Disclaimer: This is not a recommendation to Buy/Sell/Hold.
While reading 100 Baggers: Stocks That Return 100-to-1 and How To Find Them I came across a US home builder by name NVR inc. I was surprised to note that it has returned 232x [including dividends] since 1992 despite the fact that home building is a cyclical industry and USA had went through once in a century housing crash during 2006-2009. Moreover, as per popular belief there are no entry barriers or moats in sector. Most of the home builders concentrate more on building land banks. So, I decided to do a detailed study of the reasons with the sole motive to learn lessons for investment in Indian real estate companies.
This study is based on publicly available information and my very limited analysis [Negative understanding of US companies and markets] It’s possible that there are some errors. This sort of study suffers from lots of hindsight bias. I believe in the principle that we should study both extreme success and failures and learn lessons from both. Of course the aim is not to find another 100 bagger in Indian Real Estate Industry but to find companies which to some extent follow NVR business model which makes them resilient to face extreme period of demand slowdown.
You can download my NVR case study of 100 bagger from here.
You can also go through extract of excellent discussion on Value Investor Club
UK Home Builders
Another company which because of its sensible business model outperformed all its peers is UK based Berkeley Group. Berkeley Group is perhaps the only listed UK home builder which had not reported losses even during 2007-09 housing crash.
Source: Expecting value
According to this article Berkeley group followed few rules which differ it from other UK Home Builders.
- Leverage profile of the group – very little, particularly compared to other house builders – and the lack of cyclicality you would expect to find in this sort of company. The group has never made a net loss.
- The assets side of Berkeley’s balance sheet actually shrunk from 2003 – 2007,by over 10%. Most of the other house builders got around twice as big over this period, leveraging up to buy as much as possible… but most of the other house builders were then too busy dealing with land impairments and credit availability to double the size of their inventory holdings from ’09 – ’14, buying when the market was genuinely cheap.
- This is great counter-cyclicality. They’re not lazy with the money, either – in 2005, 2007 and 2008 they made substantial returns of owners’ capital [buy-back], which cumulatively totalled more than the whole share price in 2005. They were also planning to give money back in 2009 to finish their return-of-capital scheme, but politely nudged shareholders into letting them keep the money to reinvest in land holdings. [Bold mine to put emphasis]
Request investors you have followed NVR & Berkeley group closely to highlight any more reasons which I failed to notice.
Indian Real Estate
[Click on the image to enlarge]
Source: Ace Equity
From the above table it will be quite clear that profitability was never a problem for Indian Real Estate Industry. What’s missing is 1) Focus on Return on Assets by proper allocation to current land needs instead of building huge land banks and 2) Maintaining strong balance sheet to enable to face inevitable slowdown. 3) Most important to find promoters who are willing to share profits with minority shareholders.
In Indian Real Estate market there is NO Company which is following business model like NVR. If any company come close to 40-50% of the business model being followed by NVR it is 1) Ashiana Housing 2) Godrej Properties
I AM REFERRING ONLY TO THE BUSINESS MODEL of BOTH COMPANIES. AT CURRENT PRICE I WILL NOT BUY EITHER ASHIANA HOUSING OR GODREJ PROPERTIES. [Please do not ask at what price I will buy these companies 🙂 ]. I have still few unanswered questions, as far as Godrej properties is concerned.
Ashiana Housing:
Ashiana Housing has already provided more than 100x returns in last 12-15 years. This itself make it worthwhile to study to understand why Ashiana Housing is able to creat such tremendous wealth when most of the other real estate companies has destroyed or not created any value since their listing. This in itself do not mean that it’s a buy at current price. What I am suggesting is just study the company business model.
You may find my notes helpful in your study. You can download my notes from here which has extracts from annual report and transcripts..
Prof. Sanjay Bakshi has written extensively about Ashiana Housing here and here [don’t forget to read comments section]
Godrej Properties: Though I like Godrej Properties business model, am still struggling with few questions mainly its focus on high-end housing.
You can download my notes from here
High ROE is a common factor among NVR, Berkeley Group and Ashiana housing
I have rarely come across any report on Indian Real estate company which gives any importance to company’s ROCE and ROE. It looks as if ROCE & ROE do not matter for real estate companies. Most of the reports focus only on the NAV from the existing and upcoming projects completely ignoring the historical and prospective ROCE & ROE. I think this is completely WRONG. I strongly believe that its NOT a co-incidence that NVR, Berkeley group and Ashiana Housing which outperformed all their peers in their respective markets have high ROE. Lets see what Warren Buffet has said about this in his letters.
“Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. For years the traditional wisdom— long on tradition, short on wisdom— held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“ In Goods We Trust”). It doesn’t work that way.
Asset-heavy businesses generally earn low rates of return— rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation.
Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. Unfortunately, a few have very poor returns, a result of some serious mistakes I have made in my job of capital allocation.”
But the opposite is not true. All the real estate businesses which generate high ROE may not be equally valuable. Recall from the above, Buffet is referring to return on “Unleveraged net tangible assets” So if the high ROE is from financial leverage, then its not of much help. I have also analysed few other US listed Home Builders, where if one had focused only on high growth and RoE, would have made a wrong decision. One should realize that home building is a highly cyclical sector and companies which take both operating risk [in the form of huge land bank] and financial risk [in the form of huge leverage] will suffer deeply in case of any demand slowdown and fall in land prices.
Disclaimer: This is not a recommendation to Buy/Sell/Hold.
Registration Status with SEBI:
I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”
Details of Financial Interest in the Subject Company:
I may or may not hold any of the companies discussed above in the portfolio which I managed for my family and close friends. Please consult your financial advisors before taking any buy/sell/hold decision. I may change my opinion post publication of this note and may not be able to update because of time constraints. At current price there is NO margin of safety for the stocks discussed in this post and I will not buy any of them.
ContrarianValue Edge 
Sir. Insightful case study done. 🙂 Thank you so much.
I have one question. Can we say WB was referring to Economic Value Added when he says this?
“What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation.”
Thanks.
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No economic value added will be net profits less notional cost of equity capital.. return on UnLeveraged earnings means ROCE…
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Anil,
Thanks for sharing your hard work with all of us. By doing this you’re walking in the footsteps of Charlie Munger, who once said, “The best thing a human being can do is to help another human being know more.”
On average investors will not make much returns holding real estate companies due to the presence of both financial and operating leverage. In cyclical industry you can get killed from both sides. But some companies like Ashiana Housing and Poddar Developers might be able to defy mean reversion due to their unique strategy.
But one question I am not able to answer is the durability of moats [mostly process based] possessed by Ashiana Housing. Why can’t their business model be copied by other companies? Would love to hear your thoughts on that.
Regards,
Jana
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Thanks a lot Jana
I do not have exact answer to your question. But I know that in US there is only one company NVR which did not made any losses during 2007-09 because they are following asset light model. Similarly in UK only one Beverley group and in India Ashiana housing. Its not really difficult to follow their business model. But that requires a contrarian mind and patience mind set. Not everyone can be patient enough to see their peers making money and still remaining on sidelines in 2007-09. Not easy not to resist temptation of easy credit available. Actually the answer to your question is very close to the answer why value investor should continue to make money if every other investor becomes value investor. But as you very well know not everyone has temperament and patience to wait . So yes if enough people start copying Ashiana & NVR model their returns might suffer, but till then we can relax…
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I am unable to quote exact para from “Understanding Michael Porter”. But in that para Porter said many people think its very easy to copy someone else business model. But there are lots of trade offs. Recall example of Zara vs other retailers. Other retailers cannot stop advertising to increase profits like Zara, because zara stores are located in main area unlike other stores. Also read CHD developers annual report. Its talking [only talking as of now] of following business model like Ashiana housing. But it has high debt, low asset turnover ratio probably because of huge land bank. So if someone has to follow NVR/Ashiana/Berkerley housing model they have to 1) Repay entire debt 2) Sold of excess land bank 3) Build trust which many have destroyed by late deliveries…
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Anil,
Thanks for the detailed writeup.
Of the three barriers to entry Ashiana doesn’t have economies of scale. It does have some supply side advantage, very weak in my opinion, in the form of strong balance sheet. Demand side in the form of trust and strong referral in some parts of the country.
You’re right. At the right price you can ride on the business. When you see the returns mean revert due to competition then we know what to do.
Regards,
Jana
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Other points we can discuss later….
But real estate is not a business which I will buy only for right price. Unless and until one is convinced about long term, one should not invest atleast in real estate….
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Hi jana/ Anil
A real estate company like Ashiana or Poddar has a competitive advantage mainly from the local trust/ branding. A flat or house is a very value purchase for most people – even more than a car. If a builder can promise quality and timely delivery and then stick to it, it will build a reputation over time. Once you build the trust, the benefit accrues in the form of slightly better margins and better sales velocity. Also if a buyer has two equal options, they will choose a known and trusted brand over someone who has gone back on their promise.
Ofcourse the above works on the demand side only ..and that too it is local ..transfering the brand to a new location takes time and effort.
on the supply side i think there is very little difference if any, so most RE companies make fairly similar gross margins.
The other difference is ofcourse the capital allocation ..several RE companies looked at size rather ROC and hence we have wealth destruction in the sector
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Well said Rohit 1) Trust 2) Business model 3) long runway are huge competitive advantages for a real estate company.. Only problem is to find a really intelligent fanatic…
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Rohit,
Agreed and you explained it very well.
Regards,
Jana
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Hi Anil,
Thanks for the interesting Post. I have a question on Ashiana’s valuation (not sure if this is right forum);
A) Given it belongs to low base rate industry, can it be a be a drag on the P/E multiple it can command
OR
B) As number of such well-run companies are far and few in this sector, it will always trade at premium over peers
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Thanks Sai
In short to medium term both the above scenarios are possible..For me lessons from studying NVR which is the only 100 bagger in US home builders in last 20 years suggest that
1) Real estate business is not very much different when compared to other businesses which create wealth. What’s required is high RoE and high ROCE [not necessary consistent every year]
2) Because of the inherent cyclical nature, its needed that real estate companies control their operating leverage [land bank] and financial leverage.
3) Any real estate company which does both will over a period of time will command premium valuation..
To know about fair price of Ashiana, I suggest you read prof. Bakshi lecture on Final relaxo lecture https://fundooprofessor.wordpress.com/2014/03/03/the-relaxo-finale/. Any company which satisfy the quality condition mentioned in that lecture, can be valued as per methodology suggested by Prof….
Note: No way I am suggesting Ashiana satisfy the conditions mentioned in Prof. lecture.. Please do your analysis to arrive at any conclusion…..
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Hi Anil,
Really a great piece of case study NVR is.
I just have one question, if you could clarify it.
I dint understood what kind of OPTIONS in land NVR is getting?
And why it is not possible to do in India?
Regards,
Gaurav.
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Options in land means right [but not obligation] to buy land parcels once NVR is able to enter into a sale contract. Its mostly single occupancy [like villas] and not apartments. In India, land market is not so developed and we do not have organised players who are only in aggregation and development of land with sole purpose of selling it to builders….
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