“If you're not confused about the stock market...you're not paying attention."
The Portfolio Performance
The portfolio is UP +16.17% YTD
The S&P 500 is UP +11.99% YTD
In this post, I'm taking a deeper dive than usual into my next investment idea. For this post, I will try and take you through the whole process instead of just giving you a name with a short thesis. If you choose to read further, just know that you're going to be sipping from a firehose that will take you from my macroeconomic view to the specifics of my choice.
The Macro View: The U.S. housing market is going through a difficult time. The key factors in the housing market are:
- Mortgage rates are higher than new buyers have ever seen
- The Federal Reserve is saying rates may need to go higher
- Existing homeowners don't want to sell because who would trade a 3% mortgage for a 7% mortgage?
- We have a massive shortage of new homes
- The Case-Shiller Housing Price Index has gone up 18.6% in the last 12 months
Mortgage rates are higher than new buyers have ever seen
Housing is a cyclical industry when rates, inventory, and demographics are all flashing normal. But right now, I don't see anything normal about any of those factors. Looking at rates, the Federal Reserve has raised rates at a faster pace than any time in history, raising 11 times in the last 18 months. The current Fed rate is 5.25%-5.50%. That's the rate banks pay to borrow money and then sell money to you at a higher rate. The national average for a 30-year fixed-rate mortgage is 7.59%. On a $400,000 home with 20% down and a 780+ credit score, you can expect to pay $492,606 in interest alone over the 30-year mortgage, or $977,606.49 in total payments. Lower rates by just 1%, and those interest payments get reduced by over $77,000. Those numbers make it easy to see why buyers are not racing to take out loans.
Existing homeowners don't want to sell
Existing home inventory is low because of the numbers I cited above. Nobody wants to trade a low-interest mortgage for one that's double or more than their current loan. Those who are selling have a life event to complete. They're downsizing for retirement and able to pay cash for a smaller home. They're moving to start a new job, or "My home is my piggy bank" and I'm selling to capture the high value and move into a rental.
We have a massive shortage of new homes
Existing home inventory is low because of the numbers I cited above. Nobody wants to trade a low-interest mortgage for one that's double or more. The number of previously occupied homes sold in the United States dropped by 21 percent over the past year, according to new data from the National Association of Realtors (NAR). That’s on top of an 18 percent annual decline the year before, indicating the housing market has continued to slow down amid rising interest rates. Meanwhile, prices continued to rise, with the median sales price climbing 3.9 percent from a year ago to reach $407,100.
The Case-Shiller Housing Price Index
This graph looks at housing prices since 2018. The gray bar represents the 2020 recession. Some might think, who's buying a house during a recession? Furthermore, who's bidding up prices during a recession?
The answer was easy to see back in 2020 and 2021, but we like to forget history while complaining about the present. Mortgage rates have been declining since the early 1980s. By January 2021, mortgage rates hit a record low of 2.65%. During the pandemic, we saw very little inventory of available new homes or existing homes, and with rates at historic lows, buyers were able to borrow more and bid up the homes they wanted.
SUPPLY - DEMAND - RATES
What I'm doing
All this discussion about the housing market led me to my latest long-term investment idea. For several months, I've had my eye on America's largest home builder, D.R. Horton (DHI). D.R. Horton, Inc. operates as a homebuilding company in the United States East, North, Southeast, South Central, Southwest, and Northwest regions. It engages in the acquisition and development of land and the construction and sale of residential homes in 106 markets across 33 states under the names of D.R. Horton, America's Builder, Express Homes, Emerald Homes, and Freedom Homes.
The company constructs and sells single-family detached homes and attached homes, such as townhomes, duplexes, and triplexes. It also provides mortgage financing services, title insurance policies, examination and closing services, and engages in the residential lot development business. In addition, the company develops, constructs, owns, leases, and sells multi-family and single-family rental properties; owns non-residential real estate, including ranch land and improvements; and owns and operates energy-related assets. DHI has built itself into a one-stop shop for home buyers. Let's hope the FTC doesn't direct their litgious gaze at DHI, because all that integration reduces the overall cost of buying a home while making DHI more profitable.
First Check: Who are DHI's competitors, and how does DHI stack up? The top home builders in America are D.R Horton, Lennar, NVR, PulteGroup, Toll Brothers, Taylor Morrison Home Group, Meritage Homes, and Skyline Champion Homes. I've eliminated Skyline Champion because they're a manufactured home builder, which is a small percentage of overall home sales. I've eliminated NVR since the stock sells for $6,050/share and isn't available in fractional shares.
Second Check: How effective is DHI management? My second check is to compare the weighted average cost of capital to the return on invested capital (WACC% vs. ROIC%). This ratio asks, "Are you growing or destroying capital?" D.R. Horton's weighted average cost of capital is 10.52%, and the ROIC % is 18.87%. DHI has the highest WACC%, but looking at the last five years, I see their WACC% is in line with their competitors. Everyone's WACC% has increased with higher rates, but DHI has been more stable. Looking deeper, what's the ROIC%? DHI ranks second in the group at 18.87%. On this metric alone, I'm going to cut some of the competition out of my analysis. Lennar, KB Homes, Toll Brothers, Taylor Morrison Home Group. My focus is now on the top three: D.R. Horton (DHI), PulteGroup (PHM), and Meritage Homes (MTH).
Third Check: DHI has a Market Cap of $36.79B, PHM $16.40B, and MTH $4.56B. If size matters, DHI is the 800-pound gorilla in the home-building market. Remember, homebuilding is a cyclical industry, so financial strength is important in order to keep performing during slow periods.
Fourth Check: Whose growing revenue? I should note that none of these home builders are growing earnings. Current analyst's projections are that earnings are slowing. DHI gets a slight edge on Price/Earnings Growth (PEG Ratio), but not by much. So, my focus is on revenues and free cash flow. I want to know who stands out in terms of having the cash flows that can sustain operations until rates start coming down again. During the last 12 months, the two remaining competitors outperformed DHI, but looking at the 3, 5, and 10-year performance, it's clear that D.R. Horton has grown revenue better.
D.R. Horton (looking backward)
- Last 12 months, D.R. Horton's average Revenue per Share Growth Rate was 12.00% per year.
- Last 3 years, the average Revenue per Share Growth Rate was 26.50% per year.
- Last 5 years, the average Revenue per Share Growth Rate was 20.80% per year.
- Last 10 years, the average Revenue per Share Growth Rate was 20.10% per year.
PulteGroup (looking backward)
- Last 12 months, PulteGroup's average Revenue per Share Growth Rate was 24.10% per year.
- Last 3 years, the average Revenue per Share Growth Rate was 22.80% per year.
- Last 5 years, the average Revenue per Share Growth Rate was 18.10% per year.
- Last 10 years, the average Revenue per Share Growth Rate was 18.50% per year.
Meritage Homes (looking backward)
- Last 12 months, Meritage Homes's average Revenue per Share Growth Rate was 19.40% per year.
- Last 3 years, the average Revenue per Share Growth Rate was 21.50% per year.
- Last 5 years, the average Revenue per Share Growth Rate was 16.90% per year.
- Last 10 years, the average Revenue per Share Growth Rate was 15.30% per year.
D.R. Horton (looking forward)
- D.R. Horton's Total Revenue Growth Rate (Future 3Y To 5Y Est) is 5.53%.
Meritage Homes (looking forward)
- Meritage Homes's Total Revenue Growth Rate (Future 3Y To 5Y Est) is 3.30%.
PulteGroup (looking forward)
- PulteGroup's Total Revenue Growth Rate (Future 3Y To 5Y Est) is 2.39%.
Fourth Check: How much room is there for growth in the stock?
- DHI stock is up +21.94% YTD, but down -17.75% from its high. There is +32.46% upside to analysts' consensus.
- PHM is up +64.18% YTD but down -13.24% from it's high. There is +31.75% upside to analysts' consensus.
- MTH is up +33.92% YTD but down -19.0% from it's high. There is +45% upside to analysts' consensus.
All are up substantially, showing gains that are more reflective of growth companies, and analysts' 12-month price targets are substantially higher. My brain is waving some caution flags as I look at the price targets on PHM and MTH. Why are the two companies growing slower, having slightly lower earnings projections, and having much smaller operations going to have such high-performing stocks in the coming year? Looking at the analysts covering the stocks, I see that DHI has twice as many analysts, so the consensus average of all analysts is going to be lower just based on the wider distribution of prices. Other than that, analysts have their own biases. DHI is up the least YTD, and based on all the other metrics, I believe the upside price target the most out of these three.
Fifth Check: Checking my gut. All three businesses are fairly similar: they make single-family and multi-family homes, provide additional financial services, own and option land, and deliver roughly similar revenue growth rates. These three companies are close on every valuation metric, but D.R. Horton has grown more and is expected to grow revenue faster. As inflation and interest rates come down, I suspect that D.R. Horton will grow earnings faster.
Since inception, all three companies have invested in acquisitions that have grown their companies: DHI has acquired 11 companies, PHM has acquired 6, and MTH has made 1 acquisition. In the home-building business, economies of scale matter. DHI has the ability to buy lumber, pipe, electrical components, and everything else that goes into a home at lower prices.
DHI has also been buying back fewer shares than PulteGroup. I think PulteGroup has been buying back shares to raise the stock price and to retain greater control of the company after a rather noisy affair with a private equity group. Even after initiating a larger buyback program, insiders at PulteGroup own less than 1% of the stock, which is why they were vulnerable to a hostile takeover. It appears that they used too much stock to complete the six acquisitions, or insiders sold too much stock over the years. Whatever the reason, I prefer to see at least 10% insider ownership. Looking at insider ownership, Meritage Homes insiders only own 2% of the stock. Based on size, investments in the business, and a lack of insider ownership, I'm eliminating Meritage Homes and PulteGroup. D.R. Horton insiders currently hold 10.85% of the stock.
The company buys back stock opportunistically but mainly uses cash to acquire companies that are accretive to the overall business. DHI offers homes in more markets and has offerings for every home buyer, from homes for first-time buyers to luxury homes. DHI's new rental properties offer an alternative for young families looking to get a new home but either don't have the down payment to buy or want to wait until lower interest rates are available. Those rental properties are easier to rent, produce monthly cash flows, put non-productive land to use, and can be sold if the rental market is no longer viable in the future.
So what is D.R Horton worth? That depends on how you do a valuation, but with this company, I'm looking for a margin of safety that allows me to hold the stock for the next 3-5 years.
- Analysts' Consensus price Target = $144.24 (32.46% higher from today's close of $108.92)
- Discounted Cash Flow Analysis (earnings-based) = $439.38 (303% higher)
This DCF analysis is using a discount rate of 11%. If I increase the discount rate to 20%, I still get a $210.14 stock or a double from the current price. 11% is a reasonable discount rate in the current market. This "What If" test tells me that for any discount rate between reasonable and ridiculous, I get a 2 to 4 bagger.
- Famed investor Peter Lynch had a metric that I find interesting. In his book One Up on Wall Street, Peter Lynch, revealed a powerful charting tool that helped him to achieve a gain of 29.2% in his portfolios for 13 years. In this chart, Lynch drew the stock price and the earnings per share together and aligned the value of $1 in earnings per share to $15 in stock price (P/E standardized to 15). “A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.” With charting tools, we can convert Lynch's chart into a price target. Using the Peter Lynch approach, I get a price target of $351.50.
- For all the value investors, I also looked at the Benjamin Grahm Number for DHI.
The Formula for Graham Number
In his seminal investment treatise, Graham wrote that his Graham number is used as a general test when trying to identify stocks that are currently selling for a good price. The 22.5 figure is included in the calculation to account for Graham's belief that the price-to-earnings (P/E) ratio should not be over 15x, and the BVPS should not be over 1.5x (thus, 15 x 1.5 = 22.5). Calculating a Graham Number for DHI, I get $140.68, or +29.16% higher.
"Oh, thank God he's going to stop talking"
Regardless of which approach I use I get a range of price targets of $140.68 to $439.38. Every price in the range is a more than acceptable return that even a growth investor can appreciate.
This investment relies on some significant events taking place over the next 3-5 years. First, interest rates need to peak and start coming down to increase new home sales and housing starts. My thesis on rates is that the Fed will raise too far, things will break, triggering a recession, and rates will need to come down quickly to restart the economy. Next, the supply of homes is low, and I anticipate that the number of new homes will remain low even if rates decline. Existing home sales will remain low as long as rates remain high, further impacting overall supply. The Fed continues to harp on "Higher for Longer" so expect existing home sales to remain low. Home prices will only come down when the supply increases dramatically. Prior to the Great Financial Crisis in 2008, new housing starts were considerably higher. New starts peaked in 2004 at over 2 million homes; today the annual rate is about 1.3 million, and very few of these homes are for first-time buyers. All of these conditions benefit D.R. Horton the most as soon as rates stabilize or start to decline.
I've placed a limit order to buy the first 25% traunch of D.R. Horton shares at $106.84, roughly the 200-day moving average. In the Stay Invested portfolio, I've determined that 358 shares is a full position. I'm looking to buy 25%, or 90 shares as a starter position. I'll wait to buy more.
BUY DHI 90 SHARES @ $106.84
"Markets don't go to zero, Portfolio's do.
Buy quality, be patient...and look twice for motorcycles."
- Clay Baker
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Rule #1: Don't lose money
Rule #2: See Rule #1
Rule #3: Portfolios go to zero, markets don't, Stay Invested
Rule #4: When good stocks you own drop 10% below your cost basis, add shares
Rule #5: Bull markets aren't sustained without the Transports
Rule #6: When Forward P/E is lower than TTM P/E, expect earnings to increase
Rule #7: When an investment bank sells below book value, buy it
Rule #8: Tips are for waiters. Do your own homework.
Rule #9: Don't sell a stock because you're bored with it. Do your own homework.
RULE #10: Being early and being late is the same as being wrong...move on.
Rule #11: Investing is easy. Waiting is hard; waiting is the hardest part.
Disclosure: I am personally invested long in some or all of these stocks or funds that appear in the Stay Invested portfolio and may purchase or sell shares within the next 72 hours. I am also invested in other stocks and funds that do not appear in the Stay Invested portfolio but may be mentioned or related to this article. It is not my intention to advise or encourage the purchase or sale of any security. I am invested long in these securities mentioned in this post:
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is not intended to offer investing advice, guarantee 100% accurate predictions, or to be interpreted as providing a personal recommendation.