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Here's My Top Stock to Buy in November

By Brian Stoffel – Updated Nov 10, 2018 at 8:49AM

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Wall Street doesn't like the short-term outlook. Therein lies your opportunity.

Here's something I'm sure of: People will always be moving. Families grow with new children and contract when they leave. Old jobs are eliminated and new ones are created ... sometimes half a country away. And chance meetings will lead to unexpected love and marriage, creating new households in the process.

Yes, the economic climate does affect the rate at which these things happen. No one wants to buy a new house when interest rates are above 10%. But life changes, and people move. My parents often tell how they paid 11% interest on their first mortgage.

"Why'd you do that?" I asked. They replied that forming a home for their family was the most important thing to them, regardless of the money.

This will never change. But some on Wall Street are taking the short view when it comes to real estate. That's presenting a rare opportunity to buy into Ellie Mae (ELLI) at bargain prices.

Home Sweet Home Welcome Mat, Moving Boxes, Shoes and a Plant on Hard Wood Floors.

Image source: Getty Images.

The business from 30,000 feet

Ellie Mae's goal is actually pretty simple: "to automate everything automatable in the residential mortgage industry." That's right, I'm pretty sure they invented a new word with "automatable." 

The key to this goal is its Encompass platform. Mortgage professionals who subscribe can streamline their mortgage leads and origination and financing processes. The entire business is based on the very powerful software-as-a-service model. It also helps connect real estate brokers with insurers, title companies, and financing options -- all while ensuring compliance with state and federal laws.

Ellie Mae claims that by using Encompass, the average mortgage professional can save $967 per loan and can break even on the subscription costs in less than two months. Obviously, those are very enticing figures, which helps explain why the company continues to sign on users in droves.

The near-term pain

Interest rates were at historic lows for a long time since the Great Recession. That meant people who might have been on the fence about buying a new home (my family included) were incentivized to act quickly. It also meant that those who had high-interest loans from the pre-recession era were motivated to refinance.

In either instance, Ellie Mae benefited. That's because the company receives both flat monthly subscription fees, as well as usage-based fees that vary depending upon loan volume. 

As you might have heard, inflation is starting to creep up, and interest rates are heading higher. That means the incentive that pushed potential home buyers to act fast (like my family) has been taken away. That slows down business, and dries up the well for any potential refinancings.

Already, this trend is visible. On its most recent conference call, CEO Jonathan Corr said, "A combination of particularly tight housing inventory and rising interest rates is fueling low home affordability, which is stalling the purchase market more than the industry we anticipated."

This caused the company to lower its guidance for the year, and warn of continued pressure in the first half of next year. It didn't take long for the stock to react: It fell nearly 20% the next trading day.

The long-term opportunity

Let's get back to where we started: While these home purchases may be delayed, they aren't being eliminated. Families will always be looking to start new homes. If you're a short-term investor, then yes, you do have reason to worry. But if you're a long-term investor with a time horizon covering decades, you can experience the ups and downs of this cycle with ease. 

The real key is making sure that Ellie Mae continues to grow market share over time. And based on the contracted seats on the Encompass platform, it is doing just that.

Chart of contracted Ellie Mae SaaS Users over time

Data source: SEC Filings. 2018 figure is estimate for total contracted users by management as of Oct. 25.

Back in 2011, there were roughly 36,000 contracted users of Encompass. By the end of this year, that number will have jumped almost eightfold to 270,000. While not all of these users are active in a given quarter, it shows the powerful market share that Ellie Mae has been capturing.

Even now, mortgage originations are still growing at the company, as is revenue -- albeit at much slower rates. 

At the core of the long-term dynamic for investors is this: The company is building two wide moats around itself. As mortgage professionals become more familiar with Encompass, and use more of the tools that the software offers over time, the company becomes ingrained in daily operations. That sets up high switching costs.

And because Encompass allows many different sides of the mortgage process to communicate with one another, it also benefits from network effects. Title companies that want business will use the service because they know lots of loans are available on Encompass. And more title options, for instance, will draw in more mortgage professionals. It's a virtuous cycle -- especially when the market tops.

A value price

Over the past 12 months, Ellie Mae has produced free cash flows of $101 million. That means the stock can be had today for just 23 times free cash flow. That's a much cheaper price than investors have been able to get in a long time. 

Over the short term, I'm ready for the volatility that will come with rising interest rates. But over the long run, I think this is a bargain price for a company that's gaining market share and will benefit disproportionately when the housing market starts moving once again. When Motley Fool trading rules allow, I intend to bring my own holdings of Ellie Mae up to roughly 3% of my family's portfolio.

Brian Stoffel owns shares of Ellie Mae. The Motley Fool owns shares of and recommends Ellie Mae. The Motley Fool has a disclosure policy.

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