NVR – Trouncing Competitors Since 1995
Buffett has famously said that in investing (unlike in gymnastics) there are no points for difficulty. John Huber modified this thought to remind us there are also no points for originality. We took this to heart with our recent investment in NVR, Inc.
NVR may not be a household name to the average American, but it is a classic among value investors. Norbert Lou of Punch Card Capital famously recommended NVR’s stock on the investing website Value Investors Club. He subsequently had his hedge fund seeded by site founders Joel Greenblatt and John Petry after how well the investment performed. About 19 years ago Lou recommended the stock at $143 per share and distilled his investment thesis into just 816 words. His post produced a 19% annual return – dwarfing the market and most other investments over that span.
It is no secret that NVR is a great business which has been reflected in the stock’s performance over the years. Since 1994 the company has compounded earnings per share at an astounding 27% annually for 25 years. The stock price has followed suit, compounding at 30% annually over the same period through the end of 2019. The chart below paints a picture of the power of compounding.
Figure 1: NVR Stock Price: 1994 – April 2020
A dollar invested in NVR in 1994 would have been $692 at the end of 2019. Compare this to the S&P which rose 10.21% annually and $1 became $11.37 over the same period.
A quick aside. While the compounding has been exceptional, it is never a straight line. Being a homebuilder, NVR is exposed to occasional sharp declines, which should be welcome to the long term investor. These pullbacks provide periodic attractive entrance points to buy a great business for less than it’s worth. We think March 2020 was one of those times. When you own a good business, the important thing to realize is that the stock price, while occasionally volatile, oscillates around a rising number (intrinsic value). This can be easy to lose sight of during the days, weeks, and months of a sharp correction, which is why taking the long view is critical. To enjoy the exceptional overall returns since the ‘90s, investors had to hold through a 50%+ decline from 2007 - 2009, a 45% decline in 2018, and a nearly 50% decline in 2020. Such is the nature of owning equities.
NVR’s share price initially held up reasonably well during the first leg of the market sell-off, but it quickly followed suit with general market declines, and then some. In March NVR sold down more than 40% from its year-end price. It appears to be a classic “baby being thrown out with the bathwater” as NVR’s sharp decline came during the “sell everything” phase of March’s decline.
We became very interested and began accumulating shares in NVR as it breached 10x pre-tax earnings – an exceptional price for a long term compounder. To read more on our thoughts regarding how we think about valuing compounders, and why this was a great price to pay, check out our recent post.
In this post we aim to explore NVR’s business model and discuss what has enabled the company to compound results at such a remarkable rate for so many years. We also discuss our outlook for the business and why we recently made an investment.
How has NVR been able to sustain such extreme out-performance over such a long period of time? Their success can be boiled down into a few simple, but different, approaches compared to competitors, which we’ll review next.
Land Speculation
Most home builders are closet land speculators. It is not uncommon for the profits from owning and selling the land to dwarf profits from home building. Of course, land speculation is not a free lunch for outsized profits. The issue with this model is that buying large quantities of land requires significant capital, which typically comes in the form of debt, and ties up money for years leading to poor returns on that capital. Buying land with lots of debt in the hopes that someone pays more for it is a great example of the “greater fool theory”. He who holds the land last when prices finally retreat (and the land can’t sell fast enough) often goes bankrupt.
NVR learned this lesson firsthand in the early ‘90s when they too went bust from land speculation. Upon reorganizing, the management team decided to forge a new, safer path. Instead of purchasing land NVR simply acquires options to buy finished plots of land. They only exercise the option when they have a house pre-sold and sure profits in the bag. Not only does NVR avoid laying out capital for land, they also have their homes largely pre-financed by buyers. This all results in NVR turning their inventory of homes much faster and deploying substantially less capital to earn $1 than other homebuilders would need to deploy to earn the same $1.
The cost of land options is an expense that other homebuilders do not incur, but the higher returns on capital, efficiency in the rest of the business, and significantly reduced risk (via less leverage) more than offset this added expense.
Finally, and perhaps most importantly, without the distraction and risk of land speculating, NVR can focus on honing their core competency – efficiently building homes. Below are a few of the ways they do just that.
Local Economies of Scale
NVR’s management is vehemently against “growth at any cost”, as evidenced by their careful expansion along the eastern part of the United States. The company is insistent on only expanding into markets it believes it can be the #1 player. Because they only operate in areas where they are the most significant builder, they enjoy local economies of scale. This manifest itself in consistently higher operating margins compared to peers.
The company leverages relationships and volume with suppliers, contractors, realtors and other business partners to realize cost and revenue benefits leading to higher profits. There is no magic to NVR’s successful formula, but the company’s relentless focus on efficiently building homes in markets where they can “win” allows them to replicate their moat in each new geography.
Vertical Integration
While homebuilding is clearly the core competency and main driver of profits, NVR does not strictly build homes. They also operate a title services and mortgage origination subsidiary, NVRM. This growing segment originates mortgages to many of NVR’s homebuilding customers. NVR receives an origination fee and subsequently sells the mortgage and does not retain the credit risk. They also facilitate title work for many of their homes. All told this segment comprises roughly 10%, or $100M, of income to the company without requiring much in the way of additional capital.
Buying and building a home is a complex process and being a one-stop shop for customers makes the homebuilding process easier and further reinforces the value NVR brings to customers.
Management and Culture of Efficiency
NVR is run by a group of long term owner-minded managers with skin in the game. Directors and Officers own over 11% of the stock and CEO Paul Saville has been with the company since the 1980s and at the helm since 2005. The team has been incredibly consistent in applying their strategy over many decades, and we expect that to continue in the coming years. The business uses share-based programs for a large part of executive compensation, providing further alignment with common equity holders. They clearly view every dollar spent not as “someone else’s money”, but their own.
From a capital allocation standpoint, the management team maintains a conservative balance sheet to protect against downturns. They prioritize re-investing in the business and use remaining cash to buy back shares, providing further growth in per share intrinsic value.
The management team runs a lean shop with a rigorous focus on cost and efficiency. They operate the company more like an assembly line than a traditional builder and have stated “we think of ourselves as the In-N-Out Burger of Homebuilders”.
Some of the ways they optimize the building process include offering fewer customization options per model and per community, pre-assembling interior and exterior walls and staircases, and optimizing the physical building of the home. This results in NVR typically delivering homes in under 90 days from the time they break ground through completion, and often substantially faster (60 days or so). This compares to around 100 to 120 days for the average builder.
Returns on Capital
Considering the above competitive differentiators, it’s no surprise that NVR enjoys significantly higher returns on capital than competitors. The difference is stark and is highlighted in the chart below.
Return on Capital Comparison: 2015 - 2019. Source, ValueLine Review.
NVR regularly earns in excess of 30% on capital, where competitors are lucky to earn just half that in any given year.
Just as in comparison to the S&P, NVR has dwarfed the returns of competitors. Since the inception of the Dow Jones Homebuilder Total Return Index in 2010 (NVR’s benchmark), NVR’s share price has compounded by 21% annually compared to 16% for the index. $10,000 invested in NVR would have been about $62,000 at the end of 2019 compared to $41,000 invested in the index.
As a reminder, intrinsic value growth is a function of the reinvestment rate of capital and the return on that capital. With such high returns on capital NVR has grown, and is poised to continue to grow, intrinsic value at a solid clip for years.
Future Growth
NVR operates in four markets: Mid Atlantic, North East, Mid East, and South East. While the team is deliberate and thoughtful about entering new areas, clearly this has not inhibited growth. The business has grown new units at a healthy 9% annually since 2015, with significantly higher growth in the North East. There is plenty of growth in existing markets let alone in new areas of the country. We think NVR’s model will travel as far as the management team wishes to take it.
New Unit Growth by Region
Also, the company should benefit from a decade of underbuilding, as demonstrated below. Housing starts as a percentage of population have been substantially below historical averages since the great recession, leading to a likely long-term tailwind.
Source: Hoya Capital Real Estate
We have no idea what these numbers will look like year to year, but we do know people will always need houses and reversion to the mean is likely over time, all of which further benefits NVR.
A final comment on geography – the company’s core market in the DC-Baltimore area is less volatile than most areas during a recession because of the large number of steady government jobs. It’s not as if NVR is reliant on the boom and bust markets of Vegas, Phoenix, or Miami. Just one other factor mitigating overall risk to the company.
COVID-19 Impacts
It would be inappropriate to discuss an investment right now without answering the question surrounding every stock – how will the recent pandemic impact the outlook for the business? Our answer is simple for NVR (and similar for all of the positions we own): we don’t know what the impact will be, there will probably be some, but we can’t see how COVID-19 impacts the long term demand for affordable homes in the US. It’s likely NVR will earn less this year than they otherwise would have, but given their strong balance sheet they are certain to pull through this difficult period. Looking out 3,4,5 years and beyond, we don’t think shareholders will notice any impact on earnings power.
Return Expectations
NVR has compounded earnings per share at 27% annually since the mid-‘90s, and at roughly 9% since the early 2000s, which includes the unprecedented housing bust of 2008-09. We expect return on equity to average at least 30% over time, with the company reinvesting around 30% of capital into the business. This results in 9% growth in intrinsic value annually. Buybacks should boost annual per share intrinsic value growth into the low teens. Finally, a multiple re-rating to the historical median of 18x earnings provides another 6-12% annually, depending on how quickly the company returns to fair value. All together we wouldn’t be surprised to earn over 20% annually for many years on our investment.
Combine these expectations with a management team with skin in the game, a simple, effective, and proven business model and we were thrilled to become owners of NVR at less than 10x pre-tax earnings this March. As the stock price declined precipitously in March it became clear to us that NVR was an above average business at a below average price – just what we look for in an investment.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.