The Federal Reserve foresees longer durations of higher interest rates, which could harm the demand for homebuilders due to costly mortgages. Skyline Champion (SKY), a leader in the modular and manufactured homes industry, is anticpated to take a hit with the impending Fed decision. In today’s FA Alpha Daily, let’s examine how Skyline performs better than expected and stands to benefit from increasing rates, in contrast to the market’s expectations.
FA Alpha Daily:
Tuesday Company Specific
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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.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
Today’s highlight, Skyline Champion Corporation (SKY) is one of the top stock picks from FA Alpha 50 this month. To see more stock picks like this, become an FA Alpha and get access to FA Alpha 50.