Investor Essentials Daily

High interest rates are benefitting this homebuilding company

November 21, 2023

Homebuilders have turned out to be more resilient to high interest rates than most people expected. The expectation was that they were going to suffer as mortgage rates increased.

What happened is that homeowners got scared to buy homes, so they didn’t sell theirs, leaving the market to newly constructed homes.

The Federal Reserve is signaling that interest rates are going to be higher for longer. Thus, with borrowing getting too costly and home affordability getting low, one could expect people to look for more affordable homes.

This is where Skyline Champion (SKY) comes in with its affordable modular homes. The market thinks demand will fall but rates are staying high for the foreseeable future and Skyline stands to benefit.

Thus, Skyline Champion showed up on our screen. The company makes a great FA Alpha 50 name due to its potential for high returns and low expectations from the market.

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High interest rates typically aren’t the best for homebuilders. Higher rates make mortgages more expensive, reducing the affordability of new homes for potential buyers.

This decreased affordability can lead to a drop in demand for new homes, directly impacting homebuilders’ sales and revenues.

Additionally, high interest rates increase the cost of borrowing for homebuilders themselves, who often rely on loans for the construction and development of new properties, thus raising their operational costs.

However, it seems that they’ve been able to avoid these problems this year.

In the first half of this year, builder confidence surged due to sustained demand for new homes. This demand was fueled by a shortage of available existing homes, even though the Fed raised interest rates by a total of 525 basis points since March 2022, driving mortgage rates above 7% recently.

Numerous homeowners, already benefiting from low mortgage rates, were hesitant to list their existing homes for sale. They were deterred by the high costs of financing options.

This increased demand for homes has allowed for strong performance from homebuilders. That is why the S&P Homebuilders Select Industry Index has gone up by 27% year-to-date (YTD).

Now, the Fed has signaled that they’re going to be keeping rates higher for longer. This means homeowners are happy to stay in their homes for an extended period.

However, high rates are still straining buyers’ budgets, so it seems prudent to expect home buyers to look for more affordable options.

This is where Skyline Champion (SKY) comes in.

Skyline is a leader in the modular and manufactured homes industry. These homes are known for their affordability and are constructed in controlled factory environments before being transported to their final location for assembly and installation.

As interest rates rise, making traditional mortgages more expensive, potential homebuyers might turn to more cost-effective housing options like those provided by Skyline Champion.

This shift in consumer preference can lead to increased demand for the company’s products, potentially boosting sales and revenue despite the broader challenges in the housing market caused by higher interest rates.

High rates have actually already been improving Skyline’s performance and profitability. The company’s return on assets (“ROA”) jumped from 34.7% in 2021 to 65% in 2022 and then to 80% in 2023.

The chart shows that the company performed incredibly well during a high interest rate environment. As these high rates continue, Skyline is likely to continue performing well.

And yet, the market fails to recognize this opportunity.

We can see this through our Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at a company’s current stock price. From there, we can calculate what the market expects from the company’s future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

At the current stock price, the market expects the company’s ROA to fall below 25%, assuming the demand will collapse.

Given the current high interest rate climate, the Fed’s goal is to keep rates higher for longer. Considering that and the company’s leading position in affordable homes, these expectations seem overly pessimistic.

Skyline has substantial potential to scale its operations and continue benefiting from this high interest rate environment.

That is why Skyline showed up on our screen. The company makes a great FA Alpha 50 name due to its potential for high returns and low expectations from the market.

Throughout financial market history, many of the world’s most successful investors have been candid in their belief that Generally Accepted Accounting Principles (“GAAP”) distort economic reality.

Warren Buffett, for example, once said investors should “concentrate on the world of companies, not arcane accounting mathematics.”

Investors who neglect the very real issues with as-reported accounting can find themselves caught up in investing with the crowd, blindly following hot “themes” without a thorough grasp of how to understand the businesses in question.

The only true way to focus on the “world of companies,” as Buffett suggests investors do, is to present a clear picture of how a business operates, something that can only be done by adjusting financial statements to reflect the arbitrary nature of certain accounting rules that leave much to discretion.

The world’s best investors understand the need to make these adjustments, which allows them to focus not on picking out the most popular companies but rather on looking for great names in sleepy areas that the market isn’t paying much attention to. From there, the goal is to then identify quality companies with significant growth potential at reasonable prices.

That’s exactly what we’ve set out to do with the FA Alpha, our monthly list of 50 companies that rank at the top for quality, high growth, and low valuations.

This list has outperformed the market by 300 basis points per year for over 20 years now, effectively doubling the performance of the market by focusing on the real fundamentals and valuations of companies with our proprietary Uniform Accounting framework.

See for yourself below.

To see the other 49 names on the list, click here.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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