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TIP818: NVR (NVR): What's Next for One of History's Greatest Compounders? w/ Kyle Grieve & Shawn O'Malley
01:26:08
Kyle Grieve and Shawn O’Malley analyze NVR through cycles and assess whether it’s a business that is simple to understand.
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Transcript80 lines
- [00:01]
Sean O'Malley
You're listening to tip.
- [00:03]
Kyle Grieve
What if I told you if one of the most successful share cannibals in business history was a simple home builder?
- [00:08]
Sean O'Malley
We're talking about a company that has decreased its share count by a whopping 80% over three decades, compounding earnings at a high rate as a result of really having a great business model and terrific capital allocation.
- [00:20]
Kyle Grieve
So the company is nvr. But here's the thing. Not only has the share count shrunk, but shares have also increased in value from about $10 in 1996 to $5,900 today. These are returns that completely trounce the S&P 500.
- [00:34]
Sean O'Malley
The returns are absolutely mind boggling. But there's another part of the business I find fascinating which we'll get into. And that is perhaps why no competitors have been able to copy their business model.
- [00:48]
Since 2014, with more than 200 million downloads, we have interviewed the world's best investors, studied deeply the principles of value investing, and uncovered many compelling investment opportunities. We focus on understanding businesses and intrinsic value, investing accordingly, and sharing everything we learn with you. This show is not investment advice. It's intended for informational and entertainment purposes only. All opinions expressed by hosts and guests are solely their own, and they may have investments in the securities discussed. Now for your hosts, Sean o' Malley and Kyle Grieve.
- [01:34]
Hey folks, welcome back to the show. I want to start by mentioning that I recently pitched a company named costar, which is a business that is now a small holding in our intrinsic value portfolio. But if you've noticed, we don't actually pitch that many real estate related businesses on the podcast. And generally that's because it's a competitive and really cyclical space. And CoStar was an exception since it's more of a data business about real estate as opposed to being, you know, truly a real estate company. But today, Kyle will be here to help broaden my horizons by pitching a bonafide real estate pick with a company called nvr. And while it's a pretty traditional home builder business, in some ways it's actually one of the greatest success stories in American business, honestly. And the legendary investor Joel Greenblatt used to actually teach a pitch about NVR that was submitted by Norbert Liu on the Value Investors Club. And for anyone who has gone through Joel Greenblatt's old lectures on YouTube, you might know what I'm talking about. And you know, even though this was a pitch from more than 20 years ago, a lot of the key points from it still resonate today as to why NVR has been such a strong performer for so many years, which is what we'll be getting into. And so before listeners write this off as being just another home builder, Kyle, you're going to paint some color around the genuinely jaw dropping amount of value that NVR has been able to create for shareholders. And of course the question then is whether those kinds of returns will be sustainable for new investors today. Looking forward to.
- [03:01]
Kyle Grieve
That's right, Sean. So I mean the results are really impressive. But before I get to that, let me briefly cover exactly what NVR does because like you said, it's not your typical home builder. So just at a large view, they're basically focusing on building a variety of homes. Now that's whether you're looking at single family homes, townhomes or even condos. Now, depending on the type of home, it's going to be under one of NVR's three different brands. So they operate in a couple different geographies. Mid Atlantic, Northeast, Mideast and the Southeast regions of the United States. They also have a mortgage, banking and title services segment as well. Now I know what you might be thinking. This seems pretty standard for a homebuilder, but to that I'd say just look at the growth in their profit metrics relative to their peers. So NVR ranks number one in average returns on capital at a very, very high number. And this industry leading capital efficiency has enabled them to compound revenue by 8% per year for the last 15 years while compounding net income at 12.5% a year over the exact same time period.
- [03:53]
Sean O'Malley
But there is an even juicier part to this business in terms of buybacks. When the company IPO'd in the late 80s, they had 14.3 million shares outstanding. And over the decades they've whittled that down all the way to just 2.8 million shares. And so for anyone doing the math at home, that's an 80% reduction in the share count.
- [04:11]
Kyle Grieve
Yeah, and those buybacks have been incredibly value accretive to shareholders. So let's rewind back to 1996 when this business was trading at about $10 a share. Now as of today, shares trade at somewhere around $6200. Now this has created one of the greatest compounding machines in the last three decades with a 62,000% increase in price apprec, absolutely crushing the S&P 500's 1,800% over the same time period. Now, NVR obviously didn't just beat the market, completely trounced it by A wide margin, which again is really surprising to see for a company that competes in an industry that's just so competitive and is also just so dependent on external factors such as interest rates. Now, due to the massive decrease in share count from the buybacks, and frankly, just an insanely good business model, they've actually compounded EPS at a touch over 15% annually since the year 2000. Now I don't know about you Sean, but I'd be the happiest investor alive if I could find a business with a 25 year Runway of growing EPS at 15%.
- [05:08]
Sean O'Malley
Oh, clearly that's all very impressive. And I'm especially keen to better understand what makes NVR's business model so differentiated, because I wouldn't have thought that a home builder could have a secret sauce. You know, how can you reliably maintain a competitive advantage in a service that is pretty straightforward and maybe even a commoditized service in some ways. When you think about home construction, at least on, you know, for lower end and the middle end, I can see how there's some specialization for, you know, really high end, like luxury homes. But yeah, it's not like they have a secret way to build homes more efficiently than everyone else. Or maybe they do. I guess that's what we'll learn today. So on that point we should jump right into the business here and get to know NVR a little better. So my first question for you is how exactly does NVR make its money?
- [05:57]
Kyle Grieve
Yes. So at a high level, NVR basically builds homes that customers have already agreed to buy even before construction begins. So where NVR really differentiates itself is that it doesn't actually own the land, which removes a ton of risk. So instead they pay a 10% deposit on the land, which is called a lot purchase agreement or an LPA. So these LPAs are very, very crucial to understanding NVR. The payments go to a third party developer. So NVR then constructs the home on these lots using independent subcontractors and then completes the sale of the finished home to the customer who, like I said, pre purchased it and then keeps a cut of the profits. So this basic model is basically the company's bread and butter and makes up more than 90% of their revenues. Additionally, like I mentioned, NVR originates mortgages for its own customers and sells those mortgages to investors. And that business is what makes up the remaining about 10% of their revenues.
- [06:48]
Sean O'Malley
It's amazing how something so simple like opting not to purchase the underlying land and then take on all that Financing and balance sheet risk in the way that their competitors do, that can make a huge difference in a business's unit economics and returns on capital over time. It seems like a really small decision, but it's not. And you know, most homebuilders don't have moats and don't have the history of generating excess returns correspondingly that you would expect for businesses with moats. Yet by taking this more capital light approach with the purchase agreements on properties, it has been a huge boon for nvr. And you know, I don't know if I would say that's a moat per se, but it certainly showed how home builders could become more capital efficient. And you know, even though it's a fairly intuitive business, I know there's a lot more nuance here behind what has made NVR special. So how about you take me through the operating model in some more detail for this business?
- [07:43]
Kyle Grieve
Sure, Sean. So I think this is why it's worth exploring the business more. Just because in some of these industries that you find, you just find these business models that really differentiate one business, even though the industry itself might be very, very boring. And so, you know, you just never know when you're going to find a business that's going to pop up in one of these boring industries and just show you an interesting business model. And I think NVR is just a great example of that because when you look at a company like nvr, it really gives you insights into what to look for perhaps in a future investment to maybe get you ahead of the curve in finding businesses that can create a lot of shareholder value. So many listeners will be familiar with the process of buying a home, but you're probably not deeply familiar with just how that pre sold business model specifically works. Unless maybe you work in real estate. Just to mention this up front, NVR does not build a large inventory of completed homes and then hope buyers just show up. So NVR's model is instead built upon pre selling homes and then minimizing land ownership. A buyer first visits an NVR showroom, chooses a home plan and options, and signs a purchase contract with a deposit. Now, depending on how much they want to spend, customers will visit NVR's model homes in a specific geography which is going to align with different price points. So first time buyers would typically look at models from Ryan Homes brand. For example, buyers who are then looking to maybe move up to maybe a larger home or a more luxurious home would browse catalogs for maybe NV Homes or Heartland Homes, which are the two other brands under nvr. Now, from there they're going to pick the specs of the home. And for context, the average price for an NVR home sells for about 460k. From there, the customer signs a sales contract with NBR and they generally put down a deposit of about five to $10,000. Now, after that, and this is very important, NVR basically will control the land for the homes to be built on, but it doesn't own the land. So what NVR will do is enter these LPAs, which give them the option to purchase the land from a land developer. But the developer is typically responsible for acquiring and preparing that land to be built upon. So installing roads, utilities, you know, grading, getting approvals and other infrastructure are all responsibilities of the lot owner. Nvr, again, like I said, just has the option to buy them. Now, this is that 10% number that I mentioned a little bit earlier. The important thing here is that NVR can walk away if they decide not to develop homes on a specific parcel of land. In this case, the developer is going to keep the deposit, but there's no recourse to NVR's assets if this happens. Now, if NVR decides to close on the lot, they're going to pay the remaining 90% of the cost to acquire the land from the developers and then hire subcontractors to build the homes. Now, four to eight months later, the home is built and ready to be moved in on. And with the homes that are ready, then of course, the customer closes the sale for one of these homes with NVR and you're done.
- [10:20]
Sean O'Malley
That all makes sense. And maybe just to recap from my own understanding, NVR sets up contracts with land developers that then give them the option to build homes in these areas in the future. But it also does not require them to do so either, which is why they pay this 10% cost upfront for the optionality on the land. And you know, on the one hand, that is a significant cost if for some reason they can't pre sell enough homes for a community. But it is far better than the alternative of purchasing all this land at full price upfront and then trying to sell enough homes for all the lots where if you can't find enough customer demand, then you're just stuck holding a bunch of property on your balance sheet, which is really not the business that you want to be in, right? Speculating on land prices and if a housing slowdown hits, you might be stuck with depreciating land assets for several years that are tying up your balance sheet, driving marks down on your income statement and just tying up your cash. So NVR ends up paying more than it might if it owned the land outright, because it's paying for this optionality, but it avoids tying up huge amounts of capital and reduces the downside for them if housing demand deteriorates by using these option purchase agreements. So in some ways, it's really a very brilliant approach to this industry. And once NVR has a customer that's signed and they decide to move forward, then it exercises the option, as you said, buys the finished lot and then they begin construction on a new home. And so maybe just for context, I think it would be helpful if you could contrast this with the more typical business model that most home developers have.
- [11:57]
Kyle Grieve
Yeah, so I will say, Sean, I think you got the gist of the business model there. So let's go into what a traditional home builder model is. So there's kind of a few steps. It's quite simple. First, you purchase the raw land from the landowner. Next up is you hire a developer to develop it. Again, this is pre law, so this is going to include things like roads, utilities, and you pay them to do it on your behalf. Then you're going to have a business that owns the finished lots and those finished lots and all the assets are going to be placed onto the balance sheet. And now you're basically ready to build homes on those lots. Now, the weakness in this business model that NVR discovered was that if demand crashes, like you just said, you're basically stuck owning expensive land without really being able to sell it. Now, what NVR really is doing is just de risking the traditional business model. The LPA means the landowner must develop the lots that are ready for construction. So roads and utilities, etc. Are all complete by the time that NVR starts to do any work. The developer is taking significant risks in terms of cost overruns and delays, but NVR drastically limits its exposure due to these LPAs. The risk that NVR does take is whether they can sell the finished homes fast enough. Now, just to give you an idea, NVR currently controls 180,000 lots and of those, 94% are under LPAs. And right now NVR has about 920 million of cash. That's part of its deposits. So let's just say they were going to walk away from all their lots, which seems, you know, probably next to impossible. Yes, they would basically be forfeiting nearly $1 billion. Now, sure, that would hurt, but when you consider they have a $1.8 billion in cash on Their balance sheet. That's like worst case scenario. If they lost all that, they could absorb all of that, which is a pretty catastrophic loss for any company, let alone its company in real estate. But they'd still be able to continue operating into the future. Now, traditional homebuilders simply just don't have this optionality. Remember, they own the whole lot. So if a traditional homebuilder had the same amount of loss as NVR, they're going to be holding roughly $9 billion of assets on their balance sheet, which is about 10 times what NVR has, which they would be forced to sell at a discount in the case that they needed to get rid of it or decided they no longer want to develop that land. Now, the best part about this is that NVR makes a really nice profit on this segment. Revenue and operating profits have been growing really nicely, despite a bit of a lull over the last few years.
- [14:09]
Sean O'Malley
I think another way to recap everything we've said is basically that these traditional home builders, for better and for worse, are more highly leveraged to the housing cycle than NVR is. And you know, obviously as you mentioned, that's allowed them to have a more consistent business while also continuing to expand operating margins as the business has scaled. So tell us about what the margins look like on this segment and maybe you can also speak to what affects the margins since it does seem to fluctuate quite a bit.
- [14:40]
Kyle Grieve
Yeah, so that's the beautiful thing about this segment. So pre tax margins have actually improved as a business has scaled. So since this is the largest segment, having economies of scale here is clearly a huge advantage for shareholders, as it means the business can continue to compound its EPS at a solid rate, which should hopefully outpace revenue growth. But allow me to get into what exactly is driving this margin expansion. So the first reason is simply pricing power. So this is obviously tied to the industry. But Sean, you know, as a new homeowner, I know you've looked into housing prices over the years and can probably attest to the fact that housing prices simply are going up and not down. So with the current inflationary environment that we live in, chances are that prices are probably going to continue going up, which continues to allow NVR to increase the average selling price or ASP of their homes. And second, here is just economies of scale, specifically on the volume of settlements that they are now managing. So NVR has some fixed cost, but a lot of these are spread over higher and higher volumes. So this allows for margins to continue to expand.
- [15:37]
Sean O'Malley
Well, I think you mentioned that I'm a new homeowner. And I think that's really only because of the fixed rate mortgage structure. I think that's, you know, to this inflationary environment you alluded to. When I realized that, yeah, I can lock in my housing payments for 30 years and inflation is going to depreciate the real currency power or the real currency cost of that mortgage, that was pretty attractive to me. But I don't know if everybody thinks about it the same way. And so instead of looking at a new home construction that might come from nvr, we sort of took the opposite approach. We bought an older house rather than a new one. And that comes with its own pros and cons. I think our house is from the 70s. But yeah, when we were in Omaha for Berkshire weekend in the exhibition hall, they had a full Clayton home, which is the Berkshire owned competitor to NVR on the lower end of the spectrum. And anyways, you could tour the whole house and I thought that was pretty cool. Yeah, it's pretty nice, honestly, for having a price tag that starts in the 200,000. I think Clayton appeals to a lower end buyer obviously than NVR caters to. But again, I was pleasantly surprised at the quality of some of these manufactured homes. And so from an affordability perspective and from the perspective of knowing that you're getting something brand new and aren't inheriting costly problems like a 30 year old roof that needs to be replaced, I do see why it's really compelling, especially to first time home buyers to look at new constructions. And so you also mentioned the mortgage part of the business though, and I was just talking about how much I love my fixed rate mortgage. So I'd love to zoom in on that here because it's still a meaningful revenue generator for the business. And I wonder if there's an opportunity for this to be more of a growth engine going forward.
- [17:20]
Kyle Grieve
Yeah, I will say on your mortgage point there in Canada, unfortunately we do not have anything close to that, so we can't take the advantage the same way as you can. But you know, similar to you, when I was in Omaha, I also got a chance to look at the full Clayton home as well. And I agree with you. I think given the price point, I think it was, I think they mentioned it was like $216,000 for the house that they were showing. It's definitely catering to more of a lower end buyer as that price is, you know, half of what NVR offers. But you know, it was really a kind of a cool experience just to Go in, get a feel for the quality of the home and what you get for your money. So I've looked at some of the homes on Ryan Homes that they have listed and very similar to Clayton. You know, they all look quite similar, which makes the build out easier and it gives the customer a high degree of certainty, you know, that they're going to have a very good idea of exactly what they're going to be moving into. Back to your question here about the NVR mortgage segment, which I'm just going to refer to as NVR M. So this segment originates mortgage loans exclusively for NVR's home buyers. So they generate revenue from origination fees, gains on the sale of loans and title fees. NVRM will then sell the mortgage loans it closes into secondary markets. The buyer of these mortgages tend to be government backed mortgage agencies such as Ginnie Mae and Freddie Mac. Then you have the Veterans affairs and the Federal Housing Administration. Now since NVRM services only their own customers, this segment is largely tied to the building activity of nvr. If you know, if they aren't closing homes, this segment is definitely going to suffer. But in boom times, this segment will do very, very well.
- [18:46]
Sean O'Malley
And it makes sense for them to offer this whether it's a profitable offering or not, because you know, I mean, it is a low hanging fruit opportunity to cut out the middleman and originate these loans themselves and collect a fee for doing so. And at the same time it is a vastly different proposition to build homes than it is to finance them. Right. It's probably not part of their core competency to be a lender, but I am sure that it's useful in driving sales for their business because there is something about, you know, being able to offer financing on the spot, especially if you can bake in discounts that help push buyers toward closing on a deal at that moment. You know, it's you go to a car dealership if you can get financing from the dealer. Not that that always is a good thing, but that is much, much more convenient than working with an outside partner in some cases. And so anyways, beyond helping spin the flywheel of lubricating the sales process, let's say is this an area that is generating profits genuinely on its own for nvr?
- [19:50]
Kyle Grieve
Yeah, it is. And I will say to your point there about going to a car salesman, I think you're kind of just reducing friction points on the sales process. And if you can reduce friction as much as possible, then it becomes just a no brainer to do your business with a Business such as nvr. So back to the segment. So this segment is actually very, very high margin, a lot higher than the homebuilding segment, probably makes a lot of sense. So the pre tax margin on this segment have run into the 50% or higher numbers in most of the years. So this is roughly five to seven times higher than the homebuilder segment. But given you know that this is just a capital light segment of the business, it makes a lot of sense. So this segment will have more volatile margins, you know, and that's kind of based on three areas that create volatility. You have hedging of loan contracts, then you have the sensitivity of loan origination volume, and then you just have the sensitivity to what interest rates are at the time.
- [20:39]
Sean O'Malley
The assumption being that they can sell all the loans they underwrite. Then they really aren't taking on credit risk themselves directly, which is a good thing. They're just taking the risk that as you mentioned, interest rates could move before they can package up the mortgages and sell them to another buyer. And so the basics of bond math for anyone who doesn't know bond math are that if interest rates for similar loans go up, then your loan must go down in price. And so that's the price that they can sell their mortgages for to these government backed agencies. And so they want to hedge that risk. Right? They don't want to be exposed to interest rates moving at all. And even if it's just a short period between when they close on the loan and then go and package it to sell it, even in just a few days you could have movement that would be when you multiply that across many different mortgages, that could be costly. So they don't want to be implicitly betting on rates to go one direction or the other. That's not the game they're playing. They want to be completely rate neutral. And so I think that's important context to understand. And the next area I want to move into is better understanding NVR's competitive advantages. Because we've talked about the fact that they've had these incredible returns on capital and compounded and created a ton of wealth for shareholders. I think it's very important that we understand the competitive advantages that have enabled that to happen. So as we've looked at NVR's business model and how it differs from competitors and the home building industry, maybe you can expand on the advantages that NVR has.
- [22:12]
Kyle Grieve
That's right. So I would say that NVR's primary mode is probably what I just kind of mentioned, which is the ability to scale very, very well. You know, at a company wide level, operating margins went from around 9% in 2012 up to 22% by 2022. So you know, they've come down a little bit to about 16 and a half percent lately. But as I mentioned, with the advantages that NVR has in both home building and on NVR mortgages, as the business increases its revenues, they've been able to do a really, really good job of just taking advantage of the fact that many of its costs are more or less fixed. So you know, as long as incremental revenue is coming online, a lot of it's going to continue to fall to pre tax income. Now one of the most fascinating parts to me about NVR is that it's just scaled so well, despite the fact that it's not even one of the largest home builders out there. You know, it's, this isn't a business like an Amazon or a Costco, which simply just has so much volume that smaller competitors have zero hope of trying to match them on the margins. So their ability to scale is basically based on their business strategy. Now the first strategy that they took was to focus on places that they felt they could make the most amount of money. And this is in terms of geographies. So for that reason they're in about 427 different communities, around 37 metros in just 16 states. Now, because they're in these more concentrated areas, this creates more operational density which allows them to take advantage of the scale benefits of things like centralized management, logistics and even supply chains. Next you have the option to really optimize for capital efficiency rather than ownership. So rather than having complete control, they chose the LPA business model, which gives them optionality that other developers just seemingly don't have. Now, because of this unique business model, NVR was the only publicly traded homebuilder to remain profitable during the great financial crisis, while competitors faced billions of dollars in write downs. And if we're going towards another housing issue where maybe competitors are getting liquidated, then NVR is very, very well set up with their fortress balance sheet to take advantage of this with their current business model. And then finally you just get to their ability to just stay disciplined and think really long term. A business that scales well must do both of these very, very well. Simply because economies of scale generally takes time to play out. And if you don't set the business up to continue growing at responsible levels, then the day may never come that you can actually take advantage of your Scale, economy's advantages, and all these factors have helped them stay very disciplined when it comes to managing expenses. So at a company wide level, cost of goods sold has stayed quite steady around the 77% range. And they've done a good job at slowly but steadily reducing their sales, general administrative expenses from about 7.8% in 2001 to about 6.8% today. Now, all this has helped them widen their margins, which when mixed with the buybacks has created just so much shareholder value.
- [24:49]
Sean O'Malley
The margins look great and I'm probably less inclined though to say the business has a clear moat still. Right. You know, they definitely have operational efficiency and scale, but still, it's not totally clear to me why other developers can't and haven't embraced the same Capital Light business model. So if NVR had some kind of patent that nobody else could utilize, that to me would be a source of a moat. But that's obviously not the case here. And so, you know, actually the last few years have been a little concerning for NVR's business. So maybe you can go over what's happened to cause the decline in operating margins and whether that relates to the company's moat at all.
- [25:28]
Kyle Grieve
Yeah, I think you're correct here to be concerned, Sean. You know, while the margin expansion is great leading into 2022, I think it's very important to assess whether it's possible to return to the operating margins that they had here just a few years ago in the low 20s, or if maybe, you know, those were just a couple outlier years. So there, I think are many causes for the current margin compression that they're going through. So the first one is that there's just higher lot and land costs. You know, this is the number one driver of margin compression. Land acquisition prices have gone up. And even as they go up, NVR isn't always willing to build on lots that they've already signed LPAs for. Second is labor and material costs. With elevated construction wages and material costs, NVR has definitely felt the pressure. While elevated lumber prices have slightly offset this pressure, it just hasn't really been enough to fully offset it. And third here is you get to affordability issues with buyers. You know, I think really feeling the effects of inflation, NVR has had to offer larger buyer incentives, concessions and price reductions just to sell their homes. If you look at all four of their geographies, gross profit margins have declined in all of them. Fourth here is you have elevated incentives and closing costs. So as demand softens, competition is going to intensify, meaning you have to take deals that have lower margins just to maintain some top line growth. Now I've seen this in Canada as well. Fifth, you have contract land impairment. So in 2025 they had land deposit impairment reserves of 66 millions up from only 17 million in 2024. So this means that they're, you know, less excited to develop some of these lots in the current environment and they may end up avoiding a larger number of lots than they did in 2024. And lastly, here is just volume softness. So as a result of all the above, there's just softness in the volume that NVR can build. New orders for 2025 have actually declined 10% year over year, while new order prices have actually fell by 0.3%. So if you look at charts for new home construction from the Federal Reserve, new builds actually peaked in 2022, which aligns with NVR's peak in their operating margins. We are actually still coming out of the GFC drop in new builds, which just shows how long trends in real estate can be. What will that number stabilize at? Between 1960 and 2025, new builds averaged at about 1.5 million units per year. So as numbers currently tell us today, we're kind of hugging that line right now. So, you know, just to give you my honest opinion, I think the chances of getting the operating margins back up to, you know, those low 20s that they had back in 22 are probably quite slim. And I think normalized margins are probably somewhere in the high teens, kind of close to where they are right now. Let's take a quick break and hear from today's sponsors.
- [27:55]
Sean O'Malley
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- [31:22]
Kyle Grieve
All right, back to the show.
- [31:24]
Sean O'Malley
There is this trap that I just want to speak to that I know a lot of newer investors can fall into with cyclical stocks. It's a mistake I've made in the past personally, and that is in price to earnings ratio terms, when these stocks of cyclical companies look the cheapest, that's actually counterintuitively when the valuation is generally the most expensive. So what does that mean? Well, the market knows that when a cyclical business is earning peak cycle levels of margins, like in 2022, it's over earning. Right. That's not sustainable. So investors aren't going to pay a premium for those earnings. They're going to pay a lower multiple for those earnings because those earnings are expected to contract as margins swing back down. And so it's something to be careful with whenever you see a business that has big swings in margins in revenue, because you really need to have a decent idea of where you're at in the cycle to determine what a reasonable multiple is. And that's easier said than done. But directionally, if you have an idea of are you near the top of the cycle, the middle, or closer to the bottom? And you know, again, obviously you can't predict this exactly, but if you can sort of directionally have an idea, it's very helpful. So, long story short, when cyclicals have low PE ratios, they're often not actually cheap because the denominator, which is earnings, is inflated. And actually when the PEs are the most expensive, just in pure numbers, that's actually when you're sometimes getting the best value with cyclicals because the E is depressed, increasing the PE ratio overall. Not to get lost on a math tangent there, but I do want to go back to that question of why other home builders can't just copy NVR's approach and enjoy the higher margins and lower risk that NVR has historically had. It sounds great. Why would everybody not want to do this? And so I guess in my mind that's the million dollar question as to whether NVR would be investible for our intrinsic value portfolio. If we can wrap our head around why they have this unique advantage, it seems. Yeah.
- [33:29]
Kyle Grieve
So that question kind of takes my mind to the counter positioning moat. So the counter positioning moat, for those who are unfamiliar with it, is basically the idea that a company would actually harm itself by cloning a competitor's business model. So a great example that I think most listeners will be familiar with is just Vanguard, the owner of ETFs versus an active mutual fund manager. So Vanguard is completely built on low fees, whereas active managers require fees in order to fuel their business model. If they adopted Vanguard's business model, they would decrease their management fees and they'd be forced to run incredibly lean operations compared to what they're running now. So, you know, all the analysts they have employed and the large office space, these are things that are funded from their fees. So obviously if those fears disappeared, the business model just wouldn't function nearly the same. So let me answer your question by looking at the degree of which NVR has this advantage over competitors. First, we have to understand why NVR has the ability to utilize these LPAs. So NVR has, you know, literally decades of success using the LPA business model. During this multi decade time period, they've showed great abilities to reliably close deals as well as having the operating discipline to just walk away from agreements when it's obvious that the deal will not be value accretive for nvr. Another added bonus is that developers know that they can trust NVR during cyclical downturns as NVR has a very strong balance sheet. And if they can get the right returns, they're still going to take a deal during a downturn while staying solvent. But you know, some of these competitors have been around for decades, so I think there must be something else. And I think it really comes down to a few crucial factors. So the first one is the existing land inventory burden. So competitors like Lennar Pulte Group, Toll Brothers already own very, very large swaths of land. So in order to utilize an LPA strategy, they would need to divest billions in their own inventory. Now chances are that selling it would not yield the return that they want, so they just, you know, stick with it. And the legacy model of buying and developing raw lots all the way to completion, second is just accepting lower volumes. So the option model means accepting lower volumes and market share during the ramp up phase. Since public competitors are incentivized by Wall street to maintain specific growth metrics. You know, switching business models would likely spook Wall street and their shares would probably experience some type of volatility, to put it nicely. Now as a result, the easiest thing to do is just stay the course that they've always taken, even if it's not necessarily the best option. And then lastly, here is just operational discipline. Most home builders simply grow by adding assets, selling them and then making revenue. But this doesn't always result in the most amount of restraint. When things are going very, very well, home builders will often overpay for land, develop it, and then end up selling it into a weaker market, which obviously decreases their revenue and their margins. Now because NVR doesn't have to rush or can simply just walk away from developing a finished lot, they can be very, very patient and build when they know that they can hit their internal benchmarks. So you know, to your point there, while a competitor could theoretically try to copy their business model, as far as I know, nobody has. And I believe it's for the reasons I just mentioned. It's just it's not that easy to upend an entire business model to copy nvr. And even if you wanted to, the disruption simply would just not be worth it. And if you could, there's no guarantee that it would work out as well as it has for nvr.
- [36:34]
Sean O'Malley
Counter position I think is a really interesting advantage to think about. And it's not one that's easily visible or deployable by all companies. And so the classic example of this is Netflix and Blockbuster, where Blockbuster had time to recognize the way in which Netflix had built a superior business model. But learning from Netflix would have meant destroying the profits of their legacy business, which blinded them from making the necessary change until it was too late. And people also refer to this as the Innovator's dilemma. And just to say it again, a counter positioning moat is a competitive advantage where an incumbent cannot easily copy new entrants business model because doing so would damage the incumbent's existing economics. And so it's really being on the flip side of the innovator's dilemma and benefiting from it. And Hamilton Helmer writes about this in his famous book on moats called Seven Powers. But to me the key word there is new competitor. NVR is by no means a new competitor at this point in the way that Netflix was to Blockbuster 20 years ago. So I find it baffling that over so many years competitors have not migrated to the same or a similar business model.
- [37:47]
Kyle Grieve
Right.
- [37:47]
Sean O'Malley
They've had plenty of time to do so. And when I look at Adobe, which is a company that we've studied closely, they made a huge business model switch from selling software as these one off packages like Microsoft did too. And then they switched into this software as a service where instead of, you know, buying 2009 Adobe Photoshop, you know, you're paying a monthly subscription for Axis. And so anyways, point being, when there is kind of the writing on the wall that a business model change needs to occur. Even the biggest tech companies with layers of bureaucracy and stuff can find the motivation to push through and make business model changes. So, I don't know, I guess I'll leave it there for now. It's something I'm still puzzling over why this NVR model hasn't been closely cloned. But, you know, I do want to mention one thing I know about home builders and that's that they absolutely love leverage. So maybe I can ask about how NVR's debt profile looks and presumably it should be better balanced thanks to their option purchase agreement approach. But is that the right way to think about it?
- [38:54]
Kyle Grieve
Yeah, you're absolutely correct about the leverage that most home builders employ. So looking at the numbers of some of their competitors, I've seen that their debt situation just isn't nearly as good as NVR is. So, you know, Toll Brothers, Pulte Group both carry pretty large amounts of debt. I mean, they've come down a little bit over the years, but they're still carrying a decent amount of debt. Now NVR has actually had negative net debt since 2016 simply because they've piled up these large amounts of cash. And again, you know, this is an advantage that only really Lennar has been able to take advantage of. Although Lennar seems to be taking on a little bit more leverage of late. Now, when it comes to nvr, their debt is, you know, small, cheap and very easily serviceable. So they currently have about $900 million in senior notes which expire in 2030 with just a 3% coupon. So, you know, I don't really see any issues with them servicing this debt. NBR also, if they need have access to another $400 million in liquidity, but this is completely undrawn. So, you know, just comparing this to other real estate businesses, it's just a lot different because like you mentioned, real estate companies tend to just drown themselves in debt. And I think to your whole point there about changing business models, if you can just give yourself a whole bunch of debt, you can just maintain your old business model for probably a little bit longer than you would be able to do without that debt. But unfortunately, you know, over the long term, it probably isn't going to end up very, very well. Now, I tend to stay away, you know, as far away from companies in home building or real estate specifically for this debt reason. So it's very interesting to see that NVR has taken the path that they've chosen because I just think it opens them up to more optionality and I think it keeps them in the game for a lot longer, comparatively speaking, to their competitors. So it's also worth mentioning that NVR currently has about $1.6 billion of cash on its balance sheet. And if we subtract the senior notes and restricted cash, about $40 million, they still have a net cash position of 975 million dol million. So I really admire NVR for keeping a relatively low cash balance. So one of my pet peeves are businesses that are great, which allow cash just to pile up and just do nothing with it. NVR has kept cash low simply because they spend so much on buying back their own shares.
- [41:00]
Sean O'Malley
Well, we just got back from being in Omaha with our mastermind community for Berkshire weekend. And, yeah, I think Berkshire is maybe the elephant in the room. And it's been a subject of much discussion in our mastermind community because they're sitting here with, with $400 billion in cash. And, yeah, everybody wants to know, is it even possible for them to deploy a significant amount of that cash in the next downturn? And it's certainly a bit different when you've had the best allocator of all time leading a buildup in cash in Warren Buffett. And so it'll be interesting to see how people react to the allocations that Greg Abel makes. But as you said, for many businesses, aggressively reinvesting, so long as they maintain limited debt, that's much more likely to generate desirable returns than crewing a ton of cash on the balance sheet. And so it's pretty clear to me that this business is in a great position to continue growing while sticking mainly to spending from internally generated cash. But you mentioned how important buybacks are to the story here at the beginning of our conversation. So let's turn our attention to that and get a better understanding of how they're doing, doing these and how they're funding them.
- [42:10]
Kyle Grieve
Right.
- [42:10]
Sean O'Malley
How do they approach buybacks? Are they repurchasing more aggressively at low points in the cycle when shares are cheapest, or is that when they prefer to have more cash on hand and they actually repurchase more when the business is inflecting upward?
- [42:26]
Kyle Grieve
Yeah, so I have a number of checklist items that I go through whenever I analyze businesses in regard to capital efficiency and even more specifically, regarding share repurchases. You know, look, I think we both love businesses that, absent internal investments, will buy back their own shares. But there is definitely details that we have to focus on, and that's whether buybacks have been done at a good price or not a good Price. We don't really want businesses that are buying back shares simply because they have access to cheap debt and nowhere else to put cash. So I would say that NVR has been completely exceptional at buying back shares. Now just to get into kind of their program of how they do it. They don't really follow a programmatic share repurchase strategy where you know, if prices get to X, then there you go, buy them back here. If they're above it, then just skip it. You know, you brought up Berkshire Hathaway. I think Warren Buffett has historically wanted to buy back shares when it gets down to about 1.2 times book value. So from what I can tell again that maybe they do have some special formula that they don't share publicly, but they basically are completely discretionary and not rule bound. So they don't follow a programmatic share repurchase strategy. Instead it's a lot more discretionary. So basically it's more of a factor of how much excess liquidity they have. So the process is basically goes to the board. They're going to authorize a rolling buyback that doesn't have an expiration date. So over time these authorizations have really, really scaled as NVR has increased in size. So if you go back to 2018, they authorized buybacks about 300 million. The board most recently approved a another buyback for about 750 million just this year, which I believe is on top of another authorization of another 750 from last year, taking it to somewhere around $1.5 billion.
- [44:03]
Sean O'Malley
Wow, that's a lot of buybacks. Are they doing any dividends at the same time?
- [44:08]
Kyle Grieve
No, and I actually think that's a very, very good idea. I think they know that they can create the most shareholder value simply with buybacks. So they're prioritizing that form of distribution over dividends. Now I think that personally we should give them a bow as I'd love to see more businesses take this approach. NVR knows that they can compound capital at a higher rate by doing buybacks compared to dividends. So you know, they just made the decision for their shareholders and you know, so far it's been the right one as they've compressed the share count again by 80% over the last 30 years while maintaining this fortress balance sheet.
- [44:40]
Sean O'Malley
Businesses that buy back as much stock as NVR do, they do have one minor drawback. If you're distributing capital back to shareholders, in theory, that should mean there aren't any better places inside of the business to grow, to reinvest that cash into. And that tells you something about the companies longer term growth prospects in many cases. But let's shift our focus to where NVR is spending and whether they can maintain their industry leading rates of capital efficiency well into the future.
- [45:09]
Kyle Grieve
Yeah, I have no arguments on capital allocation. Where with you, Sean? So I generally love businesses that both have a high and durable return on invested capital numbers as well as the ability to hopefully reinvest 100% of its profits back into the business. So in NVR's case, as I think it's evident now, this is just not the case. So I will say I was very impressed to see that NVR clearly takes capital efficiency very, very seriously. So in their most recent proxy statement, you'll see that they're very proud of the fact they have great capital efficiency numbers compared to their industry. But these numbers are impressive even when you put them up against nearly any business out there, not just their direct competitors. You know, 10 years of 29% returns on invested capital is beyond outstanding and incredibly, incredibly rare to see. They also have it in their proxy because management is incentivized on that KPI. So we can go over that more in a little bit. But needless to say, management is very focused on keeping these numbers high and I think they also unfortunately understand reality. So if they wanted to invest 100 of their capital back into the business, it's going to drastically reduce their capital efficiency numbers. At this point, NVR is returning more than its internal cash flow generation to shareholders rather than reinvesting back into the business. And they're able to do this because they generate substantial cash and obviously have this large amount of cash on the balance sheet.
- [46:23]
Sean O'Malley
And since they're buying back shares, that functions as a very simple way to elevate their capital efficiency numbers, as you sort of alluded to. Again with the drawback being you can't spend more on repurchases than you generate in free cash flow forever. You can do it for a period of time if you have some excess cash and you take on debt borrowings. But eventually something has to break.
- [46:43]
Kyle Grieve
Yeah, you're absolutely correct, Sean. Buying back shares means that you're shrinking the equity base as well, which makes the return on capital metrics even better.
- [46:51]
Sean O'Malley
Well, so I want to keep talking about reinvestment as it relates to the growth of nvr. NVR has clearly increased its earnings per share due to these buybacks, but it's not only because of buybacks. To be clear, revenue over the last decade has compounded about 6%. So the high growth days of NVR's past are certainly behind them. But let's take a moment to talk about what it's going to take to continue growing NVR's revenue at attractive rate. So I'll hand it over to you for that.
- [47:20]
Kyle Grieve
Yeah, so growth is really a factor of just one thing, which is, you know, the amount of lots that they're currently under control by them. Now this number has increased by about 44% since 2021, up to about 180,000 lots in 2025. Now, as they sell more lots, they obviously are going to get more revenue and they're able to get more loans for their buyers, which obviously is going to help with the NVR mortgage segment. But we're currently in a pretty weak buying market and this means that NVR's lots are unlikely to grow much if they don't think they can get a good price on the land that they intend on developing. But we should dig even further here. So NVR lists four major regions that it operates in. So you have the Northeast, the Middle East, Mid Atlantic and Southeast. Now these regions all have their own markets that differ a little bit from countrywide numbers that you're going to get. For instance, the Southeast has actually been growing incredibly well, showing 76% growth in the last five years and makes up about 41% of their inventory. Now while this growth is great, the real problem for NVR right now is simply that net new orders has been steadily declining from its peak in 2020. So prices have held up well. But all regions saw rising cancellation rates, which unfortunately doesn't really bode well for the near future of nvr because net new orders haven't grown and cancellations have gone up. The backlog hasn't grown much either. For this reason. It's just, you know, kind of hard to see NVR growing its top line much past the mid single digits over the next few years.
- [48:41]
Sean O'Malley
The thing with businesses that are leveraged to the economic cycles, especially ones that are best of breed operators, is that they can 100% make for great investments if you get the timing right. And so what I mean is like you're really talking explosive returns if you get the timing right. But that typically requires either luck or a degree of foresight that the rest of the market just doesn't have for some reason. And that that's not a game that we typically want to play with our intrinsic value portfolio. But I do get why it's appealing if you think you have an advantage in your timing. And so we know the housing market is cyclical. And even though NVR can still turn a profit in pretty bad markets like today, a time will come when demand will rise again, I'm sure of that. And that implies that, hey, maybe you don't actually need an analytical advantage, but maybe simply just a patience advantage. I think that would be the counter argument to the point I made a moment ago. And so if you're pretty confident that directionally you're near the bottom of the cycle and sentiment around a stock like NVR has just been obliterated by simply being willing to tolerate the uncertainty of when a turnaround will, I would say inevitably, with some caution, but inevitably occur, you can earn excellent returns. And so I'm not sure whether NVR in the housing cycle broadly has reached this point where these companies are so beaten down that you should buy them and just hold for five years. But I think it's not a bad framework to use when thinking about this type of investment at 30,000ft. And so in terms of making the business more robust to downturns, are there any other ways they can grow in weak markets like we see today?
- [50:24]
Kyle Grieve
Yeah, I first want to just address what you just said there about the patience strategy. I think that's basically what you would have to take in order to own a business like this. You know, businesses like this that are obviously really high quality and obviously have the fortress balance sheet, there's a very good chance that they're going to survive the downturn that we're in currently. But you're going to have to be okay with probably a stock that might go nowhere for, who knows, three, four years, might have zero returns. Again, if you think that you can have some sort of ability that the market has to know where we are in the market and you think that that time is a lot shorter, maybe you think it's only year longer of being depressed and then things are going to turn around, well, then maybe it makes a really, really good investment for you, I think, for us personally. I think I speak for you as well, Sean. That's not exactly the types of investments that we are looking for. But that's not to say again, that this couldn't be the right investment for the right type of person who has the right circle of competence and can understand this at a very, very deep level, probably much deeper than we can. So back to your question here. So another potential area for growth is by adding new regions. So NVR has grown a lot over the years, starting in the mid Atlantic regions, right around where you grew up, Sean, in D.C. as well as Baltimore and Northern Virginia. They then expanded to the Northeast and the Middle east and then into more recently the Southeast, which has been a major growth lever for them. So at this point, it's certainly, you know, getting harder for them to continue to grow. If they wanted to enter new regions, they may be looking at some headwinds, such as lower margins from smaller homes and lower average selling prices and a loss in the contiguity strategy. You know, they may continue to deepen their markets in the Southeast and maybe just expand on that. You never know. You know, once demand normalizes, maybe they'll regain some market share as well in the other geographies that they're already in.
- [52:05]
Sean O'Malley
Yeah, I don't look at this and say that it's clear to me that there's a significant Runway left for them in the US without directly taking on more competitors. But I do wonder if their playbook could be recreated internationally.
- [52:17]
Kyle Grieve
Right.
- [52:18]
Sean O'Malley
That would be really interesting if they started to test that in small ways, you know, start building out projects in Mexico City or whatever it is. But I think we can agree that NVR has a wonderful capital allocation framework and probably less inspiring growth opportunities, generally speaking. And so with that, I think it's a good time to shift toward looking more closely at the company's management, because for me, whenever I'm sort of unsure about a business, I have mixed feelings. There's things I really like, things I'm not so sure about. Sometimes management can be that deciding factor.
- [52:51]
Kyle Grieve
Yeah, and I'll echo your points there about the potential of international expansion. I always love businesses that are more localized and have a really, really good business model that clearly works. Obviously, international expansion opens up a lot of potential risks because things can't always work the exact same way in your home. You know, the little intricacies of your home markets that might not transfer. Nonetheless, there obviously have been a lot of examples where it does work. So that is one potential. So back to management here. It's kind of funny. So when I went to look even for a photograph of the the chairman, who basically was their former CEO and their current CEO, I could find maybe like one or two photos. And because there was only one or two photos, I didn't even want to actually assume they were the right ones again, because I can't really cross reference it with anything else. Like I couldn't Even find a LinkedIn profile as well. I think this actually, you know, kind of tells you something and maybe it's a huge positive and it shows that NVR is most definitely not a promotional company and prefers to just spend as much of its time just running the business. And obviously, I think, you know, it's quite obvious they've done that in a very, very value, creative way. So needless to say, there's two people that I want to highlight here that I just kind of mentioned. So the pursed is Paul Seville, who's the executive chairman. So Paul joined Ryan Holmes in the early 80s, which was eventually acquired by NVR. He then worked his way all the way up to CEO by 2005, where he served in that role all the way till 2022. So he's been responsible for a lot of that value creation. Now, Forbes lists Paul Seville as a billionaire with a net worth of about $2.1 billion. So he's clearly been a very, very big beneficiary of NVR's value creation. Now, Mr. Seville has a few very great initiatives that worked out very well. So first, he separated the chairman and CEO roles as soon as he took over. He did this to make sure that both parties were held accountable and held some sort of a bridge between the management and the board. This helped give the chairman the ability to focus more on what was in the best interest of shareholders, rather than being conflicted in the role as both CEO and chairman. Now this is really interesting to me because usually, you know, in most companies that you've probably come across, Sean, I would say probably over 90% of the time, the CEO is also the chairman. Now, I really like this initiative because you're separating those roles a little bit and hopefully you're getting different perspectives. Another of his great additions was to focus on long term compensation programs. So he didn't incentivize the usual suspects such as revenue and ebitda. He actually used total shareholder returns and return on capital. Now, after Seville stepped down as CEO, the reins were then handed to Eugene Bradow. One thing I was cognizant of when looking at Eugene's history with NVR was the hand that he was dealt. So I cloned this directly from Warren Buffett, who made sure to emphasize this important nuance. Now, a manager who's stepping into a role with a ton of tailwinds is obviously going to be a lot different than a manager stepping into a role that's full of headwinds. Now, in Bred Al's case, I think he wasn't really dealt the best card, you know, taking over when interest rates were cheap and people were just buying up tons and tons of homes. So, you know, he essentially got in at the peak. Now, since he's been CEO, the stock price has keggered at about 9%, which is nothing exceptional. But given the challenging environment that it's been since he's taken over, I think this is actually a pretty commendable job. Let's take a quick break and hear from today's sponsors.
- [56:01]
Sean O'Malley
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- [59:15]
Kyle Grieve
Alright, back to the show.
- [59:17]
Sean O'Malley
It's funny how much performance is a relative thing, right? I mean, it's not always fair, especially on short time horizons, to compare every business and every manager to the S&P 500 as a benchmark.
- [59:29]
Kyle Grieve
Right.
- [59:29]
Sean O'Malley
There's something to be said for operating better than many of the competitors in your industry if you're all facing substantial structural headwinds. And so you're just not always dealt a fair hand. But. So you mentioned that NVR is a long term focused business and it appears to have been set up to create a lot of alignment between management and shareholders, which is a great thing. I just love to hear you speak more to that.
- [59:52]
Kyle Grieve
Yeah. So I think the first thing worth looking at is simply insider ownership. I think you'd agree with me, Sean, that we both prefer businesses where insiders have skin in the game and hopefully a decent sized chunk of their net worth is directly tied to the outcome of the businesses that they're running. Now, inside of NVR's proxy statement, insider ownership is very, very good, I think for a business with a market cap of $16 billion at 8.6%. So the chairman owns over a billion dollars in shares. So we can deduce, according to those Forbes numbers that I just discussed, that about half of his net worth is in NBR stock. Now, Eugene Bredow owns about 0.08% of the shares outstanding, which is a small percentage, but that's still worth $128 million based on today's market cap. So now let's talk about their incentive program. Now I'm not the biggest fan of using total shareholder return simply because businesses can have a high total shareholder return simply because they become favorable to the market at no fault of the management. Now I will say, at least with nvr, since it's in more of a boring cyclical industry, the share price will largely be tied to its intrinsic value. You know, this isn't going to capture some of that AI upside that we're seeing today where just businesses that are simply associated with AI get these massive RE ratings. NVR is in a very boring industry where that's very, very unlikely to happen. Now I already shared the capital efficiency number that NVR likes to show. So in their proxy statement they also display things like net income, earnings per share, revenue and new orders. So they said that in full year 2025 they only paid about 20% of their incentives as they were at the 20% level of their targets. So they noted that pre tax profit was about 80% of the incentive opportunity and the number of new orders net of cancellations was only 20% of the incentive opportunity. But as I mentioned, you know, compensation based on TSR isn't great, but I really like the fact that they keep this return on invested capital target. So, you know, management right now, given the fact that they were only paid 20% of their bonus, is having a very, very hard time earning those bonuses.
- [61:50]
Sean O'Malley
We talk about it a lot, but insider ownership can be very telling in different ways. And it certainly tells you whether management has skin in the game. And in combination with looking at their bonus incentives, you definitely can get an idea of whether they're more likely to create wealth for shareholders or more likely to create wealth for themselves and other employees. And those two things are not always the same, to be clear. And actually the latter is more common, honestly, where you have insiders enriching themselves with stock based comp at the expense of regular shareholders who are being diluted. And in some cases it can look like there's a good deal of insider alignment. But then you have to think about how that actually came about, right? Was it from overly generous stock based computer? Is that why they have such a large insider stake? Or is it like with Berkshire Hathaway where it comes from executives using their cash compensation over many years to consistently purchase shares in the open market. And so there's a big difference between those two things. And there was another thing that caught my eye when browsing the proxy and that's that the maximum Bonus is cat what seems like a pretty low number compared to other businesses in the industry itself. So maybe you can elaborate more on why that is.
- [63:02]
Kyle Grieve
Yeah, so they note a couple of interesting things that I think maybe make it a little bit harder to attract talent. But you know, again, given the results they've had, it seems to have worked so far. But essentially what they do is they cap their equity based compensation at just 100% of base salary. And their base salaries as well are quite reasonable. The CEO makes about $1.25 million with a couple of the other executives making, you know, 350 to $700,000. So very, very modest numbers. So if we look at some of the businesses quirks, first off, the total cash compensation for their CEO and CFO is actually below the 25th percentile of their home building group. Additionally, executive comp in total, not just cash, is lower than the average of their home building peer group as well. Now another interesting way that they create alignment is with how they vest their options. So options once granted don't begin vesting until three years after the grant date. Then they vest equally in 25% installments over the following three years. So just to give you an example, they granted options back in May of 2022 and they will vest at the end of 2024, 2025, 2026 and 2027. But here's where things get interesting. 50% of these options are time based, meaning the hold of the option must remain employed by nvr. But if the stock price doesn't rise above the grant price, these options basically expire completely worthless. Now this part isn't even as interesting as the performance options which are the other 50%. Now these have the same vesting schedule, but they rely on return on capital over a three year period compared to their peer group. If they miss the return on capital targets, the options just simply won't vest and are forfeited. Another thing I respect about this program is that the options aren't priced at, you know, 50% of the share price on the grant date, which you see very, very regularly. They issue them at 100 of fair market value on the grant date. Now this incentive program is interesting because it allows management to really, really think long term. You know, when your options aren't going to be coming to you in six years, you can really, really think far ahead to just continue trying to create value and not worry that maybe over the short term some of the things that you want to do to create value might not show up in a year or two, but they will show up in five years.
- [65:09]
Sean O'Malley
It's a creative structure and I think it's a good structure. I've also often joked with our colleague Daniel that I think these RSUs restricted stock units compensation that's based on time, where it's vesting, based simply on the number of years that you've been with a company. I call that the corporate equivalent to participation trophy. So I mean, yes, I can see how you might thoughtfully be able to include RSUs in an overall comp package, which it seems like they have here, but at a high level. I've just never loved the idea of management simply getting paid for not leaving a company, and we've definitely seen pretty egregious cases of that over the last year or so that we've been studying businesses consistently on this podcast. And so I think the focus should entirely be on the amount of shareholder value that can be created. But anyways, the next area I think that would be worth exploring for us is the attractiveness of the industry that NVR competes in overall, because we've touched on that here and there, but it really does deserve more attention. It's not the most complicated industry. You find a buyer, you develop homes, and then you close on the sale and repeat. But. But as you've already covered here, it's not that simple because customers don't buy houses on a linear basis. Demand ebbs and flows, and if you don't account for that, chances are you will get your lunch eaten by competitors or by your debtors when the cycle turns. So let's start by looking at the industry and how attractive it is generally to investors.
- [66:39]
Kyle Grieve
So I know that you're a major Peter Lynch Fanshawn. I know you mention all the time and so am I. And then one thing that I learned from studying him is that you can find some pretty interesting businesses in industries that most investors just shun simply because they just aren't sexy. You know, NVR obviously isn't a moonshot AI play. In fact, it's probably as far from that as you can possibly get. Now, home building on a national scale isn't something that most young people want to do, and even if you want to do it, there's a major difference between doing it successfully or just falling flat on your face when interest rates are low. Everyone and their dog is out there trying to buy a place, and because they have access to cheap capital, prices can be bid up to just astronomical levels as they they did during the great financial crisis. Now I remember during COVID an Acquaintance of mine was trying to buy a condo somewhere in Vancouver. Now, everywhere he looked, these places were selling quickly. And if you didn't put an offer 20% above the asking price and waive inspections, chances are that you just simply blid. Now the problem with this is that once interest rates change and the housing market cools off, many homeowners here are stuck with an asset that's now worth less than what they paid with rising mortgage payments. Now, I know things are a little different in the US but, you know, not that different. So while real estate is an industry that many people think they can succeed in, unless you're really just buying a home because you want to live in it, it's not an industry that's super attractive on the same scale that NVR has. For this reason, I think NVR is well positioned in an industry that isn't likely to get too many large scale new entrants. But I will say, you know, it's very far away from being anything close to a monopoly. The hard part for MBR is that both input prices and average selling prices aren't really under its control. With inflation affecting commodity prices and labor markets, it's simply just getting more and more expensive to build a house. And yes, they can pass some of those expenses on to the end buyer, but builders just don't have pricing power because their end product unfortunately is a commodity, you know.
- [68:28]
Sean O'Malley
Another one of our favorite investors is Palak Prasad, who wrote the book what Darwin Taught Me About Investing. And again, he's been a guest speaker to our Mastermind community. If I could just grossly simplify one of the main concepts, it's that there are some industries that are simply better deficient than others. They're more winning businesses as a share of the total. And you're more likely to have success by dipping your toe into these certain industries over others. And so airlines for example, are a notoriously difficult place to find quality businesses to own long term. If anybody has any great airline picks that have done well consistently for multiple decades, I would would love to see them. But if you look at software for the last 15 years, that has been the industry with the most winners. And like I said, airlines are probably the least investor friendly industry. And then I would think about residential real estate and specifically new home construction. And it's probably somewhere in between those two. It's somewhere in the middle at best. If I'm being completely frank, it's probably a harder place to fish for winning ideas on average than many of the other industries that we've studied, but clearly that doesn't mean NVR or any company that's operating in a challenging industry, that doesn't mean they can't be a big winner. Still, because NVR has been so on that point, do you see much potential for NVR to continue taking market share from their competitors? Is that a source of growth here?
- [69:54]
Kyle Grieve
Yes, let me just paint a little bit of a back pitch here. So NVR has three brands in Ryan Homes which are again are for entry level homes and then NV Homes or Heartland Homes for moving up or for more luxurious homes. So they're able to offer a very decent variety of homes to their customers. They focus mainly on single family homes and they skip things like rentals, multifamily and commercial real estate. Now, because they have these three brands and they don't require third parties to help them sell, most of their sales are coming from their website or their share rooms, which allows them to skip out on fees that are paid to middlemen. And since they are in these relatively concentrated markets, they're able to take advantage of their circle of competence and focus on lots that make the most sense to and them them they can figure out if building makes economic sense and if it'll help them achieve their KPIs. And unlike other home builders, if it's uneconomic to build in a specific geography, they could just let go of the deposit and focus their efforts in markets where they can see the most amount of success. And as the return on capital number suggests, the business model works. It's rare to see a business in home building industry that has returned anything close to what NVR has shown. And additionally, even though it looks like many of the home builders such as Lennar, Toll Brothers and Pulte have deleveraged, they're still carrying a decent amount of debt. And the ability for NVR to run with negative debt is a huge bonus, especially during lean times like we're in right now. So where many of NVR's comps are struggling is to develop and sell lots that have depreciated in value. And NVR can just pick those lots up at depressed prices, which I think bodes very well for future cycles once Demand returns for NVR.
- [71:22]
Sean O'Malley
I do love to see NVR's resiliency right from the great financial crisis to Covid they've endured some serious volatility in the and during the depths of the great financial crisis, their revenue dropped nearly in half from 2006, but they still turned a profit, which is something nearly no other Home builder was able to do so. That's a real accomplishment and we know that NVR can survive a massive hit to the home builder industry. But let's just go over some of the potential risks that are still embedded in their business model for investors to be aware of.
- [71:55]
Kyle Grieve
Yeah, Sean, So, you know, since NVR is in the home building industry, I think there's always going to be some sort of risk involved. Any investor out there who are fans of history or watch the movie the Big Short can probably attest to the fact that the housing market is exposed to some pretty crazy derivative products that can have massive impacts not only on real estate, but really on the world economy. Now I would say the biggest risk for NVR is simply another liquidity crisis similar to the gfc. While I hope nothing like that ever happens again, I'm not an expert by any means on US Mortgage backed securities. But pre GFC these were valued at about 2 trillion and today they're over 9 trillion. So, you know, yes, lending standards have probably improved and real estate I don't think looks like it's in a bubble at all at this point. So hopefully that problem has been fixed. But you know, if nobody's buying homes, then that would have very, very bad effects on nvr. A more realistic risk probably is the business model cyclicality. So even though I think NVR has a superior business model to most of its home builders, the model itself, you know, it's not good enough to just completely smooth out any cyclicality of the home building industry. If you were to hold this business long term, like I mentioned earlier, you're going to have to come to grips that the numbers are probably going to look really ugly at times. You might see diminishing growth or low or no growth for extended periods of times and you have to be willing to wait that out. And that's unfortunately completely embedded in the business model. And there's really nothing that they can do about that. Now this cyclicality will also cause second order effects to NVR's financial statements as well. So as I've already discussed, they've gone through some major margin compression. And unless your Hypothesis includes near 0% interest rates, again, I think the days of, you know, 20 operating margins are completely behind us. Another risk is in the communities that NVR chooses to develop. If they choose communities that just can't support growth, or maybe even buyers who just don't fit the target demographics to become potential customers, they're going to end up returning some of that deposit money to the raw land developers which obviously eats into their profits. Now, I didn't cover this that much in the intro, but I think it might be interesting to detail just a little bit about NVR's chosen geographies. Interestingly, it doesn't have a published formula for the demographics that they're targeting. They don't share whether they're looking for a specific population number, age ranges, or even per capita gdp. The core principles of where they would want to build follow three core principles that they share publicly. So the first one is just in mature markets, they're not going to operate in speculative markets that might grow. They would perceive this as being too risky. And while the upside might be higher, they tend to stick with markets that are already growing very, very well. Well, second is contiguous market expansion. So they tend to avoid entering a remote market with no exposure. Instead, they utilize their circle competence to steal Buffett's term, to find geographies that are adjacent to areas that they're already familiar with. And a third is market dominance. They focus on markets where they can be the market leader in that market. This speaks to the business's scalability. If they're mostly in the east, and if they were then to set up shop on the west coast, well, then most of that scale efficiency benefit would no longer be a benefit that they could take advantage of. Now, back to the risks here. I think the risks to point one and two are that they enter markets that are already, well, saturated and won't offer growth opportunities that NVR wants. So in that case, they may want to let those lots go. And the third point is a risk because they're geographically constrained to the regions that they're already in. They could take their current strategy of just, you know, slowly growing outwards, but it's hard to say if NVR will ever get to the point where they have a nationwide strategy or not up. The last risk that I'll mention here is that much of NVR's EPS growth since the depths of the GFC have come from buybacks. So if NVR begins running lower on cash and cannot execute their buyback program, they could see much larger decreases in their EPS growth rate, which of course is going to impact its multiple. While the multiple is already quite low, if the EPS cannot outpace the growth in profits, then forward growth is likely to stall or even decrease. Since 2022, profits have shrunk from 1.7 billion to 1.2 billion.
- [75:50]
Sean O'Malley
I know you like looking at businesses and trying to find if there's some sort of maybe hidden moat that's not so obvious. And when you go through that exercise with nvr, is there anything that comes to mind?
- [76:02]
Kyle Grieve
Yeah. So I did run the experiment on nvr and unfortunately the answer is no. I wasn't able to come up with anything that I would consider to be hidden. I think when you look at the customers that have nvr, it's really hard to say they're going to have much loyalty to their product. You know, the fact is, buying a home isn't your typical buying decision. If a home buyer gets their home right and it's well built and they like the community that they're in, there's probably a good chance that they'll never move. NVR isn't one of those businesses that can generate recurring revenue after the house was sold, although if they could, that would be outstanding. Once a buyer buys their house, they're basically set where NVR might have some extra benefits is maybe if a home buyer decides to buy another house, if they like the house that NVR initially built for them, maybe they grow a family and they want to upsize or get something a little more luxurious. If they had a good experience with their first experience with NVR in their entry level house, you could make the argument that that trust that's built between NVR and the customer will help keep them inside the NVR ecosystem once they decide to buy something else. But again, this is more speculative because nvr, as far as I know, doesn't even mention if they have a lot of repeat buyers. And again, this also assumes that the buyer wants to build a brand new home and not buy something that was built many years ago, which was the direction that I know you did, Sean. So in terms of customer loyalty, NVR had very low scores because a product is just not something that customers are going to try to buy on a regular basis. And because NVR's end product is a commodity, it's just not that differentiated from other houses on the market and therefore there weren't any, you know, obvious or non obvious hidden moats that I could find.
- [77:39]
Sean O'Malley
I think it's that time of the episode where we've covered a lot about the business. It's definitely not everything. We can certainly go deeper, but we have a pretty good lay of the land of what's going on within VR. And so now the question is what is the business worth to investors today and is it something we would consider for our intrinsic value portfolio? So I think it can be useful to start with the pessimistic side of things. What would your bear Thesis be for nvr?
- [78:07]
Kyle Grieve
Yeah. For listeners who are listening, you're probably going to get used to me talking about the bear thesis first, just because I like to make sure it gets the attention that it deserves. So the bear thesis is a great way also to start off because I think you can argue right now that the conditions aren't great for nvr and likely we're going to see similar conditions, I think going forward. You know, I don't think the market is going to continue trending down for the next five years. It's obviously going to turn at some point. So to account for the possibility that we may continue to see a downturn before an upturn, I'm using very low revenue growth rates of only 3%. Now, the revenue kegger for the last decade has actually been over double that. So this factors in a pretty sharp decline. Now this scenario assumes that mortgage rates stay elevated a little longer in the 7% range and I assume persistent inflation, which again is going to keep demand low. I'm also assuming that tariff driven inflation keeps construction input costs up. Now this results in rising cancellation rates, market share loss, and more margin compression across all geographies. I'm assuming another couple of years of no growth in market demand and that net margins will compress further to about 8%. I'm using an enterprise value to earnings, which I'll refer to here. It just says EV to earnings multiple of about nine times, which is typically the low end for this business. Now just to give you a ballpark estimate, the business is currently trading for about 12 times EV to earnings. Now I'm also assuming a 14 reduction in share count. Now this gets us to a price of about $3,240 five years out. And just so you know, I'm going to be using five years for all three scenarios here. So this gives us a negative 11 return compounded annually. And so, you know, all things considered, I think this is a pretty solid downside protection. If I could get these returns on the downside for most of our bets, I think I would be pretty happy.
- [79:49]
Sean O'Malley
Be yeah, it's never fun to start with the bear case, but I think in some ways it's the most important part.
- [79:54]
Kyle Grieve
Right?
- [79:55]
Sean O'Malley
It's not really that difficult to spend together a narrative as to why everything's going to work out great or why the base case roughly aligns with the current stock price. But if you can be honest enough with yourself to be able to handicap a realistic bear scenario, that helps you truly assess the risk reward trade offs. That's Very difficult to do well, but also very valuable. So, so let's get to the base case here. What kind of assumptions are you making and what kind of returns do you model out in a more normalized scenario
- [80:24]
Kyle Grieve
right now is when things get a little more fun. So in the base case, I assume that we're at the bottom of the cycle pretty much around now, and the turnaround is a lot quicker than in the bear case. So in this case, I'm assuming the Fed cuts rates gradually, mortgage rates decline to maybe the 6% range, inflation moderates a little bit, bringing input costs down and some buyer demand back into the market. We see new orders stabilize around 23,000 units, and cancellation rates normalize to the 15 range. All geographies begin to stabilize and the Southeast continues to carry a lot of growth. We also see a nice growth in average selling prices. In this scenario, I model out revenue growth rate of about 6%. This is still a pretty conservative number compared to the pre Covid growth in revenue of about 10%. But I'm still factoring a headwind of a year or two before the market picks up again. So I'm also assuming that profit margins remain stable around today's level at about 12%. In this scenario, because profits remain elevated, the cash pile remains solid, resulting in a negative net debt. I also factor in that buybacks are going to continue to deliver shareholder value. So I factor in about a 21% reduction in total share count, and this gives me a share price of about 8,645, which offers an 8% compounded annual return.
- [81:35]
Sean O'Malley
Obviously we're talking through different scenarios here, and there are lots of numbers to keep up with. And really the intention is just to show the exercise that we try to go through in imagining these different scenarios. And for me, when I'm looking at nvr, we really want typically businesses that control their own destiny. And for them it does seem like. I don't want to say it's all about real interest rates, but that is a huge factor here. If inflation rates outstrip interest rates, well, well, we'll have bigger problems on our hands. But you could actually see that cause a spike in housing starts since the real interest rate will have effectively declined. Right. If the inflation rate rises more quickly. But then you get into a conversation again about inflation expectations and that can get really messy. So I don't want to go down that rabbit hole, but I just don't generally feel like playing the inflation betting game as part of my investment process is all that appealing. And to see NVR as being investable. I think you have to find an entry point where the business is just, just really historically cheap relative to where we are in the housing cycle and have some confidence in that. But that's easier said than done. So finally, why don't we get to the fun part, Kyle, and while you tease out the bull thesis, let's hear what kind of upside a business like this can offer if everything works out, you know, close to perfectly.
- [82:50]
Kyle Grieve
Yeah, and before I get to that Sean, I will say I completely agree. I think that MVR is one of these businesses where it can control its own destiny in terms of the business model and they've done an exceptional job at that. But unfortunately the inputs and the outputs of that business model are largely out of their control. So while they'll probably stick around again I'm similar to you. I prefer a business that has a large ownership of its destiny and not one that is so reliant on external factors. But again, let's get back to the bull case here because it's always exciting to do that. And to do my bull case I definitely have to temper my assumptions because it's an exciting thing to do. So but keeping that in mind, I'm only using about a 15% probability for the bull case as I think it's the least likely outcome to play out anyways. Now for this scenario. Again talking about interest rates, the Fed cuts rates more and mortgage rates come down to, you know, maybe call it 5%. Consumer confidence recovers and new housing builds accelerate to meet supply and demand dynamics. I assume the volume of new houses rises about 15% from the current base and new orders reflect the pent up demand that gets unlocked by lower borrowing rates. Now because of this increased demand, cancellations also drop somewhere around say the 13% level. In this scenario I'm using a revenue growth rate of 8%. Again this is still lower than that 10 year average pre Covid which was about 10%. But we also have to think that the base of this time range was in the depth of the great financial crisis. So they were building off a very low base number. And I don't think we'll get similar demand or growth compared to that period. Now because input costs are dropping, I'm assuming profit margins rise to say about 14%. Now this is still a pretty big discount to the 2022 number of 16. But as I mentioned, I don't think we get get back there anytime soon. But this definitely assumes a large increase in demand. So I'm assuming the average Selling price also grows by about 4% or so. Now lastly, I expect their debt to continue falling as net debt becomes even more negative, I give them a 14 times EV to profit multiple and assume that shares shrink at an even more aggressive rate of about 25%. Now in that case, I get a price of over $25,000 and this offers a very high return of 34%. Again, I assigned a very, very low probability specifically for this reason. Now if I put all these numbers together and I add a 25% margin of safety to account for all the cyclicality in this business and the fact that I just really think it's hard to predict, I get an IRR of only 3%. So even though this business is superior to many in its industry, I just don't think I can get a good enough grasp of the housing industry to really ever be comfortable with buying this without a massive margin of safety. If we like the business and we were comfortable with it, it we'd still need to buy this business at about $3,800 a share, which is 38% below where shares trade today. So you know, to be honest, I'm not the biggest fan of businesses in highly cyclical industries like housing, so I'd be fine just really taking a pass on this even if it were to drop down to that price.
- [85:39]
Sean O'Malley
I just want to mention for folks listening at home as we work through these different cases, we'll bear base case for the analysis. If you feel like it's a little hard to follow along with, I would encourage you to check out our Intrinsic Value newsletter. We walk through the valuation step by step, show screenshots of the model and actually a link directly to the model so you can access and see exactly how we work through the logic of valuing these businesses. And we do that with every company we cover. So I would encourage you to go to theinvestorspodcast.com and there you can sign up for the newsletter. But there are a lot of different ways to win at investing it. And some people can come in with one year or three year time horizons and have luck betting that something is cheap. But I just don't see that as an exercise in intrinsic value as much as I see it as a form of making bets where maybe the odds are stacked in your favor more so than making ultra short term bets. But they're still not as stacked in your favor as buying excellent businesses at fair prices and holding for the long term. And I'm sure NVR will do fine as an investment and I do love a good share Cannibal, a business that eats up its own shares while keeping enough cash on hand to aggressively invest when the cycle turns. That would be how you make a lot of money on this name if you can get the timing right, like I said. But again, if I'm thinking with a longer term horizon and trying to make fewer investment decisions but hit with a higher accuracy rate on those investments and in a bigger way, then it's hard for me to get super excited about nvr. And so over the next decade, for example, I just don't know if I have any conviction in the business being able to generate abnormal excess profits, which is what stems from having some sort of competitive moats where nobody can come in and reduce your margins because you have such a strong foundation around your business. I think they'll do decently, but I also do think that we need businesses that do better than decently in our intrinsic value portfolio. So it's been a really interesting case study, but I agree with you. I'm happy to pass on this one.
- [87:37]
Kyle Grieve
Yeah, and I would echo Sean's sentiments on the newsletters if you do want to understand some of the numbers here in a lot more detail. I'm a visual learner. I like looking at visuals, so that'll give you a much better detailed. And then another thing I will say is just, you know, getting to the point that, for instance, Mohnish Pabrai likes to make, which is, you know, thou shall not use Excel. You know, a lot of the assumptions that you make, there's just, there's a lot of them in here that you have to make in order for this business to get to where you want. And unfortunately, a lot of those assumptions are like we mentioned earlier and we've mentioned this entire episode based on extrinsic factors that are completely out of NVR's control. And in that case, you know, I just feel like if you're attacking this from a circle of competence point of view, it's just a little bit too hard for me and think Sean probably agrees with me to just understand at this point. So I just wanted to add that as well.
- [88:24]
Sean O'Malley
Well, folks, on that note, I think it's time to end today's episode. I want to leave you with a very brief but powerful quote from the late and great Charlie Munger who says, pay attention to the cannibals. And had we heeded this advice 30 years ago and been comfortable with a business in a volatile industry like housing, we could have landed on one of the greatest value investing businesses in history with with Charlie's help. So really do pay attention to the shared cannibals, the companies that are able to buy back their own stock hand over fist. And so today I still think NVR will be a share cannibal, but there are limits to how long it can grow in terms of its organic, addressable market and to me that raises the concern of whether it can outperform long term. And on that note, we'll see you all again next time.
- [89:15]
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