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What Am I Missing With This Fast-Growing Housing Stock?

By Tyler Crowe, Jason Hall, and Matthew DiLallo – Updated Nov 29, 2018 at 5:12PM

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LGI Homes looks well-suited to handle a slowing housing market and its stock is trading for a dirt cheap valuation. So I asked some friends to pick my thesis apart.

Even when we're not writing about stocks, we're probably discussing some investment theme or company that piques our interest. Here's a sneak peek at some of the conversations that go on behind the scenes with some of our writers here at The Motley Fool.

One of the best ways to better form your investment thesis is to talk it out with a few trusted friends or colleagues who may or may not have the same view as you. Maybe it helps you see something you previously overlooked, or it can force you to better articulate what you want to get out of an investment. I (Tyler here) recently started a position in homebuilder LGI Homes (LGIH -2.98%) and was considering adding to it, but I wasn't completely sure if it was the best decision right now. So I bounced the idea off two of my colleagues. Here's what they had to say about it.

New homes in a row.

Image source: Getty Images.

Well-suited to address the problem with today's housing market

Tyler Crowe: If there was one word to describe the housing market today, it's affordability. Inventories of homes for sale hit historical lows in 2018, the St. Louis Federal Reserve's home purchase price index is at all-time highs, and rising interest rates are turning some buyers away from the market.  At the same time, though, demand for housing remains incredibly high. The millennial age group (currently 22 to 36) is the largest in America and is entering the market for their first homes. While there are endless stories of how millennials are changing (or ruining, depending on your source) the housing market, the fact of the matter is that we have one of the largest age demographics set to get into the housing market over the next five to 10 years. 

This many buyers coming to market means that we are going to need an increasing supply of housing -- especially homes in the first-time buyer price range. Of all the homebuilders out there, LGI Homes is well-suited to meet the needs of this group. It bases its entire business around building and marketing to first-time buyers. LGI focuses on affordability by producing a limited set of house designs within a community that are easier and quicker to build. It also actively markets to first-time buyers and renters with advertising that encourages building equity at mortgage rates comparable to regional rental prices. This approach is how the company is able to have an average selling price $100,000 less than most of its peers. 

What's compelling about LGI is that the company makes good money selling more affordable homes. At the end of the most recent quarter, gross margin was 25.6%, which is more on par with luxury homebuilders. This means LGI is built to compete on price and attract buyers that are concerned about affordability. 

LGI Homes has grown units sold by more than 10 times since the company went public in 2010, and management expects to grow its community count by 20%-30% in 2019 to fuel further expansion. Despite a great business model and a robust growth platform, the shares trade for only seven times earnings. 

This stock seems like a slam-dunk investment at today's price, so what am I missing? 

What about the impact of rising interest rates?

Matt DiLallo: On the one hand, I'm in complete agreement with you on the thesis that affordability is becoming an issue in the housing market, especially for first-time homebuyers. The lack of supply at that end of the market seems like a big opportunity for LGI Homes. I like that niche focus and love those margins.

I also like its shareholder-friendly approach. While the company is investing capital to expand its community count, it's not growing just to grow by spending at full capacity. Instead, it's returning some of its cash to shareholders through a recently announced $50 million share repurchase program. That buyback seems to confirm your view that shares are cheap. It also reminds me of NVR, which is my homebuilder of choice. NVR has a history of buying back its stock to drive shareholder value and recently announced a new $300 million repurchase program.

However, the one thing that concerns me specifically about LGI Homes is that its buyers might be much more sensitive to rising interest rates than other buyer sets. The rise in rates over the past year is already impacting potential buyers, with recent data by the Mortgage Bankers Association showing a double-digit decline in mortgage applications for newly built homes compared to the same time last year. If that trend continues, it could eat into LGI Homes' margins should it need to lower home prices to offset the rise in interest rates.

Because its target buyers are more rate-sensitive, it wouldn't be my homebuilder of choice for what's increasingly looking like a turbulent period for the housing market.

It's still a homebuilder

Jason Hall: Considering that I personally doubled my stake in LGI Homes in October, you and I are essentially on the same side of this argument. But having done plenty of analysis as part of my decision to double down, I spent a lot of time asking myself this exact same question. 

And the downside that keeps LGI Homes from being a "slam-dunk investment," as you put it, is that it's still a homebuilder. It's a highly leveraged company operating in a very cyclical industry. That can send even the best-constructed investment thesis up in smoke quickly. 

I'll even use your own words against you: "LGI's third-quarter result had all the makings of a housing slowdown." The company reported big quarter-over-quarter declines in both home closing revenue and earnings per share last quarter. And it's not just LGI; most homebuilders are seeing sequential softness, as rising interest rates and weak inventory keep hurting affordability. 

All that to say this: I think the worst-case scenario for buying LGI shares now could be timing. There's a chance the entire housing market takes a breather in the next few quarters, and that could take a big bite out of LGI's profits, making it far less cheap than it appears to be today. 

But I don't expect that to remain the case over the long term, no matter what happens in the next few quarters. There is major pent-up demand from millennials who are starting families and want a place of their own. I expect that will make LGI Homes a big winner over the next decade, even if the next year isn't great. It's one of the few homebuilders squarely focused on where demand will be for years to come.

Jason Hall owns shares of LGI Homes. Matthew DiLallo owns shares of NVR. Tyler Crowe owns shares of LGI Homes. The Motley Fool owns shares of LGI Homes and NVR. The Motley Fool has a disclosure policy.

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