This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Cyclical Stocks Are Just a Bad Idea Right Now…
Oil prices tumbled again yesterday. Prices of Western Texas Intermediate shed 6% within minutes before the opening bell, sending stocks from blue chip Exxon Mobil (XOM) to meme stock Indonesia Energy Corp (INDO) plummeting.
There’s a reason why the Profit & Protection core list contains zero oil-producing stocks.
These headline-grabbing moves are only part of a broader collapse in cyclical assets. Lumber prices have fallen 50% over the past several months. And share prices of lithium and rare earth miners — once considered growth catalysts for the electric vehicle industry — are moving in reverse. Prices of lithium miner Sociedad Quimica y Minera de Chile (SQM) are down 30% since late May.
But fears of a recession are creating fantastic deals in countercyclical companies that work in cyclical ones. Markets often penalize entire sectors without considering the varying qualities of companies within them.
Today, we will consider two tech-based firms that have fallen in lockstep with other real estate stocks. Thanks to their strong businesses, these stocks have become picks that investors need to watch.
2 Real Estate Tech Stocks Ready for a Resurgance
On Thursday, I introduced five high-potential tech companies in the real estate market:
- eXp World Holdings (EXPI). A+
- Airbnb (ABNB). A
- Redfin Corp (RDFN). A
- Zillow Group (ZG). B+
- Appfolio (APPF). B+
These companies have remained fast growers despite turbulence in the markets they serve. All are expected to churn out double-digit earnings growth over the next several years, earning them high marks in the quantitative Profit & Protection stock grading system.
The five firms are also asset-light businesses that can generate high returns on capital invested (ROIC) — an essential ingredient for my Perpetual Money Machine strategy. By avoiding the capital-intensive work of home construction, these service-oriented firms are far better at turning small investments into significant profits.
But the share prices of these high-flying companies have been penalized for their proximity to the real estate market. Just as many successful companies lost value in the early 2000s, fears of contagion today are driving shares of high-quality tech outfits into yard-sale territory.
Long-Term Trade: Appfolio (APPF)
Nowhere is this clearer than at Appfolio (APPF), a tech firm providing building management software to real estate companies.
The AppFolio Property Manager serves as a recording system for building management services. The system logs transactions, leasing inquiries, work orders, inspections and other day-to-day tasks. AppFolio also offers value added services, including electronic payment services, tenant screening and insurance products.
In other words, if you’ve ever rented an apartment, there’s a good chance you’ve run into Appfolio or one of its competitors.
And business has been swift.
Appfolio has nearly doubled its revenues since 2019. Analysts expect another 20% increase by 2023. EBITDA earnings should soar 6x by 2024, earning the firm one of the top “growth” grades in the Profit & Protection scoring system.
There are five reasons to remain bullish about the firm:
- Minimal Exposure to Real Estate Prices. Appfolio charges landlords on a per-unit basis rather than on the value of the underlying real estate. Real estate management companies still need CRM software during market pullbacks.
- Software Quality. In 2019, Garner ranked the firm as one of the top Frontrunners for Residential Property Management. Software consulting firm Software Connect named it “one of the best property management software options on the market.”
- Trend Towards Renting. A study by iPropertyManagement found that only 64% of Americans now own their homes, a 2.8% decline from the year before. Homebuilders are taking note; The U.S. Census Bureau found that multifamily housing starts in May 2022 rose 19.8% compared to a year earlier, while single-family housing declined -7.9%.
- Covid-19 Behavior. The Covid-19 pandemic has increased the demand for touchless services. Today, even smaller landlords are turning to AppFolio’s software to manage payment and billing for 1 or 2 properties.
- Scalability. Appfolio’s software-based business means it can scale quickly to meet demand. The company has managed to maintain positive free cash flow since 2017, even while doubling revenues. No homebuilder can expect to do the same.
The firm’s valuation is also reasonable considering its rapid growth. In 2020, buyout firm Thoma Bravo took slower-growing rival RealPage private in an all-cash $10.2 billion deal. A similar top-line valuation would value Appfolio at $113 per share, a 25% upside. And once its faster growth is factored in, Appfolio’s valuation is closer to $150 per share.
However, Appfolio only scores a “B+” in the overall rankings due to its middling value and quality scores. That suggests APPF will take longer than the 12-month holding period for gains to come. Only patient investors should apply.
Tactical Trade: Redfin Corp (RDFN)
Meanwhile, shorter-term traders should consider Redfin (RDFN), a company that scores an “A” grade in the Profit & Protection system. This suggests Redfin’s shares will outperform over the next twelve months.
Investors have plenty of reasons to expect a near-term recovery from a bottom-up standpoint. Since 2021, shares of this tech-focused real estate brokerage have collapsed from $98 to $8, a number its shareholders would prefer to forget. That bellyflop earns Redfin an “A+” in momentum as a turnaround play.
Then there’s the market’s perception of Redfin’s business.
Markets have long expected a decline in real estate activity. The Mortgage Bankers Association expects mortgage refinances to decline from $2.3 trillion in 2021 to $730 billion. Home sales will likely slip 6% this year.
But Redfin’s business doesn’t rely on mortgage refinancing or the number of homes sold (Its loss-making mortgage business only exists as a convenience to homebuyers).
Instead, the company’s top line depends on the total volume of housing transacted. Analysts expect that figure to rise 6% to 8% as increasing home prices offset a decline in the number of units sold.
Redfin’s costs are relatively fixed. The company treats its agents as salaried employees rather than commission-based affiliates. That means the company can increase sales without incurring a comparable rise in expenses. Investors should expect earnings surprises to drive up shares over the next several quarters.
Redfin, however, remains a tactical trade rather than a core Profit & Protection holding. The company has struggled to turn its tech-based capabilities into a winning formula — rival Compass Group (COMP) is now four times larger. And Redfin remained deeply unprofitable in 2021 — one of the best years on record for real estate brokerages. Its overhead costs are still too high for a tech company.
Still, the company’s rock-bottom valuation of 0.37x price-to-forward sales gives it the potential for 3x to 5x returns. Though it’s not a stock you want to hold forever, Redfin is a solid play for those seeking quick gains.
Luke Lango’s Bonus Pick
And finally, Luke Lango is back with information about a tech-based real estate company that beat Zillow (Z) at its own game.
Buying and selling a home is one of the only shopping processes in the world that has yet to be digitized, and by extension, streamlined and made hyperefficient. But now all that changes… One small, emerging tech company… is pioneering a breakthrough, e-commerce platform across the entire U.S. real estate market… And in so doing, will finally leapfrog the $1.6 TRILLION real estate industry into the digital era – and eventually turn into the “Amazon of houses.”
Click here to learn more about Luke’s pick.
Why Are Houses So Expensive?
On Tuesday, I noted how the U.S. housing market will likely face a 1950s-style price slowdown than a 2008 crash. Tight inventory and low leverage mean that current homeowners are less stretched than in the mid-2000s.
I also noted that home prices are at some of their most unaffordable levels on record.
“A renter must now land in the top 16% to 21% of U.S. incomes to meet the typical ‘28% of gross income’ housing guideline.”
These two factors seem to run in opposite directions. Why is housing so expensive when people can’t afford it?
The answer comes down to the size of houses.
According to the U.S. Census Bureau, the average American home size has increased from 1,660 square feet in 1973 to 2,687 square feet today. By some estimates, the average home was only 1,048 square feet in the 1920s.
Meanwhile, construction costs have remained stable on an inflation-adjusted price-per-square-foot basis.
According to the American Enterprise Institute, the average price per square foot for new U.S. houses sold has remained close to $116 since 1973.
Attitudes to bigger houses are slowly changing. A New York Times article in 2019 noted how many cities are pushing back against laws prohibiting anything other than detached single-family homes. And migration from high-cost cities to lower-cost ones has sped up since 2020.
Yet, these changes will take time to bring housing costs down. Until then, the U.S. seems stuck in a stagnating real estate market that’s too expensive for new buyers and not rising fast enough for homeowners to profit. Better to stick with stock market investing.
P.S. Do you want to hear more about cryptocurrencies? Penny stocks? Options? Leave me a note at feedback@investorplace.com or connect with me on LinkedIn and let me know what you’d like to see.
