NVR - Right Tail Capital - NVR Corp:  Fantastic Returns On Incremental Capital

2023-07-26 10:00:00 ET

Summary

• NVR, Inc. operates differently from other home builders by not owning the land it builds on, reducing risk and freeing up capital.
• NVR has a strong presence in select markets, often being the low-cost producer due to market share concentration, vertical integration, and tight SG&A control.
• NVR's returns on incremental capital have been impressive, averaging well over 30%, and its market cap has grown by more than $16bn since 2010, indicating significant value creation for shareholders.

The following segment was excerpted from this fund letter.

Investment Spotlight: NVR, Inc. ( NVR )

One investment where I’ve been a patient long term holder over much of the past 5 years has been NVR.

NVR is one of the largest homebuilders in the US, operating in over 30 markets. There are several attributes that are underappreciated about NVR. First and foremost, it’s not your normal land-owning homebuilder: NVR options their land which leads to outsized returns and less risk by having less capital tied up in land. Many homebuilders cite the positives of owning land such as more control over the entire building process and higher margins.

NVR mitigates the lack of control inherent in their option strategy by working extremely closely with local land developers. These partners appreciate NVR’s trustworthiness, pristine balance sheet and quick turnarounds. As one developer tells me, “They do what they say they’ll do and they honor their commitments to buy a set number of lots.” While owning land may lead to higher margins during most economic times, it takes up much capital and is incredibly illiquid. It’s also likely worth much less during tougher economic times…exactly when you might want to have more cash on hand.

NVR is so focused on not owning the land that they even refuse to own the model homes for each community – instead, they’d rather free up the capital and pay an above market rent to a local resident who’s willing to own it. The model homeowner also may receive the benefit of that home’s price rising as NVR further builds out the community, creating a win-win for all parties.

Another underappreciated advantage is having a dominating presence in select markets. NVR has a huge share (>20% in largest markets) in some of its largest markets which leads to local economies of scale. Through their market share concentration, vertical integration, and tight SG&A control, NVR is often the low-cost producer in their markets.

I often find myself thinking about this quote from one of investor Josh Tarasoff’s essays ^[4] :

I think of the highest quality companies as being in a class of their own: the 99th percentile is not 10% better than the 90th percentile but 10x better. Linear thinking and analysis—though they play an important role in building a full understanding— are insufficient for revealing superlative quality…Because the best companies are so good, are so rare, and defy standardized methods of analysis, I suspect they remain undervalued for a long time.

In NVR’s case, the most often cited advantage they possess is not owning their land. This seems like a simple and easy to replicate advantage. However, it’s hard for larger homebuilders to clone when a part of their culture and profitability is tied to land ownership. A new company can organize this way but will not only struggle to access capital, they’ll face NVR’s less visible moats, such as its network of partners who can help with issues like local permitting. Of course, NVR’s success is much more than any one factor and is due to doing several little things well. For example, their excellent balance sheet and longterm approach allow NVR to keep investing and opportunistically enter new markets during more difficult economic environments.

NVR’s returns on incremental capital have been fantastic. Over multi-year time periods, they have averaged well north of 30%...not surprising, given that the business requires little capital and turns its inventory so quickly (4-5x per year). NVR also scores well on Buffett’s retained earnings test. Since 2010, its market cap has grown greater than $16B while retained earnings have grown ~$400M. This indicates that the earnings reinvested in the business are creating significant value for shareholders. Not surprisingly, this has shown through in the stock’s return over the last 10 years with NVR rising >6x or ~21% CAGR.

I remain confident that over long periods of time NVR will remain well run and continue to gain market share. It’s not hard for me to pencil out a mid-teens IRR from today’s prices. While the housing market seems to be under-supplied, anything can happen in the short term with the economy and housing market. I consider position-sizing more so with NVR than other companies, and it’s an investment that is less likely to be Right Tail’s largest position after a longer period of company fundamental and stock price outperformance.

As an aside, if you’d told me that a homebuilder would be one of our best investments since Right Tail’s inception, I would not have guessed it. It speaks to the importance of partnering with a diverse set of great companies, even within a concentrated portfolio, and not trying too hard to predict macro events and stock market movements. It also speaks to the importance of dampening the noise of stock market news as most housing-related news has been negative.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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