Monday, 12 November 2012

Home Capital Group - Investment Analysis

There is currently a low-risk, high-growth company, with a glorious track record and bright long-term future.  Here's the punch line: it's a sub-prime mortgage lender.  But this is not a joke.  The improbable-sounding company is Home Capital Group, a Canadian mortgage lender that focuses on niches ignored by Canada's dominant handful of big banks.  Most of Home Capital Group's customers are small business owners, immigrants, and the self-employed.
Qualifying business owners typically have significant assets and cash flow, but they may not have the required tax forms to prove their income.  That’s reason enough for the high-volume banks to decline their mortgage application.  HCG, however, is willing to take a careful, detailed look at the businesses in question, and the individuals operating them, and often find low risk opportunities to lend.

The second major group of customers is immigrants, who typically do not qualify for standard mortgages until they have lived in Canada for several years.  Immigrants are very low-risk customers: they simply don't leave family, friends and home to fail.  Invariably, they're willing to work sixty-hour weeks (or more) if necessary to make their mortgage payments.  Moreover, many of them were prime mortgage customers in their home country, and have an established track record for reliability.
50% of Home Capital Group's portfolio is composed of self-employed workers, who account for 16% of Canada's workforce.  Not only is this group growing quickly, it's well off.  On average, the self-employed are worth 2.7x more than their clock-punching counterparts.  Because of the "on again, off again" nature of such work, though, not all institutions are comfortable lending to this group, despite its appealing elements.  Once again, HCG is willing to spend the time trying to separate the reliable from the unpredictable, with enviable results.

Because the aspiring homeowners that the company caters to have few other options, Home Capital Group commands a sub-prime interest rate, but the quality of the mortgage holders is anything but sub-prime.  Just the opposite, in fact.  Measures of risk remain low - often lower even that the big banks - including the percentage of impaired loans, write-offs, and loans in arrears.  Though Home's customers may get a chance to own a home that they otherwise wouldn't, it's worth noting that the company is not engaged in charity work: it turns down most applicants.
If the returns are so great, though, won't the big banks move in?  It's unlikely.  The large institutions take a cookie-cutter approach to lending, and there's little sign that they are interested in, or able to, moving into Home Capital Group's niches.  In the unlikely event that the big banks were able to effectively compete and enjoy returns on capital as high as Home's, it would scarcely be noticed given their sheer size.  While Canada's sub-prime mortgage market is large enough to offer Home many more years of above-average growth, it's not large enough to be attractive the elephant-sized financial companies that already dominate the prime mortgage market.

Even if they wanted to, it's unlikely that they would do well.  Each has hundreds of branches, a physical footprint and army of staff that requires a high-volume business.  Whereas Home Capital Group spends a great deal of time and resources training staff, the banks tend to have a more automated system of approving or rejecting applications, which allows them to pay mortgage officers more modest salaries.  In addition, having been doing business in its niche for nearly thirty years, Home Capital Group has gained highly detailed knowledge about sub-prime lending, and proprietary systems, too.  It's not at all clear that the big would-be competitors could compete effectively.
In fact, while some have always predicted that the big banks would eventually move onto Home Capital Group's turf, the opposite has occurred recently.  The financial turbulence of the past few years has further strengthened the company’s competitive advantage, as many competitors have left the market.  They are now among about a dozen decent companies in their niche, half as many as in the recent past.  The company’s end market is large, offering an opportunity to grow rapidly for many years to come.  Often, excellent companies have more than one competitive advantage, and Home Capital Group can add its low cost structure and deposit taking licence to its niche dominance.


Though a superb business, Home Capital Group can't run on cruise control.  Like any financial company, it offers ample opportunity for failure by ignoring risk.  In addition, the complexity and flexibility of the financial accounting offers the chance for snake-oil salesmen to push their dark product.  Happily, Home Capital Group is under the wise and honest stewardship of Gerald Soloway.  Don't be fooled by his low-key, down-to-earth style: he's one of Canada's finest entrepreneurs and most accomplished chief executives.  In the late 1980s, he took control of a tiny company, and turned it into an exceptionally consistent and profitable business.
Whether small or large, every decision he makes is careful, conservative and sensible.  For example, when the Canadian government shortened the amortization period to 30 years, it left a window of several months before the changes came into force.  Many other institutions used the occasion to push a lot of long-dated product; HCG, on the other hand, stopped doing so immediately.

The management team is rational, conservative and candid.  In a business where a cautious approach to risk is imperative, the CEO rightly considers himself the chief risk officer, rather than delegating the responsibility to somebody else.  The results show: HCG has higher capital ratios than any of the large banks, and the proportion of delinquent accounts is as low or lower.
Management has been superb at allocating capital.  Most of the company's earnings have been retained, and have generated very high returns on capital.  In fact, return on equity has averaged around 28% for more than a decade.  Home Capital Group pays an average but steadily growing dividend, which is targeted at about 15% of earnings per share.  Currently yielding 2%, the payout will grow in line with earnings over time.  Finally, the company repurchases stock in small amounts, largely to offset stock options.  Unfortunately, a large-scale share repurchase is not in the cards, as Canada's regulators would frown on the company drawing precious capital for that purpose.


No business, no matter how dominant, is worth paying an infinite price for.  However, because of wariness about the financial sector in general, and specific concerns that Canada's real estate market is overvalued, HCG is selling at a cut-rate price.  Indeed, it currently trades hands at just 8x 2012 EPS, despite high returns on capital and a high growth rate.  The company has often traded at 15-20x earnings in the past, a level it will likely return to at some point.  Assuming a 15% growth rate for the next 5 years - far lower than it has been over the past 5 years - and a return to a multiple of 15x earnings, the stock would trade at $180-190 in 2017, not to mention dividends that will probably add up to $6-8.

With a solid and enduring "moat," a high return on capital, a truly superb management team, yet selling at a bargain price, Home Capital Group is a fantastic opportunity for investors.  The company, to be sure, is not without a few challenges.  The All-Star CEO is now in his 70s, and seems likely to step down sometime in the next few years.  While Soloway will ensure that whoever succeeds him is excellent, he's leaving impossibly big shoes to fill.  Next, it's likely that Canada's real estate market is overpriced, at least in certain markets.  While a correction of 10-15% is unlikely to affect Home Capital Group much, it could weigh on results somewhat.  Still, all things considered, investors who buy HCG today are likely to earn very good returns over a period of several years. 

There's ongoing commentary on Home Capital Group: A 2012 Third Quarter Update

Disclosure: At the time this article was published, the author had a long position in HCG.
Sources: A wide range of company filings available on Home Capital Group's website.
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