Six new stocks make our Exec Comp Aligned With ROIC Model Portfolio this month. March’s Exec Comp Aligned With ROIC Model Portfolio was made available to members on 3/15/17.
Recap from February’s Picks
Our Exec Comp Aligned With ROIC Model Portfolio (-1.5%) underperformed the S&P 500 (+1.0%) last month. The best performing stock in the portfolio was Children’s Place (PLCE), which was up 13%. Overall, five out of the 15 Exec Comp Aligned With ROIC Stocks outperformed the S&P in February.
Since inception, this model portfolio is up 24% while the S&P 500 is up 12%.
Value Partners Asia ex-Japan Equity Fund has delivered a 60.7% return since its inception three years ago. In comparison, the MSCI All Counties Asia (ex-Japan) index has returned just 34% over the same period. The fund, which targets what it calls the best-in-class companies in "growth-like" areas of the market, such as information technology and Read More
The success of the Exec Comp Aligned With ROIC Model Portfolio highlights the value of our forensic accounting (featured in Barron’s). Return on invested capital (ROIC) is the primary driver of shareholder value creation. By analyzing footnotes in SEC filings, we are able to calculate an accurate and comparable ROIC for 3000+ companies under coverage.
This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating and align executive compensation with improving ROIC. We think this combination provides a uniquely well-screened list of long ideas.
NVR Inc. is one of the additions to our Exec Comp Aligned With ROIC Model Portfolio in March.
Since 2011, NVR has grown after-tax profits (NOPAT) by 26% compounded annually. Per Figure 1, NVR’s NOPAT margin is currently just under 8%, which is up from 5% in 2011.
Figure 1: Growing Profits & Margins
Sources: New Constructs, LLC and company filings
NVR currently earns a top-quintile 21% return on invested capital (ROIC) and has generated a cumulative $821 million (11% of market cap) in free cash flow over the past five years.
Return on capital has been part of NVR’s executive compensation plan since 2014. In 2016, half of NVR’s equity grants were tied to the firm’s return on capital performance. For performance-based options, vesting is subject to NVR’s return on capital relative to its peer group.
The focus on return on capital helps ensure executives are good stewards of capital. Despite only adding return on capital to its compensation plan in 2014, NVR has a history of improving its ROIC. Per Figure 2, NVR’s ROIC has improved from 12% in 2011 to its current 21%. Longer-term, NVR has earned a double digit ROIC in every year of our model, which dates back to 1998.
Figure 2: Improving ROIC Improves Shareholder Value
Sources: New Constructs, LLC and company filings
We’ve detailed ways in which ROIC is directly correlated to changes in shareholder value here. NVR’s use of return on capital to measure performance ensures executives’ interests are aligned with shareholders’ interests.
NVR Remains Undervalued Despite Strong Fundamentals
Investors have clearly rewarded NVR for its improving fundamentals and the stock is up 176% over the past five years, while the S&P 500 is up 69%. Despite this increase in stock price, NVR remains undervalued.
At its current price of $2,016/share, NVR has a price to economic book value (PEBV) ratio of 0.8. This ratio means the market expects NVR’s NOPAT to permanently decline by 20%. This expectation seems overly pessimistic for a firm that has grown NOPAT by 26% compounded annually since 2011.
If NVR can maintain current NOPAT margins (7.5%) and grow NOPAT by just 8% compounded annually over the next five years, the stock is worth $3,594/share today – a 78% upside.
Impacts of Footnotes Adjustments and Forensic Accounting
Our robo-analyst technology enables us to perform forensic accounting with scale and provide the research needed to fulfill fiduciary duties.
In order to derive the true recurring cash flows, an accurate invested capital, and an accurate shareholder value, we made the following adjustments to NVR’s 2016 10-K:
Income Statement: we made $44 million of adjustments, with a net effect of removing $14 million in non-operating expense (<1% of revenue). We removed $15 million in non-operating income and $29 million in non-operating expenses. You can see all the adjustments made to NVR’s income statement here.
Balance Sheet: we made $1.4 billion of adjustments to calculate invested capital with a net increase of $770 million. One of the largest adjustments was $390 million due to asset write-downs. This adjustment represented 30% of reported net assets. You can see all the adjustments made to NVR’s balance sheet here.
Valuation: we made $1.4 billion of adjustments with a net effect of decreasing shareholder value by $1.3 billion. One of the most notable adjustments to shareholder value was the removal of $583 million in outstanding employee stock options. This adjustment represents 8% of NVR’s market cap. Despite the decrease in shareholder value, NVR remains undervalued.
This article originally published on March 16, 2017.
Disclosure: David Trainer, Kyle Guske II, and Kyle Martone receive no compensation to write about any specific stock, style, or theme.
Article by Kyle Guske II, New Constructs