Long-Term Thinking in the Cyclical Housing Industry
One of the key tenets that drives our thinking at Diamond Hill is the importance of long-term perspective. Being able to think and act in a long-term manner is one of the most significant competitive advantages an investor can possess, and I believe it is an especially valuable mindset to apply when analyzing cyclical stocks.
The highest-quality cyclical companies are able to grow during the good times and, more importantly, are able to not just survive but also strengthen their competitive advantages during the downturns by gaining market share, entering new markets, repurchasing stock, and/or making opportunistic investments or acquisitions. In some ways, being a high quality, long term-oriented business in a cyclical industry provides more advantages than being a similar quality business in an economically stable industry, as the downturns provide the best businesses significant opportunities to invest for the future when peers may be hampered by weak balance sheets and low levels of liquidity.
In the U.S. housing industry, I believe that NVR, Inc., one of the largest homebuilders in the United States, is an excellent example of a company that is able to grow shareholder value during downturns.
The Homebuilding Industry
Homebuilding is an industry that is often avoided by long-term investors, and generally for good reason. It’s a cyclical, capital-intensive industry with limited differentiation amongst products and limited (but not non-existent) competitive advantages available.
There are a variety of different homebuilding business models, but a traditional homebuilder generally seeks to: 1) raise capital to buy land, 2) develop the land, 3) sell a house on the land, and 4) take proceeds from the sale and primarily reinvest the cash back into land. In times of rising home prices and good demand, this model works just fine and, if a builder buys land well, can result in low double-digit returns on equity during the growth phase of the cycle.
However, when the cycle inevitably turns, the debt-laden, land-heavy strategy tends to work very poorly and often results in material impairment to shareholders. If debt is taken out to buy land and land prices decline, the builder’s land value could drop below their outstanding debt. In addition, land purchases are often made multiple years in advance and land that was good before the cycle turns may not be as attractive when the next cycle begins. Finally, this model constrains the builder from having the balance sheet flexibility to be opportunistic when assets are cheap, so the management team is essentially forced to batten down the hatches and ride out the storm as opposed to investing counter-cyclically.
In the midst of this capital-intensive, cyclical industry, NVR stands head and shoulders above its peers. During the most recent housing crisis, every other public homebuilder lost money with the largest homebuilders cumulatively suffering billions of dollars of losses, but NVR was profitable every year. In addition, most homebuilders are still trading below their peak share prices from more than a decade ago, whereas NVR is trading around 4x its peak share price before the crisis. Finally, NVR doesn’t just compare well against other homebuilders; over the last 20 years NVR has compounded its per-share value by roughly 29% per year, which puts it in the upper echelon of all publicly traded global companies during that time period.
How is this possible in such a tough industry? There are a number of reasons for NVR’s strong performance, including excellent capital allocation (share count has declined about 75% since 1994) and a disciplined management team that runs their business with indifference to the short-term pressure and noise from Wall Street. However, there are two aspects of NVR’s business that have been crucial to its long-term success in a cyclical industry.
First, their business model is structured such that being right or wrong on macro dynamics doesn’t make or break their business. For a typical homebuilder who takes out debt to buy land or do large M&A deals, it’s important for the management team to be at least roughly right on major macro factors most of the time or else a long downturn could lead to bankruptcy. NVR, however, accepts that the future is unknowable and structures its business accordingly by choosing to avoid the industry practice of buying and developing land. Instead, NVR buys already developed lots from land developers, paying developers a 5-10% deposit on the land for the option to purchase a lot in the future. If the cycle turns downward, NVR is able to either renegotiate the purchase price of the lot or walk away from the option with only the loss of the deposit. This allows NVR to control thousands of lots without tying up large amounts of capital, thus minimizing inventory risk and enhancing returns on capital.
This decision to not buy land reverberates throughout the rest of NVR’s business model and dictates many of its operating decisions because traditional homebuilders typically make a significant portion of profits on land versus the homes themselves. Without profits from land, NVR is laser-focused on building houses profitably and reducing costs where possible. The company’s strategy thus emphasizes gaining high levels of share in their markets (which allows them to leverage SG&A expenses, among other advantages), utilizing off-site construction facilities to pre-assemble various housing materials before delivering them to the construction site (to improve quality and efficiency), and using significantly fewer floor plans than other builders (which reduces complexity).
Second, NVR maintains a strong balance sheet at all points in the cycle and is currently the only traditional homebuilder in a net cash position. Many management teams give lip service to having a “strong balance sheet” but a net cash position is rare in the housing industry and is not a common trait in general in the public equity markets today. However, the first rule in a cyclical business is that you have to be able to survive the trough of the cycle and come out on the other side, and a solid balance sheet allows that to happen.
NVR’s Actions during the Housing Crisis
So, what happened with NVR during the most recent downturn? How did their conservative operating model and strong balance sheet help them increase shareholder value in the midst of a significant housing crisis?
First, they had the balance sheet flexibility and managerial willingness to buy back stock at cheap prices. From November 2005 to October 2011, a chaotic six-year period in the U.S. housing industry, NVR’s diluted share count declined by about 30% as they bought back 3.3 million shares of stock for $2.18 billion (an average purchase price of $656 per share versus today’s price of $3,500).
Second, the company gained share in its markets as weaker players pulled out and NVR had the capital to grow. From 2005 to 2012, NVR’s market share in its key markets grew from 12% to 20% in Washington, D.C., 14% to 34% in Baltimore, 4% to 13% in Philadelphia, 13% to 34% in Pittsburgh, and 5% to 29% in Richmond. This pattern of share growth repeated itself in the vast majority of remaining markets where NVR operated during the crisis.
Third, NVR took advantage of the distressed land market and entered Columbus, Indianapolis, Raleigh, and Orlando in 2009, then Chicago and Tampa in 2011. The Indianapolis entry was the result of a bankruptcy auction, and the Columbus entry occurred when NVR bought lots from a builder that was financially stretched at the time. Many of these markets are now good contributors to the company’s results, with the Florida market in particular providing excellent growth opportunities.
Our Circle of Competence
At Diamond Hill, our circle of competence is not in predicting turns in macroeconomic cycles; rather, our strength is in business analysis. With a company like NVR and a long-term perspective, we are able to focus on the company’s business model, management’s capital allocation decisions, shifts in market share, and longer-term risks. These items sit firmly within our circle of competence.
When (not if) there is another cyclical downturn, I expect NVR to again buy back stock at reasonable prices, gain share in existing markets, and/or potentially enter new markets at attractive prices. Unlike many other debt-laden cyclical companies that are forced to be passive observers during downturns, NVR provides long-term investors the opportunity to capitalize on both cyclical growth and cyclical declines. No company is perfect or immune from challenges, but I believe NVR is an example of a high-quality cyclical stock that is ideally built for the long-term investor.
As of December 31, 2017, Diamond Hill owned shares of NVR, Inc.
Originally published on January 18, 2018.
The views expressed are those of the research analyst as of January 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.