In times of high inflation, the homebuilding sector will do well because of its favorable business economics. Over the long term, house prices have increased faster than inflation rates and construction costs. While there is no long-term uptrend in the average annual Housing Starts, revenue for the sector will grow because of the price uptrend.
I favor NVR Inc (NYSE: NVR) because of its return track record and its ability to create shareholders’ value. NVR is also financially sound.
At the current price of USD 4,445 per share, NVR is trading at a 23% discount to its long-term cyclical value. In valuing the company, I projected its revenue pegged to the long-term average annual Housing Starts. I also based on its gross profit margins and SGA margins on its past 17 years’ average values. This will reflect its performance over the housing cycle.
Inflation is not transitory
The Federal Reserve has not established a formal inflation target. Policymakers generally believe that an acceptable inflation rate is around 2 percent or a bit below. (Source: FED). Using this as the base, I would define high inflation as 5% or higher.
Chart 1 shows the annual inflation rates in the US from 1914 to 2021. I identified 7 occasions when there were annual inflation rates of 5% or more. Of these 7 occasions, two lasted for a year. The average was 3.6 years and the longest was for 10 years.
The uncertainty is not how long the high inflation period will last. The other unknown is the impact of the counter-inflationary measures on GDP growth.
Furthermore, the last high inflation period was from the early 70s to the early 80s. The current management teams in all companies are not likely to have personal experience in managing in such an environment.
Not only will it be a new ball game, but it is likely to last for more than a year. When investing in a high inflationary environment, we should be looking for companies with a proven management team and good business economics.
Favorable business economics
Companies that do well during inflationary times will be those that will be able to pass on any increased cost to their customers. At the same time, inflation should not affect the sales volume.
The US homebuilding sector fits the above criteria. I examined the key drivers of business performance for this sector for the past 46 years from 1975 to 2021.
I first looked at 2 key metrics for the homebuilding sector relative to inflation. The first is the number of houses constructed as represented by the Housing Starts. The other is house price as represented by the House Price Index. Refer to Chart 2.
You can see that the HPI increased more than the Inflation Index. At the same time, the Housing Starts index does not show any long-term uptrend. I would interpret the results as follows:
- There is no long-term growth in the average Housing Starts. Long-term volume growth for any homebuilder has to come from taking market share from its peers. If there is no track record for this, you have to assume a long-term average sales volume that is pegged to the long-term average Housing Starts.
- Even if there is no long-term volume growth, there will be long-term revenue growth due to the growth in house prices.
Notes to Chart 2.
The index for each metric was constructed by dividing the value for a particular year by the respective value in 1975. The base in 1975 was set to 100 for each of the metrics.
To get an indication of whether the homebuilders would be able to pass on their costs, I next plotted on the same chart the Building Cost Index. As can be seen from Chart 2, the cost index increased less than the HPI. I interpret this as a positive sign.
Note that the increasing gap between the HPI and the Building Cost Index does not mean that the sector would be able to generate greater profits. This is because I have not factored in the land cost or the SGA. Even so, the analysis shows that from a long-term perspective, this sector can withstand the effects of inflation.
But this is not the full picture as inflation will affect the demand for houses. In its 2021 Form 10k, NVR stated the following:
“High rates of inflation generally affect the homebuilding industry adversely because of their adverse impact on interest rates… have a significant adverse effect on housing demand…”
I am not an economist so I would not try to project the short-term impact of high inflation on the homebuilding industry. Rather it is better to take a long-term view of the sector. Over the past 70 years, which covered several high inflation periods, the Housing Starts have gone through several cycles with no uptrend in the long-term average annual units. Refer to Chart 3.
I interpret this as a positive sign. The long-term average annual Housing Starts are not affected by high inflation. Any valuation of NVR should be pegged to this long-term average annual level.
Builder magazine identified the top 100 homebuilders in 2021. I am recommending NVR as it is a fundamentally strong company on this list.
- It had the best average performance among the top 5 homebuilders.
- It is financially sound.
- It has a track record in creating shareholders’ value.
Best peer returns
To compare the peer returns, I considered several performance metrics from 2005 to 2021. If you look at Chart 3, you can see that this period covers one Housing Starts cycle.
NVR had the best results compared to its peers as per Chart 4.
Notes to Chart 4.
a) Gross Profitability = Gross profits/Total Assets. According to Professor Novy-Marx, this has roughly the same power as book-to-market predicting the cross-section of average returns.
b) The data from Taylor Morrison was only from 2009 to 2021 and hence did not cover a full Housing Starts cycle.
I would consider NVR financially strong for the following reasons:
As of the end of Dec 2021, NVR had a negative Net Debt (Debt less cash). In contrast, the other 4 peers had positive Net Debt with Net Debt to Total Equity ratios ranging from 0.14 to 0.65.
About 55% of NVR Total Capital Employed (SHF + Debt) comprises cash. Considering that the returns from holding cash are low, the returns from the operations would be much higher than those shown for NVR in Chart 4.
From 2005 to 2021 it is generated USD 8.2 b Cashflow from Operations. Unlike its peers, NVR did not have any year with negative Cashflow from Operations during the past 17 years. I would rate NVR’s cash-generating capability as good compared to its total Net Income of USD 8.1 b for the same period.
These cash reserves would enable NVR to withstand any negative impact of a slowdown in the homebuilding industry.
Creating shareholders’ value
I looked at the following metrics in assessing whether a company has created shareholders’ value.
- Comparing the firm’s return with the WACC.
- Comparing the gain in SHF assuming no dividend was paid with the cost of equity.
- Comparing the gains by an investor who bought a share at the end of 2005 and held onto it till 2021 with the cost of equity.
As can be seen from the chart below, NVR returns were higher than the respective cost of funds. I would conclude that it had been able to create shareholders’ value.
Notes to Chart 5
(a) The value was based on average EBIT/TCE from 2005 to 2021 assuming a 33% historical tax rate. I then compared it with WACC.
(b) This looked at how the SHF at the end of 2005 would have grown by the end of 2021 assuming that no Dividends were paid. I compared it with the cost of equity. Note that in the case of NVR, no Dividends were declared for this period.
(c) Computed assuming that an investor bought 1 share at the end of 2005 and held onto it till the end of 2021. His gain would be 14.2% CAGR as shown below compared to the cost of equity.
My valuation of NVR is based on a single stage valuation model for the firm = FCFF X (1+g) / (r – g)
FCFF = EBIT X (1-tax rate) X (1 – Reinvestment rate)
EBIT = Gross profits – SGA
= (Revenue X GP margin) – (Revenue X SGA margin)
g = growth rate
Reinvestment rate = g / Return
r = WACC. The WACC was derived based on Damodaran’s build-up method for the Beta. The risk-free rate = 1.51%, and the cash-adjusted unlevered Beta = 1.59.
The value of equity = Value of firm – Debt + Cash
Revenue is a function of the Housing Starts. I used the 2021 Housing starts of 1.595 m units and NVR 2021 revenue of USD 8.966 billion as the base. I assumed that the long-term average Housing Starts to be 1.5 million units.
The other assumptions are shown in Chart 7.
The homebuilding sector is cyclical and thus the long-term performance of NVR should be based on its value over the cycle. I have taken the past 17 years’ average values for the gross profit margin and SGA margins.
In my other Seeking Alpha articles, I have demonstrated that there is no growth in the long-term average annual Housing Starts. Refer to “MDC Holdings Is A Cigar-Butt Opportunity” and “The Market Is Not Pricing DR Horton As A Cyclical Group.”
Thus, the value of NVR is based on the revenue assuming 1.5 million units of Housing Starts in perpetuity. While there is no growth in the volume of Housing Starts, there is long-term growth in prices. I have assumed that this will be at the long-term HPI growth rate of 4.3%.
I valued NVR based on the following scenarios.
- Earning Power Value (EPV). I assumed that Reinvestment = 0.
- Earnings with growth. I assume that growth is the long-term growth in the House Price index of 4.3%
Chart 8 below summarizes the valuation.
- Asset Value (Dec 2021) = USD 839 per share
- EPV = USD 2,866 per share
- Earnings Value with growth (EV with g) = USD 5,454 per share
The current market price of NVR is USD 4,449 (as of 19 April 2022). You can see that there is a 23% margin of safety based on the Earnings Value with growth.
We do not know how long the current high inflation period will last. Furthermore, high inflation rates will lead to lower demand for houses. But these are looking at the short time impact. I am coming from the perspective of a value investor holding onto stocks for 7 to 8 years. As taking such a long-term view of the business performance is more relevant.
Over the long term, house prices have increased at a faster rate than inflation and construction costs. The long-term average annual Housing Starts are also not affected by inflation. This meant that if you value homebuilders from a long-term perspective, you are likely to have more reliable estimates.
I carried out a valuation of NVR on such a basis. It indicated that there is a margin of safety at the current market price. At the same time, NVR is fundamentally strong. It has a track record of peer-leading returns and creating shareholders’ value. It is also financially very sound.
The issue is not the track record. Rather the track record points to an underlying strong management and good business model. This is important given the uncertainty regarding the duration and other impacts of high inflation.
NVR is riding into the high inflation environment with a good jockey on a good horse. Why would you not be on this stock?