As I’ve commented on a few times this summer, rising interest rates and a flatter yield curve have been applying pressure on the economy. One area in particular that has seen a fairly strong slowing is the housing market, with home builders and related housing stocks down significantly from their highs earlier this year. I expect pressure to remain on the housing market into and through 2019 but this short-term weakness is creating an attractive opportunity for investors with a long-term view.
Here in the US, we’ve largely under-invested in new housing for the last decade. This is pretty typical following the unwind of a bubble but we’re now 10 years later and demographics are turning from a headwind to a tailwind which will ultimately create a 10 to 15 year run of strength for the housing market.
US Housing Starts
Demographics are the key to understanding this story. We’re going from roughly 75 million Baby Boomers trying to downsize to 65 million Gen X’ers, to a market where 75 million Millennials will be chasing 65 million Gen X’ers. Millennials have been slow to join the housing market, largely due to onerous mortgage regulations, too much student debt, and a desire to live in urban areas (which often means renting), but are now quickly entering the market, starting families, and spending money on everything related. After bottoming at levels last seen in the 1980’s (when the Baby Boomers largely entered the housing market), homeownership rates are now starting to push higher, a clear sign that Millennial buying is picking up.
Total Population by Generations
US Homeownership Rates
And here’s the best way to illustrate this demographic tailwind. This chart shows the US population between the ages of 35 and 44, a key home buying age as families often start to move up to bigger homes for their growing family.
Population between the ages of 35 & 44
I used October’s drop in the stock market to purchase a few new stocks, two of which are housing related. This is absolutely a contrarian call right now as Wall Street analysts are out in force downgrading the housing stocks (after 35% declines…). See here and here. This is yet again another example of how you can use Wall Street’s short-term view as an opportunity to make long-term investments.
NVR (NVR)
NVR is a homebuilder located primarily in the Mid-Atlantic region that operates under the units of Ryan Homes, NV Homes and Heartland Homes. They are different from every other homebuilder and by different I mean smarter. NVR uses an asset-light business model where, instead of taking the full risk on land and development, they secure finished building lots from other developers with a 10% deposit once they have clarity on demand. This limits their risk to only the deposit instead of taking the full risk of potentially being stuck with the entire lot/development in the event that the housing market slows. It also requires the company to raise far less capital which means a higher return on capital. What could be better than a higher return on invested capital and less risk in a cyclical industry? This ultimately means far more Free Cash Flow (FCF) which the company uses to repurchase stock every year.
Paul Saville has been with NVR since 1981 and has been CEO since 2005. He has made it very clear that share repurchases are a key part of their strategy to create shareholder value and will continue doing so. He also owns over 200,000 shares himself, representing nearly $500 million of his personal wealth in the stock. This is a prime example of the owner-operator type of companies that I prefer to partner with.
We purchased the stock down about 40% from its all-time high in January. This certainly reflects the concerns about a slowing housing market enough for me to step in with a starter position. Could the stock continue lower in 2019? Yep. But that would be the best thing that could happen for long-term investors. When a company has a proven recipe for success and generates returns on invested capital well above their cost of capital, share repurchases create shareholder. With an ongoing buyback in place, the lower they can repurchase stock, the more value that is created for us as shareholders in the long run. So I welcome further weakness so we, and the company, can buy more shares at lower prices ahead of a 15 year tailwind.
NVR – 20 years
AO Smith (AOS)
AO Smith is a manufacturer of water heaters, boilers, water purification and air purification equipment. The company generates solid rates of return, consistent FCF and has a rock solid balance sheet with no debt. The investment theme for AOS is two-fold. First, they are an established market leader in the US for water heaters and boilers with a 40% and 55% market share, respectively. 60% of their sales come from water heaters in North America which, given that hot water is not a discretionary item in America but is an absolute requirement, provides a very stable and recurring line of business. Every time a water heater breaks, it is immediately replaced. New sales tend to be more cyclical as they are tied to new construction but this is an area that should be strong for the next 15 years, as discussed above.
10% of sales come from commercial boilers and the remaining 30% is from emerging market business. The company began investing in China some 15 years ago and India about 10 years ago. In addition to water heaters, the company is seeing strong demand for their air and water purification products – a common and big problem in both China and India. Their early investments have given AOS a strong position in both markets and the company expects growth to be about 15% per year for the foreseeable future.
While the emerging markets business provides growth potential, the stable and recurring FCF from North America is used to fund the dividend. The company just joined the illustrious group of Dividend Achievers after raising its dividend for the 25th consecutive year. They boosted the dividend by 28% in January and another 22% last month! Companies don’t do that if they have concerns about business conditions over the next 12 to 24 months, which says to me that the recent drop is a wonderful long-term buying opportunity. AOS is down a little over 30% from their highs earlier this year on a combination of fears of a housing market slowdown and China trade concerns. This allowed us to buy an initial position at a roughly 1.90% dividend yield in a company that has increased their dividend at an annual rate of 18.4% over the last decade. I expect this run of dividend increases to continue for the next decade at least as the US housing market picks up steam through the 2020’s.
AOS – 10 years
Thank you Mr. Market for putting two extremely well run companies that I have long admired on sale for us.
-Nick