14% FCF Yield + Undervalued Real Estate

I have a contrarian view on the quality of this industry; surprisingly solid ROIC's & consistent FCF generation, plus real estate carried on books at decades old cost offers downside protection

Ben Graham called the market a “voting machine” in the short-term but a “weighing machine” in the long term. Stocks are often driven by narratives, which cause their prices to move away from intrinsic value, sometimes by wide margins. This creates occasional opportunities for investors who can look past the voting machine’s timeframe (a year or two at most, often much less).

In my opinion, the “narrative” surrounding stocks is actually correct most of the time. The “votes” and the “weight” are accurately in line. But there are two opportunities that create bargains, even in large cap stocks:

1. When the narrative is directionally correct but goes way too far or is too short-term focused. In 2016, the market correctly saw that Apple would face a slower iPhone upgrade cycle; sales were in fact down 8% that year, but the market went way too far — AAPL traded all the way down to 8 P/E net of cash at the low.

2. When the narrative is incorrect. In 2022, homebuilder stocks were hit especially hard as the market worried about high interest rates slowing demand for new homes. In fact, housing was challenged but with inventory at all time lows and existing homeowners unwilling to give up their 3% mortgage, builders were the only ones able to provide supply to a very supply constrained market. Their sales not only hung in better than expected, but actually grew as they took market share.

I’ve found #1 to be more common than #2. The market is right most of the time, but its frequent mood swings create opportunities when the pendulum swings too far. But every once in a while, the market gets it wrong (and when the market corrects its error, it can happen fast: PHM has gone from a low of $36 to $140 in just 2 years, a nearly 4x return in one of the largest and most well-followed homebuilders).

Today’s topic falls into #2: stocks in an industry with a narrative that I think is incorrect.

I think these are quality companies that are more predictable than the market believes. Because of the pessimistic outlook, the stocks offer double digit free cash flow yields — excess cash that should get sent back to shareholders via dividends and buybacks.