Thoughts on LGIH.
What do they do? Well, let’s get a little bit more basic. They manufacture. Like all manufacturers, they buy stuff, they add value, they sell the stuff in a different form. For LGIH, the primary stuff is raw land. They buy raw land, add value by subdividing it into lots. They add more value by buying other stuff that gets turned into houses. They have two limits to business growth. One is raw land, the other is customers. LGIH targets apartment dwellers that are convinced of the value of home ownership. This is a small demographic.
LGIH started out in Houston. They became experts in the Houston market. They know the tastes in housing. They know the planning commission and the issues. They know the building inspectors, the sub-contractors, the appliance vendors, etc. It must become very routine and they must have become very efficient. But there is a limit to household formation and apartment dweller demographics.
Having the ability and desire to grow, LGIH expanded to Dallas/Ft. Worth, learns the growth trends, planning commission, etc., etc., rinse and repeat in Austin and San Antonio.
Texas ain’t big enough for the both of us :), so fairly rapidly they expand to Phoenix/Tucson, the Carolinas and Florida/Georgia. I would like to make two points about this. One, it is similar to growth by acquisition. Two, each of these markets has is own saturation point—or a point at which growth has to slow to population growth.
Unlike other kinds of manufacturing, this type of home building requires inventory that is held for years. There is no ‘just in time’ delivery of land. This process is subdivision creation and the process is three to five years. I suppose that this is good news/bad news. You could say that this provides 3 to 5 year’s visibility. You could also say that this requires a lot of debt and the uncertainty of market conditions over an extended period, i.e., uncertainty, lack of visibility as to the local economy, interest rates…
My theory on LGIH is that they no longer have exceptional growth in Texas. Their growth is not organic to Texas. The growth is in the new markets. The Texas market was so large that it takes three distinctly different markets to provide growth at recently experienced rates. So what should be watched with respect to LGIH? Well, the big item is the number of lots owned or controlled, which LGIH reports quarterly. The number of lots, the house inventory and the homes sold, all these region by region. Of course we would be watching revenue and earnings growth, but the early warning sign for LGIH would be a slowdown of lots under control. At least, that is my theory.
This brings me to an discussion on the investment method of this board (which I am using more and more). I’d like to examine a danger of the method, and how it relates to LGIH. The Method is finding companies that are growing rapidly and sporting a relatively low valuation as measured primarily—or initially—by p/e. Of course other factors are examined before significant investing, and one of those is ‘room to grow’ or ‘addressable market’. This is modified buy and hold. In my mind, one of the inherent modifications is that the growth rates are of a magnitude that realistically the holding period of even 3 to 5 years is problematic. Why? Because the market eventually (quickly?) catches on.
Here is my cyclic view, call it the 1-yearPEG version of the hype-cycle. Stage one, a company somewhere in the market haystack begins to make good profit and starts growing. Stage two, this needle of a company is discovered by a denizen of this board and we (after doing our own due diligence) begin to accumulate shares. Stage three, the earning growth continues, the stock price increases but by less than the earnings and the p/e drops. Stage four, the woods contain hunters armed with stock screens which also locate our company and the stock price now increases at rate similar to earnings. The p/e is stable. Stage five, it is like opening day of hunting season, the woods are full of momentum hunters, the earnings are increasing but the stock price is increasing faster, the p/e rises. We are all congratulating each other and calculating the portfolio year-to-date percentage increase. Stage six, The Event happens, the momentum hunters flee the woods, we take a p/e compression bath. The late comers to the party are looking at 25+% losses and wondering what is so great about these (sorry to use the term) Saul Stocks. Color me ‘I bought SWKS and AMBA in June’.
Who knows what The Event might be. But likely it is the hint of slowing growth, or something raising the fear of slowing growth. If LGIH gets to the opening day stage five, it could be something like flat sales in, say, the San Antonio and Tucson markets. Maybe a fifty basis point rise in interest rates where a twenty-five point rise was expected.
So, back to LGIH. One could argue that the p/e is low because it is a home builder and home builders have low p/e’s. Maybe they have low p/e’s because they carry high debt and have a long manufacturing cycle, holding a lot of inventory with unit sale price sensitive to overall economy (demand) and interest rate (demand and cost of carrying inventory). Or, it could be that home builders typical p/e is low because typical home builders are low growth. Take your pick. Certainly there is a strong argument that LGIH ought to have a higher p/e than other home builders due to its faster growth. They build a different type of house for a specific demographic and this has been working for them. I’m o.k. with that. I’m in the ‘if it has been working, why won’t it continue to work’ camp.
I have small position in LGIH, smaller %-age than Saul. I will increase it if earnings grow and I get similar or better value points. But I will be watching several things. I’ll be monitoring p/e expansion on at least a weekly basis. I’ll check the land inventory every quarter. If it begins to look like stage 5, I would reduce exposure. Likewise if inventory stagnates, because you can’t build increasing numbers of houses without increasing numbers of lots.
There was a concern raised that the management is young. I’m not concerned about that. 40’s might be young for executives, generally speaking. But these guys started in this business in their 20’s. They didn’t just fall off the turnip truck. I consider this industry to be uncomplicated. As I stated above I have the concern that this is somewhat similar to growth by acquisition. They are acquiring new geographic markets and real estate is very much location, location, location. They need to get it right in each new city. But I’m o.k. with young, energetic 40-ish leadership.
KC, long LGIH, AMBA, SWKS, SKX, INBK, BOFI, CASY, SNCR, ABMD, PAYC and about 50 others (sigh).
