Dear clients and fellow shareholders:
Stock prices generally continued their decline in the first quarter, with the tech-heavy Nasdaq Composite posting the largest loss among the three major U.S. indices. Our stock portfolio held up well, declining approximately one-half percent.
Generally absent from the constant commentary about rising consumer prices is the effect inflation has on the actual value of financial assets, particularly bonds. Conventional wisdom is that including bonds in a portfolio provides a volatility-dampening balance to the unpredictability and risk of owning stocks. That conventional wisdom is naïve. Since 1982, interest rates have been in an almost constant state of decline, but that long streak is over. Yields on short- and medium-term Treasuries have spiked this year, pushing the U.S. bond market to its largest quarterly decline since 1980. (Reminder: there is an inverse relationship between interest rates and bond prices. That is, when interest rates increase, the prices of bonds decline.) Bond funds almost universally produced losses in the first quarter, with the longest maturity funds posting the worst returns.
As we have repeatedly written over the past year, the recent inflation spike is unlikely to be temporary or transitory. There are several factors at play that we expect will continue to put upward pressure on consumer prices – and, by extension, on interest rates. We have enjoyed a seldom interrupted 40-year bull market for bonds, but that long-term trend of declining interest rates is almost certainly over. The only questions are how long will the correction last and at what level will inflation/interest rates peak?
The war in Ukraine
It always feels a bit crass or cold to write about the financial implications of a catastrophe. The loss of both life and way of life is a human tragedy that infinitely outweighs any monetary considerations. Nonetheless, our job is to make decisions in whatever environment exists – and at present, that environment is one of war in Eastern Europe and the threat of its expansion westward. While there are and will continue to be many significant consequences to the war, ranging from human to geopolitical to economic, we limit our discussion in this letter to items that relate specifically to the Russian economy and its impact on financial markets.
As we noted in our last memo, war (along with its cousin, “minor incursion”) places additional inflationary pressures on the U.S. and around the world. These effects can already be seen in the amplifying inflation in energy, agriculture and other commodities.
In terms of economic muscle, Russia accounts for just 1.7 percent of global GDP, a figure that is comparable to that of the state of Texas. (At 16 percent of the world’s total, U.S. GDP is almost ten times that of Russia’s.) Where Russia punches well above its weight is in the production of natural resources. Russia is the world’s second largest oil producer, supplying one-third of Europe’s oil, half of its coal and 45 percent of its imported gas. Ukraine is a crucial link in the transport of these products, as 80 percent of the natural gas shipped from Russia to Europe passes through pipelines in the war-torn country.
In normal times, the export of oil and gas provides 30 percent of Russia’s GDP and 40-to-50 percent of its federal government revenues. To paraphrase the late John McCain’s curt assessment, Russia is a gas station with nukes. But for much of Europe, Russia is unfortunately the only gas station in town. At present, Europe produces 3.6 million barrels of oil per day, a fraction of the 15 million barrels it consumes. The European Union’s massive dependence on energy imports results in it paying for Russian gas (funding the war) to the tune of $700 million per day.
In addition to upheaval in the world’s oil market, worldwide food stocks are at risk from supply disruptions in potash and ammonia – two of the critical ingredients in fertilizer. Russia and its client-state Belarus account for more than 40 percent of global potash production; Russia alone accounts for more than 22 percent of the world’s ammonia. (Or at least did, prior to this year.)
Making matters worse, natural gas is required to produce nitrogen-based fertilizers – and the skyrocketing price of natural gas has forced several European facilities to halt fertilizer production. As legendary value investor Jeremy Grantham recently highlighted, everything is interconnected to the oil and commodity complex. In other words, energy price increases reliably result in higher prices for food prices across the board.
Transportation issues are also putting pressure on food supplies and prices, as wheat shipments through the Black Sea have already been heavily disrupted. While the oil shortages predominately hit Europe, any food shortages will disproportionately affect emerging markets, as many countries in Africa receive more than 80 percent of their wheat imports from Russia and Ukraine.
Until our purchase of Alphabet (parent of Google) in reaction to the March 2020 covid sell-off, it had been several years since we owned any traditional technology-type companies. For much of the past several years, technology investing has fallen into one of two broad strategies, neither of which we viewed as offering compelling risk/reward ratios. Investors were paying astronomical multiples of earnings for proven tech businesses, or they were buying stocks based on growth projections that almost required a suspension of reason. While we are not opposed to paying for growth, we have found that it is much easier for companies to project rapid growth than it is for them to actually achieve it. Rather than trying to predict the next big thing (an exercise somewhat akin to throwing darts), we would prefer to purchase already successful and profitable companies – including tech companies – at reasonable or even bargain prices. Seldom have we gotten that opportunity in recent years; our Google purchase was an exception.
More recently, however, the post-covid tech bubble appears to be coming to an end. With some of the froth flowing out of tech stocks (roughly 40 percent of Nasdaq stocks have lost half of their value since November), the space is starting to offer more fertile grounds for bargain hunting. One such bargain we recently purchased was financial software company MeridianLink.
MeridianLink (MLNK) is the country’s leading consumer loan origination software company. While large institutions such as Bank of America have in-house, proprietary systems their lenders use when analyzing the creditworthiness of a potential borrower, MLNK offers a cloud-based system for middle-market banks (such as credit unions, including TVA Employees Credit Union and UT Federal Credit Union.) The company’s products automate workflows for its credit union customers, addressing an area in which these smaller institutions have long suffered a disadvantage when trying to compete with much larger, tier 1 banks.
The company generates ridiculously high margins (50 percent operating margins), yet is less susceptible to pricing pressure and renewal risk because its product becomes embedded in its customers’ workflows. It also doesn’t hurt that its contracts are long-term, with autorenewal provisions and early cancellation penalties.
MeridianLink generated $265 million in revenue in 2021 and essentially ignored covid, growing 35 percent annually from 2019 through 2021.
Given the company’s extraordinary annual retention rate (in excess of 100 percent in dollar terms), we think $300 million in 2022 revenue should be easily attainable. The company expects to generate 48 percent EBITDA margins in 2022, even after a substantial increase in its sales and marketing expenses. This should provide $140 million in EBITDA and more than $100 million in free cash flow.
Our purchase price of $19 a share (approximately 14 times free cash flow) should prove a bargain, as the company is poised to continue to compound free cash flow at healthy rates. We think one of our biggest risks in owning MLNK is that a larger company could see the same bargain that we do and buy it before the market price fully reflects the company’s fair value, which we estimate to be $30 per share.
Some housing stats
Even if you are among the vast majority of Americans who have neither bought nor sold a house in the past two years, you may have heard that home prices have skyrocketed in the past 24 months. (Apparently, the only people unaware of the jump in house prices are the government economists tasked with measuring it, as the official CPI calculation reports a 4.1 percent increase in the cost of “shelter” in 2021.)
While interest rates are almost certainly headed higher, we estimate that there have been two million too few single-family homes built in the past decade. Since 1960, the U.S. has averaged building around one million new single-family homes each year. Following the peak of the housing bubble in 2007, the industry spent 13 years building fewer than a million houses a year, even as population grew and the number of households increased by 14 million. Despite future higher mortgage rates, the ongoing supply deficit should provide homebuilders with a substantial runway to continue to generate attractive returns.
Not only is the housing market “underbuilt,” there is also a severe shortage of homes for sale. Across the US, there were only 338,738 active home listings as of February 2022. This is down 25 percent from February 2021 – and more than 66 percent below the February 2020 pre-covid levels. The constrained inventory leaves homebuilders in a prime position to help balance the market and gain share in new listings, as demand for new homes continues to far exceed supply.
Aligning with this theme, we recently purchased shares of homebuilder LGI Homes (LGIH), a company we have previously owned. By coincidence, our purchase price of $118 per share was approximately equal to the price at which we sold the stock less than two years ago. And although we repurchased the shares at 2020 prices, the company’s earnings have increased 70 percent since then.
The biggest risk to this investment is that the company is currently “over-earning.” Not only are average home sales prices much higher than anyone expected, but unprecedented high demand for new homes has reduced the company’s need for marketing expenses. This combination has resulted in historically high margins for all homebuilders, including LGIH.
However, the difference between LGIH and most other homebuilders is that LGIH operated a great business pre-covid. In fact, LGIH was even growing and increasing earnings in the wake of the 2008 housing crisis, when the homebuilding environment was terrible.
Yet, even if the company’s earnings are abnormally high, our purchase price of less than 7 times earnings is a bargain. We estimate that LGIH will have generated $50 per share of incremental equity capital in the three years from 2020-2022. If we assume the company can reinvest that capital at a 20 percent return on equity (well below the company’s recent returns) that incremental capital would produce an additional $10 per share in normalized earnings. Combined with the company’s pre-covid earnings profile, LGIH should continue generating more than $17 of earnings per share, even assuming a significant profit normalization.
In three years, we expect LGIH to be generating more than $20 per share in earnings, even assuming complete earnings normalization back to historical trends. At 12 times earnings (it generally trades at that price at some point every year), it would be a $240 stock, which equates to a more than 25 percent annual return on our purchase price of $118 per share.
Green Brick Partners
When we added LGIH to the portfolio in February, we only purchased a two percent position in the stock, knowing that our intention was to add an additional two percent to the industry if homebuilder prices remained attractive or weakened any further. In late March, we allocated another two percent of our stock portfolio to Green Brick Partners (GRBK), a homebuilder and land developer.
Similar to LGIH, Green Brick trades at a discount to its publicly traded homebuilder comparables (which trade at a 50 percent discount to the S&P 500), despite having a much better growth profile and much higher returns on equity.
Green Brick’s land development operation (its original, legacy business) acquires and develops raw land, which includes entitlement and land readiness – things like grading, sewage, roads and lot planning. This process takes several years, given the complexities of zoning and permitting.
After preparing a property for building, the company sells finished lots to either its fully-owned homebuilder partners or to third-party homebuilders. Green Brick’s six fully-owned homebuilders are located in the central region, which includes the high growth U.S. metropolitan areas of Dallas, Atlanta and parts of Florida. Dallas and Atlanta, two areas that contribute most of Green Brick’s profits, are consistently included in the U.S. Census Bureau list of ten most active residential real estate markets.
Green Brick’s differentiating business strategy comes from its ability to combine its legacy land acquisition and development expertise with homebuilding operations to maximize profitability. While many national builders purchase developed land or manage their land inventory through lot options (LGIH’s primary strategy), GRBK acquires and develops its own land, which it then can distribute to its builder partners. While GRBK does not have the scale of the largest homebuilders, it does have local relationships and significant market share in its major markets.
The company also operates a more standard homebuilding model through its wholly-owned Trophy Homes division. From a scratch start in late 2018, the company has gradually grown Trophy Homes to more than 35 percent of home closings revenue. Given the higher absorption rate in Trophy communities and better margin profile, this business is generating superior returns to Green Brick’s legacy business and continues to become an increasingly larger part of the whole.
Based on our valuation, we think Green Brick shares are worth at least $30 per share, an almost 50 percent premium to our purchase price of $20.80.
We are pleased to introduce Beau Fancher, our newest team member at Moon Capital Management. Beau is an attorney whose previous career stops include the U.S. Department of State and the Tennessee Attorney General’s office. He has a master’s degree from the University of St. Andrews (Scotland), a law degree from the University of Memphis and a bachelor’s degree from Samford University. Beau and his wife Beth (a dentist in Morristown) are the parents of two daughters, ages four and two. He looks forward to meeting everyone.