peanut butter, and blue jeans. As the trade war continues to expand, U.S. markets will likely continue to drift – or plummet – downward.
2. Inflation cools faster than expected, diverging from its 1970s path. Today, the Bureau of Labor Statistics reported that the consumer price index (“CPI”) rose 0.2% in February, bringing the annual inflation rate to 2.8% – down from 3.0% in January. It’s the slowest rise in headline inflation in four months. While an encouraging sign for the Federal Reserve, with inflation returning toward its 2% target, today’s report reinforces concerns about a cautious consumer, as discretionary services such as hotels and airfare saw slower price gains, while grocery prices remained flat.
3. The next government shutdown looms. On Tuesday, Republicans in the U.S. House of Representatives passed a continuing resolution to fund the federal government through September 30. The measure now moves to the Senate, where it will need the support of at least seven Democratic senators to reach the 60-vote threshold to advance. If the Senate fails to pass the measure, the U.S. government will officially shut down at 12:01 a.m. Saturday… which at this point looks more than likely – and will be a source of yet more uncertainty for markets.
And one more thing…
In the January 22 Daily Journal, Porter updated readers on the property & casualty (“P&C”) insurance industry following the California wildfires… and flagged one company in particular – which we don’t formally cover – that he wrote “might be a great opportunity over the next year.” Since then, shares of Mercury General (MCY) have – as of yesterday’s close – risen 13%… compared to the 9% decline in the S&P 500.
That kind of strong short-term performance – and massive outperformance versus the index – doesn’t happen often… but it also doesn’t happen by chance.
To learn more about P&C insurance – and to see the stocks that made the cut to be in the portfolio of The Big Secret On Wall Street – Porter explains it all here.
Coming Up This Week…
In a new recommendation for paid-up subscribers to The Big Secret On Wall Street, tomorrow we will report on a company that has moved on from a bad acquisition, getting itself on the right side of a booming trend. If you’re not a Big Secret subscriber and want access to the new recommendation, the full archive of issues, and the portfolio, click here.
Also tomorrow… Marty Fridson and his team in Distressed Investing recommend shares of a company whose bond price has recently risen after a rebound in the company’s overall performance…. It’s clear skies ahead for this company.
Tell me what you think… good, bad, or indifferent: [email protected]
Porter Stansberry
Stevenson, MD
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