Seeking Treasures from the Storm

21 July 2022 | by Todd Wenning, CFA

My wife is an avid seashell hunter. Her family tells me this has been a lifelong obsession. She’s intent on only keeping the good ones.

Within five minutes of setting up our umbrella, I’ll look up and she’ll be halfway down the beach looking through the sand, increasingly with our kids in tow, unknowingly learning from a master.

Oil on canvas by Anna Bryant

She’ll go hunting no matter how busy the beach may be, but in the peak summer months on popular beaches, the good shells don’t last long. Either tourists grab them up or they get stepped on during an errant frisbee toss.

Instead, the best searches take place in two settings, and ideally together – on secluded beaches and after storms. Our best haul came years ago when we ventured out on kayaks to a remote part of a remote island in North Carolina where we found an elusive intact Scotch bonnet.

Author’s photo

To increase your odds of finding the highest quality shells, you need to do the work others don’t want to do and be willing to see storms as opportunities.

There’s no question that the last six months have been rough for quality-focused investors and particularly so for our strategy. With the benefit of hindsight, the beaches (if you will) for quality stocks became overrun with tourists and the storm of stagflation rolled in, sending them running for shelter and aloe vera for their burns.

While it seems many beachgoers have called it a day, intending to return next summer only when the sun is bright and the sky is clear, we’re back on the beach looking for what treasures the storm has left behind.

We consider some of our housing stocks, such as homebuilder NVR and retailer Home Depot, trading with price/earnings ratios unseen since the depths of COVID lockdowns in 2020 and see opportunity. We don’t believe either company’s recent earnings will be their peak over the next three to five years.

The velocity with which mortgage rates have risen in 2022 is indeed concerning, but it doesn’t have anything to do with the fact that the most populated age cohorts in the US are 29 and 30. As those peak millennials enter prime earnings and household formation years, the odds are good that they will look toward single-family homes to set down roots in the coming decade.

Work-from-home flexibility has increased in the “post-COVID” era, with McKinsey reporting that 58% of Americans surveyed saying that they can work from home at least once a week. This massively opens up housing options for families that can now live further away from city centers since their commuting time has been reduced. NVR specializes in building communities in the exurban areas around second- and third-tier cities, so we believe they are well positioned for this trend.

As many of us experienced during 2020, the longer you’re in your home during the day, the more you start noticing things that need repair or improvement. That leaky faucet, once tolerated when you were away 10 hours each day, is now unbearable. Working from the kitchen table with kids running around doesn’t lend itself well to productivity, so it’s time to convert a room to an office space. And so on.

We think Home Depot will continue to benefit from home renovation and repairs, both with do-it-yourself customers and their important pro contractor customers that use Home Depot as a materials supplier.

Despite the rise in mortgage rates and the doom-and-gloom headlines about the housing market right now, this does not appear to be anything like the 2008-2009 housing crisis. For one, the bulk of US homeowners currently have fixed rate mortgages, rather than adjustable-rate mortgages, and used the opportunity in recent years to refinance at low rates. The risk of mortgages “resetting” higher due to rising rates and impacting affordability is far lower than it was in 2008-2009.

Second, the amount of home equity in the US has surged well beyond levels seen before the housing crisis. As such, homeowners have considerable project financing options for remodels and renovations.

Finally, if a homeowner needs to sell their home due to job loss or some other unforeseen event, it is unlikely that they will need to offer deep discounts to entice buyers, especially with limited existing home inventory and strong demographic tailwinds.

NVR and Home Depot are just two examples of high-quality businesses that have been tossed about in this stagflation storm. We see many more opportunities across sectors left behind by fleeing quality tourists. It may not seem like it right now, but it’s a fine time to be on the beach looking for treasures.

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