Cabot Value Investor Issue: September 5, 2024

Homebuilders Have Adopted a Better Business Model. And Now Rate Cuts Are Coming

Six years ago, in the fall of 2018, few new homes were being built in the U.S.

From May 2018 to the end of that year, housing starts declined steadily from 1.36 million units to 1.09 million units, a two-year low. The reason was obvious: 30-year mortgage rates had spiked to 4.8%, their highest point since early 2011, as the Federal Reserve – in an effort to combat creeping inflation (sound familiar?) – had raised short-term interest rates from near zero at the end of 2015 to 2.4% by December 2018. New home sales slowed, so fewer new homes were being built.

So the Fed pivoted and started slashing rates. By the end of 2019, the federal funds rate was down to 1.5%, the 30-year mortgage rate had dipped to 3.7%, and, sure enough, new homes were being built again, to the tune of 1.55 million units, a post-Great Recession high.

Then Covid happened, and all trends went out the window. The Fed immediately slashed rates back to near zero, but few houses were being built – housing starts bottomed at 931,000 in April 2020 – because almost no one was looking for a new home in an uncertain new pandemic world. We know what happened next. The world began to reopen, people fled cities and moved to more rural areas to get away from the virus, and thanks to government stimulus checks, some (though certainly not all) people had more money to spend, and they used it to take advantage of record-low mortgage rates. (Personal note: My family did just that, closing on a new house one town over from our previous one in Vermont in November 2020; it was my wife’s idea to pounce on a hot market, so I take no credit for our 2.75% 30-year mortgage rate.)

The housing market was red-hot for nearly two full years, with housing starts doubling from the April 2020 bottom to the April 2022 peak at 1.83 million units built. That, of course, is when it became crystal clear that inflation was not just “transitory,” to borrow a poorly chosen Fed term. It was here to stay. By October 2023, mortgage rates had spiked to nearly 8% after the Fed had raised interest rates from near zero to the current 5.25%-5.5% range to bring inflation down from four-decade highs. High mortgage rate fatigue has taken a toll on the housing construction market, as only 1.24 million new homes were built in July – the lowest monthly tally since the early days of Covid.

That’s about to change.

Two weeks from now, the Fed will – almost surely – start to cut rates for the first time in four and a half years. Comparing anything to what happened during Covid isn’t even apples to oranges; it’s more like apples to eggplant parmesan. But perhaps a better comparison is what happened to the housing market in the second half of 2019, before Covid arrived: The Fed slashed rates by 100 basis points, and housing starts – at multi-year lows at the end of 2018 – spiked to a 13-year high by January 2020.

That’s a fair template for what could happen this time around, especially given that mortgage rates are twice as high as in mid-2019 – and there’s theoretically more pent-up buying power that’s been sitting on the sideline. Homebuilder stocks could be the earliest beneficiary once the Fed starts slashing: From the December 2018 housing start bottom to the February 2020 pre-Covid top, the iShares U.S. Home Construction ETF (ITB) surged more than 64%, more than double the 30% run-up in the S&P 500 over the same span.

I think we could see similar outperformance in the homebuilders this time around. And this time around, there’s another potential tailwind, according to an industry source who co-founded a residential development firm that builds single- and multi-family homes in the southeastern U.S.: “Homebuilders are attractive to me because they are no longer real estate companies,” says the source, who preferred to remain anonymous. “They are really manufacturing companies now, like a car maker, but with a greater upside on the residual value of their product.

“The big shift to me with the homebuilders,” he continues, “is that they’ve all switched their models to de-risk their balance sheets and let land developers carry inventory for them until it’s ready to go vertical. So despite their profit margins not expanding, their IRRs (Internal Rate of Return) are materially up under that structure. So, depending on how well they’ve dealt with interest rate buydowns, their balance sheets are healthy and they are better built to ride out volatility in the home-buying market, similar to how car manufacturers are set up.

“It’s a nice, sustainable model.”

Sustainable is a good word to associate with an asset you want to invest in for the long term. And when that asset is on the precipice of a major potential catalyst like rate cuts, it makes for an attractive long-term investment.

But which homebuilder should we invest in? One big-name company stands out to me…

New Buy

Toll Brothers (TOL)

Despite new home construction slowing to a crawl, homebuilder stocks have actually fared pretty well this year. The aforementioned ITB, which tracks the price of some of the biggest publicly traded names in the industry, is up 15% year to date, but 64% since the October 2023 bottom, when the Fed finally signaled that rate cuts might be on the table in 2024 (technically we’re still waiting). But they’re still undervalued. The average homebuilder stock trades at 13x earnings.

Toll Brothers (TOL) is even cheaper, trading at a mere 9.5x forward earnings estimates and 1.4x sales. Granted, it was way cheaper two years ago, trading at less than 4x EPS estimates and 0.5x sales in late 2022. But it’s also growing faster. In fiscal 2024, analysts anticipate 18.4% EPS growth on 7.1% revenue growth, both of which would easily top 2023 results (13.6% EPS growth on a 2.7% downturn in revenues). Those figures are expected to level off next year – to 3.6% revenue growth and flat EPS. But the company has a knack for topping EPS estimates – it’s done so comfortably in each of the last four quarters – so it’s quite possible those estimates are conservative, especially if the industry-shifting catalysts discussed above are not being factored in yet.

Toll Brothers isn’t the biggest homebuilder in the U.S. – its $10 billion in revenue last year paled in comparison to the likes of D.R. Horton’s ($35 billion), PulteGroup’s ($16 billion), or Berkshire Hathaway holding Lennar’s ($34 billion). But it’s cheaper and growing faster than all of them.

TOL is down about 6% from its August highs just below 149 a share. Given the sharp pullback in the last couple weeks, I think this is an ideal entry point. To get in line with the average homebuilder stock’s forward price-to-earnings ratio, TOL would need to reach at least 180 a share. Let’s add TOL to the Growth & Income Portfolio (it does pay a small dividend), and set 180 as our price target, giving us 29% upside from current levels.

If the Fed cuts rates more than once this year (September is assumed), I think it could reach our target quite soon. But with rates likely to come down much further in the next 12 months and with a sea change in the way homebuilders do business well underway, there’s a case to be made for Toll Brothers to be a part of any long-term portfolio. BUY

Note to new subscribers: You can find additional commentary on past earnings reports and other news on recommended companies in prior editions and weekly updates of the Cabot Value Investor on the Cabot website.

Send questions and comments to chris@cabotwealth.com.

Also, please join me and my colleague Brad Simmerman on our weekly investment podcast, Cabot Street Check. You can find it wherever you get your podcasts, or you can watch us on the Cabot Wealth Network YouTube channel.

This Week’s Portfolio Changes
Toll Brothers (TOL) – New Buy with a 180 price target

Last Week’s Portfolio Changes
Canadian Solar (CSIQ) Moves from Buy to Sell
Philip Morris (PM) Moves from Hold to Sell (reached 120 price target!)

Upcoming Earnings Reports: None

Growth & Income Portfolio

Growth & Income Portfolio stocks are generally higher-quality, larger-cap companies that have fallen out of favor. They usually have some combination of attractive earnings growth and an above-average dividend yield. Risk levels tend to be relatively moderate, with reasonable debt levels and modest share valuations.

Capital One Financial (COF) is a diversified bank that provides banking services to consumers and businesses, as well as auto loans. Though it is probably best known for its credit cards – if you watch any TV, you’re probably familiar with its, “What’s in your wallet?” tagline. It’s the fourth largest credit card company in the U.S., with $272.6 billion in purchase volume in the first half of 2023 alone. And it’s on the cusp of getting even bigger: Capital One is in the process of acquiring fellow credit card giant Discover Financial (DFS) for $35 billion. If approved, the deal could be completed either later this year or early next year and would make Capital One the largest credit card issuer in the U.S. and the sixth-largest U.S. bank by assets.

Even absent the Discover buyout, Capital One is growing just fine on its own. Its revenues have expanded from $28.5 billion in 2020 to $36.8 billion in 2023; this year, they’re expected to swell another 5%, to $38.7 billion, with another 5% uptick estimated in 2025.

And yet the stock is cheap, trading at a mere 10x forward earnings estimates, 96% of book value, and 1.48x sales. The share price peaked at 177 exactly three years ago, in August 2021; it currently trades at 145.

The bank has caught Warren Buffett’s attention. In May 2023, Berkshire Hathaway disclosed that it had taken out a nearly $1 billion stake in Capital One. With earnings per share expected to rise more than 25% by the end of 2025, and with Discover Financial possibly adding an even greater windfall should the deal gain approval, it’s easy to see why the Oracle of Omaha likes it.

There was no company-specific news this week for Capital One Financial, though the share price continued its late-summer resurgence, adding another 1.5% to get back above 145.

The slow-and-steady recovery is evidence that investors aren’t terribly concerned about last month’s revelation that Buffett had sold 2.65 million shares, reducing Berkshire Hathaway’s position by 21%. Perhaps investors see the bright side: that Berkshire still owns $1.4 billion in COF stock, and more importantly, that the potentially game-changing merger with Discover Financial seems well on track to approval, perhaps as early as later this year, according to Capital One executives.

Despite the recovery from an early-August trip down to 131, COF still has 28% upside to our 185 target price. BUY

Dick’s Sporting Goods (DKS) has been growing steadily for years.

From 2016 to 2023, the sporting goods chain’s revenues have improved 64%, from just under $8 billion to just under $13 billion. This year, the top line is on track to top $13 billion for the first time. It should top $13.5 billion next year.

Dick’s, in fact, has grown sales in each of the last seven years – including in 2020 and 2021, when most other retailers saw sales nosedive due to Covid restrictions. But Dick’s all-weather ability to keep growing no matter what’s happening in the world or the economy speaks to its versatility. Since Covid ended, however, Dick’s sales have entered another stratosphere. As youth sports returned in 2021, Dick’s revenues jumped from $9.58 billion to $12.29 billion. They’ve been rising steadily each year since and are expected to do so again this year.

But Dick’s isn’t purely a growth stock—it’s also undervalued. DKS shares currently trade at just 17x forward earnings estimates and at 1.49x sales. To be sure, it’s not the cheapest stock in our portfolio. But it is one of the fastest growing – and pays a solid dividend to boot.

Dick’s reported good-not-great earnings on Wednesday, which was enough to send DKS shares tumbling as much as 7%. First, the good: the $4.37 in earnings per share blew analysts’ Q2 estimates of $3.86 out of the water and marked a 55% improvement year over year, while sales ($3.47 billion) narrowly topped estimates ($3.44 billion). Same-store sales growth came in at 4.5%. All of it was enough for the retailer to raise full-year 2024 guidance to a range of $13.55 to $13.90 in EPS (up from $13.35 to $13.75 previously) and same-store sales growth to 2.5% to 3.5% (up from 2-3% previously). However, the midpoint EPS guidance number ($13.73) came in shy of analyst estimates $13.84), hence the selloff. That seems like an overreaction to a mostly encouraging report. Lingering bad feelings from industry peer Foot Locker’s full-year guidance “miss” (it didn’t raise full-year EPS expectations like analysts had hoped) may have contributed to Wednesday’s selloff.

We’ll see how the stock behaves in the coming days, and whether some kind of bounce-back is in order. Even with the down day Wednesday, DKS shares are still up 8.5% in the last month. They now have 16% upside to our 250 price target. BUY

Honda Motor Co. (HMC) – After years of declining sales, Honda was rejuvenated in 2023 thanks to hybrids. The Japanese automaker sold 1.3 million cars last year, up 33% from 2022; a quarter of the cars it sold were hybrids, led by its popular CR-V sport utility vehicle (SUV) and Accord mid-size sedan. The CR-V was the best-selling hybrid in the U.S. last year, with 197,317 units sold. The Accord wasn’t far behind, with 96,323 sold. All told, Honda’s hybrid sales nearly tripled in 2023, to 294,000 units.

So, Honda is making the full pivot to hybrids, with the Civic soon to become the latest addition to its hybrid fleet. Investors have started gravitating more to the companies that sell them. Invariably, those are well-established, big-name car companies made famous by many decades of selling internal combustion engine vehicles; most aren’t ready to fully abandon their roots but want to tap into the surging national (and global) appetite for electric, so they instead are turning to hybrids as a compromise. As a result, these once-stodgy car companies are tapping into new revenue streams, and their share prices are surging accordingly.

Among the hybrid-rejuvenated, brand-name automakers, Honda offers the best value.

There was no company-specific news for Honda this week, and the stock remains in its 31-32 range, though it is testing the bottom of that range as of this writing.

The Japanese automaker got a mid-August share price bump (up from 29) after reporting another strong quarter, reporting an 8.7% year-over-year profit increase on a 17% improvement in global sales, assisted by a 9% uptick in U.S. sales – thanks to growing demand for its hybrid vehicle models here. A weak yen also had a hand in the company’s profitable quarter, adding nearly 48 billion yen ($326 million) to Honda’s quarterly operating profit. A spike in motorcycle sales in Brazil, India and North America also helped the company offset weakness in China, where total sales tumbled 23% due to escalating competition, rampant price cuts and a shift toward all-electric vehicles – an area in which Honda is still playing catch-up. Still, the company maintained its full-year operating profit forecast of 1.42 trillion yen.

Shares are still well shy of their March highs above 37, and remain laughably cheap, trading at 6.6x forward earnings estimates, 0.36x sales, and at 56% of book value. The stock has 42% upside to our 45 price target. The 4.1% dividend yield helps tide us over until the share price becomes more in line with the company’s value. BUY

United Airlines (UAL) – People are flying in planes again in Covid’s aftermath, and no major airline is taking advantage of it quite like United.

United Airlines is the fastest-growing major U.S. airline. The third-largest airline carrier in the world by revenues behind Delta (DAL) and American (AAL), United is expected to grow sales by 5.9% in 2024 – more than its two larger competitors – and that’s with revenues already topping a record $50 billion in 2023 – 19.6% higher than in 2022, which was also a record year. For United, business has not only returned to pre-pandemic levels; it’s better.

Meanwhile, the stock is super cheap. It trades at a mere 3.7x forward earnings estimates, with a price-to-sales ratio of just 0.26 and a price-to-book value of 1.37. The stock peaked at 96 a share in November 2018; it currently trades at 44.

A company that’s making more money than ever before (gross profits reached a record $15.2 billion last year, though earnings were still second to 2019 levels on a per-share basis), and yet its stock trades at barely more than half its peak from five and a half years ago. A true growth-at-value-prices opportunity.

UAL shares were up more than 6% this despite no news and a mini-market pullback – perhaps a sign that institutional investors have spotted a bargain now that they’re back from their summer vacations. Shares are still well below their May peak above 55 but have recovered nicely since sinking as low as 37 exactly a month ago.

The stock is still a shade below its 200-day moving average (45), so I’ll keep it a Hold for now. But there’s no denying the value – few big-cap stocks that are growing sales (+5.7% in Q2) and earnings (+23.1%) like United can be had for cheaper, at the moment. If you want to buy it here, I won’t argue with you. HOLD

Buy Low Opportunities Portfolio

Buy Low Opportunities Portfolio stocks include a wide range of value opportunities. These stocks carry higher risk than our Growth & Income stocks yet also offer more potential upside. This group may include stocks across the quality and market cap spectrum, including those with relatively high levels of debt and a less clear earnings outlook. The stocks may not pay a dividend. In all cases, the shares will trade at meaningful discounts to our estimate of fair value.

Aviva, plc (AVVIY), based in London, is a major European company specializing in life insurance, savings and investment management products. Amanda Blanc, hired as CEO in July 2020, is revitalizing Aviva’s core U.K., Ireland and Canada operations following her divestiture of other global businesses. The company now has excess capital which it is returning to shareholders as likely hefty dividends following a sizeable share repurchase program. While activist investor Cevian Capital has closed out its previous 5.2% stake, highly regarded value investor Dodge & Cox now holds a 5.0% stake, providing a valuable imprimatur and as well as ongoing pressure on the company to maintain shareholder-friendly actions.

Aviva’s India branch is under investigation for evading taxes and breaching commission regulations, though so far it hasn’t hurt the share price much. Aviva remains one of the most reliable stocks in our portfolio and is coming off a strong first half of the year in which it reported operating profits of £875 million, up 14% from the first half of 2023 and ahead of analyst estimates. Insurance premiums increased 15%, which helped, as did a 49% boost in its protections business thanks in large part to the company’s acquisition of AIG Life earlier this year. And yet, the stock remains cheap, trading at 10.3x earnings estimates and at a mere 0.34x sales. The 6.5% dividend yield adds to our total return. The stock has 6% upside to our 14 price target, though given the still-cheap valuation, we may need to raise that target soon. BUY

CNH Industrial (CNH) – This company is a major producer of agriculture (80% of sales) and construction (20% of sales) equipment and is the #2 ag equipment producer in North America (behind Deere). Its shares have slid from their peak and now trade essentially unchanged over the past 20 years. While investors see an average cyclical company at the cusp of a downturn, with a complicated history and share structure, we see a high-quality and financially strong company that is improving its business prospects and is simplifying itself yet whose shares are trading at a highly discounted price.

News has been scant for CNH since the company reported second-quarter earnings a little over a month ago.

The results were mixed. Revenue declined “only” 16% year over year to $5.49 billion, beating analyst estimates of $5.32 billion. Earnings per share of 38 cents were in line with analyst expectations but down from 52 cents in the same quarter a year ago. The company also lowered full-year profit guidance, down to a range of $1.30 to $1.40 from a previous range of $1.45 to $1.55. Declining crop prices coupled with higher production costs have hit farms hard around the world of late, thus lowering demand for farming equipment.

CNH shares are down about 5% since the report, though they have rebounded nicely in recent weeks and have seemingly left the mid-9s bottom from mid-August well in the rearview mirror. CNH shares are quite cheap, trading at 7x earnings estimates and 0.57x sales.

Given the recent weakness in the stock (down from highs above 13 in early April), we will maintain our Hold rating for now. HOLD

Gates Industrial Corp, plc (GTES) – Gates is a specialized producer of industrial drive belts and tubing. While this niche might sound unimpressive, Gates has become a leading global manufacturer by producing premium and innovative products. Its customers depend on heavy-duty vehicles, robots, production and warehouse machines and other equipment to operate without fail, so the belts and hydraulic tubing that power these must be exceptionally reliable. Few buyers would balk at a reasonable price premium on a small-priced part from Gates if it means their million-dollar equipment keeps running. Even in automobiles, which comprise roughly 43% of its revenues, Gates’ belts are nearly industry-standard for their reliability and value. Helping provide revenue stability, over 60% of its sales are for replacements. Gates is well-positioned to prosper in an electric vehicle world, as its average content per EV, which require water pumps and other thermal management components for the battery and inverters, is likely to be considerably higher than its average content per gas-powered vehicle.

The company produces wide EBITDA margins, has a reasonable debt balance and generates considerable free cash flow. The management is high-quality. In 2014, private equity firm Blackstone acquired Gates and significantly improved its product line-up and quality, operating efficiency, culture and financial performance. Gates completed its IPO in 2018. Following several sell-downs, Blackstone has a 27% stake today.

Gates has also been quiet on the news front since reporting earnings a month ago.

Like CNH, its results were mixed. Earnings per share of 36 cents narrowly topped estimates of 35 cents and were flat year over year. Sales, however, fell just shy of estimates ($885.5 million vs. $893 million expected) and were down 5.4% year over year. The relatively “blah” report – neither good nor overly bad – initially triggered some fierce selling in GTES shares (the stock was down 13% in the first week of August), but it appears the worst is behind it, and the stock has recovered most of those losses, though it was down about 3.5% this past week.

It remains our best performer, up nearly 60%, and the stock has 17% upside to our 20 price target. It trades at just 10x forward earnings estimates. BUY

NOV, Inc (NOV) – This high-quality, mid-cap company, formerly named National Oilwell Varco, builds drilling rigs and produces a wide range of gear, aftermarket parts and related services for efficiently drilling and completing wells, producing oil and natural gas, constructing wind towers and kitting drillships. About 64% of its revenues are generated outside of the United States. Its emphasis on proprietary technologies makes it a leader in both hardware, software and digital innovations, while strong economies of scale in manufacturing and distribution as well as research and development further boost its competitive edge. The company’s large installed base helps stabilize its revenues through recurring sales of replacement parts and related services.

We see the consensus view as overly pessimistic, given the company’s strong position in an industry with improving conditions, backed by capable company leadership and a conservative balance sheet.

While there was no company-specific news for NOV this week, crude oil prices have dipped below $70 a barrel for the first time all year, sending NOV shares tumbling more than 4% along with most other energy stocks. As long as oil prices remain this low, it will be difficult for NOV shares to gain traction with investors again. But I doubt they’ll stay down for long – the last time crude dipped below $70 a barrel, in December 2023, it was back up to $75 by month’s end.

Fortunately, NOV is still just a few weeks removed from a very strong quarter in which revenue ($2.22 billion) improved 5.9% from the second quarter of 2023; earnings per share ($0.57) improved 46%; and profit margins increased from 7.4% to 10%. Its adjusted EBITDA margin came in at 12.7%, the highest since 2015. Energy equipment accounted for more than half of total revenues ($1.2 billion) and was up 8% year over year.

NOV shares were initially gobbled up after the report, rising to six-month highs near 21, but market forces and tumbling oil prices conspired to knock the stock back down to pre-earnings lows in the high 17s. Now they’ve dipped below 17 a share, thanks to the depressed oil prices.

The stock is 42% below our 24 price target. And shares are quite cheap, trading at a mere 6.5x earnings estimates and at 0.77x sales. BUY

The next Cabot Value Investor issue will be published on October 3, 2024.

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