Superior Fundamentals = Superior Returns
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When you buy a share of stock you are buying a share of a business enterprise and becoming part owner. Over the long term the business fundamentals and price paid are what determine your long-term investment returns.
I was looking at my Motley Fool Caps home page and realized that an old favorite homebuilder of mine NVR, Inc (NYSE: NVR) held the number three spot. I started the pick on Oct. 30, 2007 and it has since appreciated over 80% versus the S&P 500 gain of 0.17% as of Sept. 20. Not only has NVR beaten the S&P 500 during this time it has also beaten many of its competitors (see chart below). D.R. Horton (NYSE: DHI) is catching up with NVR but still lags by about 6%. NVR stock appreciation far exceeds the 15% and 13% return of Ryland Group (NYSE: RYL) and Pulte Group (NYSE: PHM) respectively.
What is the story behind superior returns from NVR compared to other companies in this troubled industry? Superior fundamentals. NVR was the only homebuilder of the four to maintain profitability and positive free cash flow over the past five years.
Even though NVR isn’t at the top of the ranks when it comes to the percentage change in profitability or free cash flow (see charts below) you will note their relative stability (smooth lines) in net income and free cash flow versus the fluctuations (zig zags) of their competitors, especially D.R. Horton and Pulte Group.
All four companies experienced a loss in free cash flow. Pulte Group experienced the lowest percentage of decline in free cash flow which was 63% between Oct. 31, 2007 and Sept. 20, 2012, but unlike NVR they couldn’t always maintain profitability or sustain positive free cash flow. NVR had the 2nd lowest percentage decline in free cash flow at 84%. Ryland Group experienced the largest decline in free cash flow at 165%. Clearly homebuilders are in a troubled industry.
NVR is winning the debt to equity ratio contest. Ryland has the highest debt to equity ratio of 226%. Pulte Group has the second highest debt to equity ratio of 157%. D.R. Horton has the second lowest debt to equity ratio of 60%. NVR’s debt to equity ratio declined over the past five years and now stands at 0 (see chart below). I like companies with little or no debt. I prefer companies with a long-term debt to equity ratio less than 50%.
NVR will be taking on $600 million dollars worth of debt which will put their debt to equity ratio at 40% which is still below my personal threshold. This is an effort to make stock buybacks and for general corporate purposes. I think the better use for these dollars is for general corporate purposes considering they are in a volatile industry.
Unlike their competition, NVR focuses exclusively on homebuilding. According to NVR’s 2011 annual report, what gives this company an edge is that they don’t develop land thus expending less capital. They line up an already developed property with a person who wants to build a home and then enter the transaction to purchase when the home is ready to be built. They aren’t spending a great deal of cash developing a property or buying property someone might not be interested in.
Given NVR’s stability during difficult times combined with prudent use of cash and low debt levels I am compelled to reaffirm my outperform rating for NVR. If it does well in difficult times it should do even better during good times. Remember, be Foolish and do your research before investing.
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