Morningstar Advisor - October/November 2013 - (Page 32)

Sector Rap its diluted share count down by 58% since 1999. The company has generated very strong returns on invested capital. Its ROICs dating to 2002 have averaged 54%, well above peer averages of about 10%. So, we think that NVR really stands out as a best-in-breed homebuilder, even though we don’t think it possesses an economic moat. NVR is our top industry pick and is on our Morningstar Best Ideas list. We have a fair value estimate of $1,190 on NVR. The current stock price is approximately $870, making the company attractively valued here in our opinion, unlike the other homebuilders. Alukos: Explain NVR’s land-light business model a little further. It only buys finished lots? Krapfel: Yes. Most homebuilders acquire land through a mix of finished lots, semi-developed land, and undeveloped raw land purchases. Raw land investments sometimes involve many years of government permitting and infrastructure development before homes are ready to be built. Alukos: You mentioned that the rest of your homebuilding names are overvalued. Does one particularly stand out? Krapfel: We believe that Lennar LEN is the most overvalued. Lennar has done very well timing the cycle. During the down cycle, Lennar quickly pared its inventory levels and prevented its balance sheet from becoming strained. Then, it got a jump on its peers in the down cycle, buying land on the cheap. Investors have bid up Lennar’s shares over the past couple of years because of this strong execution. But land inventory is only advantageous for the next several years to come. The company will have to continually time the cycle well for it to keep generating abovepeer earnings growth. Although a strong executor, Lennar has no single competitive advantage that it can rely upon, so we don’t think that the company deserves to trade at a premium to the group. Alukos: Looking at the industry more broadly, a lot of the small mom-and-pop homebuilders were strained, if not forced into foreclosure. How has the overall market share NVR is the only company that nearly exclusively relies on finished lots to build homes upon. The company options its land from developers and puts down a cash deposit of up to 10% of the agreed-upon price. It takes ownership of the land on a pre-determined pace and price, with a takedown schedule management tries to match up with expected demand. If the local operating environment deteriorates, the company can walk away from that option and simply forfeit its cash deposit. Because of this business model, NVR’s free cash flows are far better than its peers. Its free cash flows as a percentage of sales since 2002 have averaged 9%. For the other homebuilders that we cover, the range is 3% to 6%. For homebuilders that we do not cover, which are generally lower quality companies, free cash flow as a percent of sales ranges from negative 5% to positive 2%. NVR really stands out as the best-of-breed company. 32 Morningstar Advisor October/November 2013 evolved over the past few years? The market seems too fragmented for anyone to have Krapfel: Removing the deduction is highly unlikely. Of all the reforms mentioned over the past six months, removing the mortgage interest tax deduction probably is the least likely to occur. There has also been talk of reforming Fannie Mae and Freddie Mac. Many Republicans wish to eliminate the government backing of those firms and have the housing market purely exist on the private market. But we don’t think there’s enough support for this in the House and the Senate, and we don’t think the president would support that measure either. We think Fannie and Freddie will still play a key role in the housing market by backstopping mortgages. We think that recent proposals in the House and Senate in which the private market would have to assume certain losses before the government steps in is probably the more likely option. We think that the ramifications of this would be limited for the housing market. One area that might increase costs for homebuyers is the cost to insure their mortgages since the GSEs have been raising charged premiums. However, we expect any impact this has on the overall housing market to be minimal. an advantage. Alukos: So, it sounds like an investor should Krapfel: Large homebuilders clearly gained a lot of market share over the past decade, and that really accelerated in the downturn. Small homebuilders had little access to capital, and many went out of business. We estimate that the largest five U.S. homebuilders by market cap grew their market share from 9.8% in 2002 to 16.2% in 2012, with minor mergersand-acquisition activity, other than the $1.3 billion acquisition by PulteGroup PHM of Centex in 2009. Alukos: Let’s talk about things that might affect housing affordability. For example, consider buying NVR, or buy a house. Krapfel: Housing prices have run up a lot recently. Clearly the best time to buy was a year or two ago, especially with mortgage interest rates now rising approximately 100 basis points from the low. However, housing is still very affordable on a historical basis. As far as stocks, most homebuilders appear fully valued to us as the market already seems to anticipate a strong recovery in the homebuilders’ financial results. Best-ofbreed operator NVR is the exception, trading at a nice discount to our fair value estimate. K there’s been talk in Washington about getting rid of the home-mortgage-interest deduction. Have you looked into what might happen if the deduction went away? Basili Alukos, CPA, CFA, is an equity analyst with Morningstar.

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2013

Morningstar Advisor - October/November 2013
Contents
Contributors
Letter From the Editor
How to Make Social Media Work for You
Do Mutual Funds Still Have a Role?
More Personal Than Finance
How to Handle Your TIPS Positions
A Real Estate Veteran Starts From Scratch
Investments á la Carte
Investment Briefs
When to Say No
Take a Guarded Approach to Homebuilders
Fund Distribution Has Been Turned on Its Head. Now What?
Winning the Distribution Battle
Active ETFs Wait for Their Heyday
A Fund Firm Defies Indexing Trend
Piloting New Channels
A Good Fit
The Predictive Power of Fair Value Estimates
Does Being Prudent Pay Off?
Utilizing Utilities’ Total Return
Stuck in the Middle Is Not a Bad Place to Be
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Good Guys Win

Morningstar Advisor - October/November 2013