By Paul Farah
In the first edition of Investing chronicles, Lockstep CEO Paul Farah shares the importance of having a clear investment thesis – your rationale for buying a stock. He also tackles one of the most challenging aspects of investing – knowing when to sell a stock.*
Several long-standing Lockstep Community members recently contacted me concerning Legacy Housing Corp (LEGH), a company that has been a part of my portfolio since its inception, following its disappointing fourth-quarter (Q4) 2023 results. Understandably, these members wanted to know if it was time to sell LEGH.
By addressing their concerns, I aim to provide a response that will benefit you as well by tackling one of the most challenging aspects of investing – knowing when to sell a stock.
Company description
Established in 2005, LEGH is the sixth-largest producer of manufactured homes in the United States. Specialising in the construction, sale, and financing of these homes, the company primarily operates in the southern United States, with over 50% of its sales originating from Texas, 12% from Georgia, and 9% from Louisiana.
Targeting customers with household incomes below $75 000 per year, representing over 50% of all US households, LEGH constructs homes in its three factories, sells them through independent retailers and company-owned outlets, and offers customised financing solutions.
How the company earns its money
LEGH generates revenue primarily from product sales (manufactured homes) and its financing business. As of full year (FY) 2023, 76% of its revenue stemmed from product sales, 20% from financing, and 4% from “other” sources.
LEGH’s revenue more than doubled from 2016 to 2022, meaning it has been growing at roughly 15% per year, which is not bad.
A terrible fourth quarter (Q4)
In 2023, LEGH experienced a significant decline in revenue, down over -26% year-on-year (YoY), with Q4 2023 revenue dropping over -50% compared to Q4 2022. The poor Q4 results are due to 1) lower housing demand caused by higher interest rates and 2) a significant one-off gain in Q4 2022 due to a change in revenue recognition.
Consequently, the company’s share price fell from over $25 per share to under $20 per share, prompting concerns. I bought LEGH at $16.51 per share, and given the bad Q4 2023 results, is it time to sell the stock, secure my gains, and deem it a victory (albeit a minor one)?
When to sell an investment
I believe there are only three valid reasons to sell a stock:
- Overvaluation: When the share price appreciates to a level where the company is significantly overvalued.
- Opportunity cost: When better investment opportunities are available elsewhere.
- Change in investment thesis: When the original reason for investing no longer holds true.
Let’s have a look at each and see if any applies to LEGH
Overvaluation
I was initially attracted to LEGH because it was significantly undervalued relative to its peers. Besides being a relatively small, unknown business, the company had issues with late filings of its financial reports, which the market punished by selling its shares down. After some digging, it was clear the late filings were due to non-material issues, and the market overreacted, providing an opportunity to invest.Over time, management resolved the financial reporting issues. As a result, the share price appreciated, from my initial purchase price of $16.51 per share to a high of $26.50 per share. Even with this significant gain in value, LEGH was still only worth 12x operating profit while profit had been growing.
Therefore, I should NOT sell because it is overvalued.
Opportunity cost
Another reason for selling is that better investments are available than the one you are currently in.For a while now, I have held almost 5% of my portfolio in cash, and with the indices at all-time highs, I am not overly confident that now is the time to look for new investments.
Therefore, I am NOT selling because I need the money to invest in better opportunities elsewhere.
- Change in investment thesis
This brings us to the final reason for selling – perhaps the investment thesis is no longer valid.
Why do you need an investment thesis?
For those acquainted with my investment approach, I emphasise the importance of having a clear reason for investing before purchasing shares. This planning becomes crucial when faced with inevitable setbacks, enabling you to steer clear of emotionally driven decisions – a pitfall in investing.
Each investment carries its unique thesis, and while LEGH’s financial reporting issues presented an opportunity, they were not the sole reason for my investment.
LEGH’s investment thesis – The US housing deficit
The United States currently grapples with a significant housing shortage.
Since the 2008 housing crisis, the pace of new home construction has lagged far behind the demand. Estimates suggest a deficit ranging from 1.5 to 6 million homes nationwide, depending on the source. Moreover, Texas – LEGH’s primary source of income – has one of the most significant deficits in the country.
Data source: FRED Economic Data
As housing prices continue to increase due to supply constraints, more households are priced out of traditional housing and are turning to manufactured homes like LEGH’s. Consequently, companies like LEGH should benefit from a multi-year tailwind driven by sustained demand for homes and manufactured housing in its region.
Is the thesis broken?
Despite the disappointing Q4 2023 results, growth doesn’t happen in a straight line, and there will always be obstacles to overcome, such as the current high-interest-rate environment. But thanks to my investment thesis, I don't have to act on impulse. Instead, I stepped back, removed emotions from the equation, and comprehensively reassessed my investment.
After meticulously examining the annual report, thoroughly analysing competitors’ recent performances and even talking with the company’s CEO just last week, one thing has become abundantly clear – there’s no need to panic.
The US housing shortage persists, and people will always want homes. Interest rates will come down, and when they do, LEGH should be well-positioned to capitalise on that demand pickup.
My next move
Experiencing a decline in the value of your investment is always painful, but such decreases can present opportunities. After doing my homework, I feel confident in my work and believe LEGH is a high-quality company in an industry with a significant tailwind behind it.
Therefore, instead of selling, I am looking to increase my investment in LEGH and will likely buy more shares if the share price retreats to $20 per share or below.
Interestingly, I’m not alone in this sentiment, as the company itself is also buying shares.
Summary
Investing is inherently emotional because it involves our money.
Buying is easy, but as soon as we do, our emotions take over, making selling one of the more challenging aspects of investing. It is critical to have a game plan for selling to minimise reacting from a place of emotion and instead act with logical reasoning.
My approach to selling involves the following:
- Sell when a company becomes significantly overvalued.
Sell when better investment opportunities are available.
OR
- Sell when the original investment thesis is no longer valid.
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*Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and is for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas,and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.
