Studying Winning Stocks: Analyzing NVR in 2001
Can You Spot a 20-Bagger?
I buy and share baskets of stocks called Coffee Cans. You can see the most up to date list of stocks and their performance here, on my Scorecard.
As I said last week, without leverage, the most you can lose on an investment is 100% (and that is also rather unlikely), but you can make multiples from a winning stock.
Therefore, rather than figuring out what to avoid when making an investment, I think a far better ROI can be had by learning what makes a winning stock instead.
Last week, I shared Norbert Lou’s simple and elegant NVR stock pitch from June 2001. This stock has been a 22-Bagger since 2001. You didn’t even need to come up with the investment idea. But if the thesis made sense to you, you could have made 20 times your money. All you had to do was buy, then do nothing.
Remember, Shameless Cloning Can Lead To Financial Success. So let’s reverse engineer what Norbert Lou may have been thinking in 2001.
How Can We Evaluate His Pitch?
Well, one framework is what Warren Buffet uses:
Do I understand the Business?
Does the business have a durable competitive advantage?
Is the company management talented and can they be trusted?
Can I buy the business for a reasonable Price?
Let’s get started.
Do I understand the Business?
Norbert clearly understood the business well, and shared the two key success drivers of the business.
Specifically:
That the company is a homebuilder, with a unique operating model, where it purchases the right to buy finished lots from developers (as opposed to bare land), which costs them significantly less to control a piece of land, compared to competition who tend to purchase land and develop the lots on their own. This leads to significantly less capital upfront and thereby produces much higher returns on invested capital.
That the company manages risk further by getting pre-orders for homes before purchasing lots.
Sounds reasonable, and pretty easy to diligence. So far so good.
On Competitive Advantage
Although Norbert mentions that NVR is dominant in its markets, it isn’t clear why.
Let’s tease that apart:
NVR focused only in concentrated geographies where they developed a solid reputation so they could work well with local developers. This power of relationships had become an advantage over time.
Think about it. If you were a tiny local developer and NVR came in and offered to buy options on your entire inventory, and was willing to begin a working relationship with you (to potentially buy your future inventory) you'd consider going to their options model. It sure beat selling one property at a time.
As a result, as long as there were markets served primarily by small, private builders, NVR would be able to find new markets where it could apply its operating model.
This wasn’t an obvious insight.
But if you read the messages in the discussion forum, Norbert told you this himself.
Pretty cool eh?
All you had to do then was to find some homebuilders to talk to, perhaps even ones who had sold options to NVR, and determine whether they shared the above sentiment. Not rocket science.
Based on the above, NVR was dominant in their markets. They were actually the biggest home-builder locally and hence had large local economies of scale! This gave them cost advantages in manufacturing, hiring, advertising etc. These advantages accumulated over time which allowed them to move to adjacent markets.
Separately, Norbert also understood that NVR, as a home builder, faced minimal technological or obsolescence risk.
On Management Talent & Integrity
Assessing management quality may be the hardest of the 4 questions to develop conviction on. The below clearly demonstrates it is more an art than it is science.
The thesis outlines the importance of smart management. That said, Norbert doesn’t really talk much about why he believes the management is talented and trustworthy.
It is interesting to review the discussion thread to get a glimpse into this.
“Schar's [NVR’s CEO] discipline in sticking to the land-light model and returning excess cash to shareholders deserves much of the credit for the company's success. Also, Schar's way too greedy to make it to my favorite CEOs list. His mansion was paid for with wheelbarrows of liberally-issued stock options. NVR would have been a truly fantastic [investment] if they had just kept their stock option appetite in check.”
Norbert felt comfortable that management would not waste excess cash-flow, and instead continue deploying it to purchase shares of the company. At the time of the investment, there was already historical precedence for this.
More interesting however is that he felt the management team was greedy. By paying themselves excessively high amounts via stock options, they were taking away from shareholder returns. Despite this conflict of interest, Norbert was comfortable owning the stock.
Can I Buy the Business For a Reasonable Price?
Norbert felt the company was cheap in relation to what was “inevitably going to happen”. Norbert clearly recognized how enormous NVR’s total addressable market was.
He also had solid reasons for why he felt the stock was cheap and why that would change in the future. This is apparent in his exchange with another investor, who questioned why the stock was cheap:
Other Investor:
“All [homebuilder] stocks are cheap by normal measures - their operating margins and profits have gone up incredibly for the last 10 years – and the cycle shows no sign of turning given the lower interest rates. Today’s Lennar results have propelled the entire group so your recommendation looks timely. But, the relative P/E ratio of these companies has historically been around 60% of the market P/E. Notwithstanding the superior cash flow and share repurchase policy, I view NVR as a trading opportunity to be sold on any run ups – the market just won’t apply a decent multiple. The market schizophrenia about the industry should result in continued volatility (buying and selling opportunities). All of that leads me to think that I can wait for the price to come down to 125 before jumping in.”
Norbert’s response:
“Yes, all of these homebuilders are cheap on a P/E basis. Some of them deserve low P/Es -- many have leveraged themselves in order to buy land and speculate on development, and none of them (other than NVR) produce attractive returns on capital because of their operating model. So perhaps a sub 10 P/E is appropriate for the leveraged companies in the industry with 10% returns on equity.”
He agreed that the other homebuilders deserved their mediocre multiples.
But he also felt NVR deserved better, as he so colorfully explains below :)
“NVR does not have these same drawbacks. It's leverage and ROEs are magnificent. Maintenance capex is almost zero. I am mystified that any company with these characteristics trades for less than a market multiple.
I suspect that it is because 90% of all investors have (like you) said to themselves "oh, all of the stocks in this industry trade for a low multiple, it's not really that undervalued after all" without really thinking whether the financial characteristics of this specific company warrant a low multiple.”
I’ll let you decide whether that was a convincing argument.
In Conclusion
NVR has been a tremendous winner... and it may still have room to go.
I ask again, would you have bought this stock had you come across Norbert’s thesis?
What can we do to increase the likelihood of that happening?
Well, one way is to study more winning stocks.
We now live in an age where smart credible people all over the world share their investment thinking publicly, usually for free. Heck, large hedge funds in the US are required by law to disclose their investments.
We can look for investors whom we can trust, and whose investment philosophies we agree with. We can then analyze, reverse engineer and understand why these investors are fond of a particular investment idea. Often, but not always, investors will announce that to the world themselves. We can then make our own conclusions.
I believe this approach is a very fertile hunting ground for investment ideas. You likely have less competition, and frankly much of the work is already done for you.
Next, I hope to outline some of my key learnings from this case study.
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