The fifth Contrarian Investor Virtual Conference is over, and investors are mulling over the stock picks that were presented. Sean Stannard-Stockton of Ensemble Capital Management was among the presenters. He offered his long thesis for First American Financial, a title insurance company.
Details on First American Financial
First American has a $5.8 billion market capitalization. The company insures titles, making sure they are free and clear and actually owned by the person who’s selling a house. Title insurance companies enable the housing market to function by providing a service that the government doesn’t.
First American Financial and Fidelity National are the two major players in the market, holding well over half of it between the two of them. Stannard-Stockton describes First American Financial as a “idiosyncratic business” that’s better understood as offering a fee-based financial service instead of insurance. The loss ratio on titles is low at only 4% or 5%.
Stannard-Stockton explained that the company is a “tollbooth offering a mission critical service at a cost that is a tiny portion of the overall transaction. First American is only covered by five analysts, and usually, only one or two update their estimates intra-quarter. Between April and mid-July, there were no updates to 2020 revenue estimates from any analysts even though that was one of the most dynamic times for the housing market.
Stannard-Stockton said some hedge funds have taken activist runs at First American, calling title insurance a license to steal, but he believes that is a fundamental misunderstanding of what the company does. He sees First American Financial as similar to a utility company because it is providing a necessary service that the government doesn’t provide.
Stannard-Stockton said they don’t focus on environmental, social and governance (ESG) issues when making investments, but there is one issue that makes First American ESG-friendly. The company committed in April to not making any layoffs through the end of the second quarter despite the pandemic.
Management took a long-term perspective and said although the move would negatively impact the company’s short-term results, the benefits to their people, customers and shareholders are worth the investment.
On the other hand, competitor Fidelity National laid off 18% of its field operations and 11% of its corporate staff, saying it was committed to maximizing profitability at all times. Stannard-Stockton said they don’t want companies that maximize profitability at all times. They want long-term profitability, which means sometimes short-term results take a hit for the benefit of the long term.
It turned out to be a good thing that First American didn’t lay off staff because although existing home sales dropped off a cliff early in the pandemic, there was a massive rebound, and home sales rose dramatically on a year-over-year basis. Stannard-Stockton said some of the summer strength was a delay in spring sales, but the sales strength has continued into the rest of the year.
He also outlined positive secular trends for the housing market. He noted that the population got bigger, but home sale levels have remained steady. The market returned to pre-bubble activity levels, but the entire economy and population has grown, which means housing activity has a lot of room to grow.
Stannard-Stockton noted that the peak year for Millennial births was 1990, so those people are turning 30 now, which is about when most people buy their first home. People ages 25 to 35 are entering the home buying market at a much higher level now than seen in recent years.
Although some argue that the pandemic set Millennials back, Stannard-Stockton said his research shows that homeowners are doing OK, but renters are in a depression. Thus, the home buying market should remain strong. In fact, he argues that some are saving money toward a down payment because they’re not traveling.
Where will the housing market go from here?
Stannard-Stockton considered why housing activity is depressed, and he noted that the number of years people live in a house in the U.S. has gone up a lot, moving toward 10 years. He said the question is whether housing activity has been depressed because people are settling down or whether they are simply stuck in their homes and can’t move.
In the early years after the housing bubble, many people had negative equity in their homes. However, he said the real estate market is unique because every buyer is a seller, and every seller is a buyer. Stannard-Stockton argues that the housing market is now “primed and coiled” to increase after a decade of low activity levels, and the pandemic is causing that trigger.
What is First American worth?
He said First American Financial is trading at less than 10 times PE. While the company won’t offer a high return on invested capital, it is very stable. He thinks in a more normalized environment, a valuation in the low teams would be appropriate, but the current depression on earnings has the stock “deeply cheap.”
The shares have been trading at around $50, but Stannard-Stockton believes they should be trading at around 13 times 2019 earnings, which would be closer to $75. Shares of First American Financial climbed by about 1% after he presented his thesis at the Contrarian Investor Virtual Conference.