Dear fellow investors,
There appears to be a few huge statistical bargains available in the stock market based on the simplified version of Benjamin Graham’s intrinsic value calculation. For back-of-the-envelope purposes, we use the following equation to calculate net present value:
- V = Estimate of a company’s intrinsic value
- EPS = Recent yearly earnings estimate of a company
- 8.5 = Price to earnings (P/E) afforded to companies that have shown no-growth in recent history
- G = Estimated long-term growth expectation for earnings
- Y = Current yield on 10-year AAA corporate bonds
As we seek a big margin of safety, we are very conservative with “G” and “Y”. We’ve been using a 5.5% estimate for our “Y” discount rate, and we generally are 20-30% lower with our growth estimates than what Wall Street consensus may imply. At the time that Graham wrote about this, he looked backward and saw that AAA bond rates had averaged 4.4% over the prior decades. The 4.4% assumption is adjusted by the “Y” denominator, causing the formula to be germane in differing rate environments.
A long time ago, we heard Warren Buffett say that all the math you need to be a successful investor was learned by the seventh grade. We are happy to admit that we probably could never have been hired at Amazon or Microsoft, where they are looking to hire mathematical/technological geniuses. Hence, our simple calculation with very conservative assumptions.
What triggered these thoughts was the behavior of home builder share prices each time interest rates have ticked up recently. The myopic media has preached that home buying will be determined by interest rates and affordability going forward. We believe it will be driven by a massive shortage created by horrifically low home building in the 2009-2019 period and an explosion of interest in the 90-million-person Millennial age group which will dominate the 30-45-year old contingent over the next ten years.
Other than the ridiculous mania of 2005, all past home building peaks were in the 1970s and early-to-mid 1980s. This was almost all done at double-digit interest rates and was driven by 79 million Baby Boomers wanting homes, replacing the 44 million folks in the Silent Generation. The last one of those included 1983, when the Smead’s bought their first house on a Washington State buy-down program at a 13.5% interest rate. Why would anyone want to pay very high interest rates back in the 1970s and 1980s?
- Most Americans build their net worth via the forced savings and inflationary appreciation of owning their home.
- Inflation is a product of too much money chasing too few goods. Inflation reached 11% in 1981. Milton Friedman, the great economist, said, “Inflation is always a monetary phenomenon.”
- The four trillion dollars (possibly with more to come) of fiscal spending to combat shutting down the economy to slow the COVID-19 virus, along with massive money creation by the Federal Reserve Board, will be like a cocktail which is mixed, but is just now being served.
- Millennials and Americans in general are in the best position to leverage up on homes in 40 years. Consider the chart below showing the scant portion of discretionary incomes crowded out by debt servicing obligations for today’s U.S. households:
Major banks are drunk with deposits from folks not having much to spend money on as they spend time imprisoned in their own homes.
- Looking at housing start history is far more telling when adjusted for U.S. population. Ask any Millennial and they’ll tell you the only thing that matters is housing supply per capita. They are forced to put in escalation clauses on no-contingency offers. Here’s the more appropriate housing supply chart:
Today’s home building per capita number only brings us up to the bottom of the chart prior to 2006, a function of the home building depression of 2007-2017.
With the average home in America being 45-years old, you need to look no further than the composition of lumber use to see how early we are in the cycle. Home repair and remodel is using more lumber as home building ramps up.
Therefore, we did the following intrinsic value calculation on the back of our envelope for Lennar (LEN) and D.R. Horton (DHI). Here is what we found based on a conservative ten-year earnings growth rate and an outlandishly high ten-year AAA bond rate of 5.5%:
As you can see, based on our conservative estimates of earnings growth and a whopping 4%-plus rise in yield over and above today’s AAA long-term corporate bond rates, LEN and DHI look like screaming bargains. A few caveats: 1) The good things that happen to these stocks over the next ten years won’t come in a straight line, and 2) Stock market selloffs will affect short-term performance. The biggest current problem for these stocks is that momentum investors were attracted to them because they more than doubled from the nightmarish March lows. Despite doubling, they trade for around ten-times earnings.
These builder stocks will be a freak show for owners of the S&P 500 Index and growth funds/ETFs. The publicly-traded home builders, whose market share and moat grow by the minute, make up only a scant 0.23% of the S&P 500. At Smead Capital Management, we are practicing what Warren Buffett describes as the Mae West Theory, “too much of a good thing can be wonderful.” We currently own around 14% of our portfolio in home builders. As they prosper the next ten years and interest rates rise as a result of Millennial household formation, this could be one of the few industry groups which won’t suffer from valuation contraction.
Tony Scherrer, CFA
The information contained in this missive represents Smead Capital Management’s opinions and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and Tony Scherrer, CFA, Director of Research and Portfolio Manager wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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