Thursday, 16 May 2013

Home Capital Group - 2013 First Quarter Update

Amid a weakening housing market, Home Capital Group recently reported adjusted EPS that grew 19.1% in the first quarter of 2013.  Over the same time frame, Canadian home sales fell 15% year over year, though prices have increased modestly.  Despite the doom-and-gloom predictions in the media, HCG sees a fairly balanced relationship between supply and demand, however.  Sales trends have improved in the early second quarter, and new listings have increased as well, while prices have remained fairly flat.  Overall, management sees no bubble in Canada's housing market.  

The company's return on equity remained high at 24%, though that figure has been falling somewhat in recent quarters.  Still, it stands at about twice the level of the average North American business, and the company is able to redeploy the vast majority of its earnings at that level.  In addition, non-performing loans remained low, despite the usual upward blip in the first quarter, due to customers that tend to be recovering from Christmas expenses and seasonal layoffs.  Since customers’ average Beacon score is improving, this trend is likely to continue.  CEO Gerald Soloway reaffirmed full-year 2013 guidance, and pledged that if he ever doubted Home Capital Group's ability to deliver on it, he would say so.

Mr. Market, however, isn't impressed.  In fact, HCG's stock has swooned by more than 15% from its recent peak, with much of that fall occurring over only a few recent trading days.  Several prominent investors are short the stock - a remarkable 23% Home's shares outstanding were held by short sellers as of May 14 - mostly as a macroeconomic bet that Canada's housing market is overvalued.  While it’s likely that home prices are overvalued by 10%-15%, it’s unlikely that Canada will see a US-style crash.  After all, 70% of Canada's aggregate home value is equity, a significant proportion of home owners have fixed rate mortgages, the jobs market has grown slowly but steadily since 2009, and regulators have taken responsible measures to prevent excess.  

Even if Canada's housing market falls harder than expected, it's unlikely that Home Capital Group would suffer adverse consequences.  The company has a long history of careful lending, and has avoided risky areas of Canada's mortgage market, such as condominiums and high-priced neighborhoods.  As a further safety net, HCG insists on meaningful down payments, and its borrowers tend to have significant equity in their homes.

Assuming growth at the low end of its guidance – the company has given a range of 13%-18% for the year - Home Capital Group is currently trading at just 7 times 2013 earnings.  There's no guarantee that the stock can't fall further, but investors should keep in mind both of Ben Graham's two most important ideas.  First, the aforementioned Mr. Market is there to serve patient investors, not to frighten them.  Second, the lower the price of a stock, the higher the margin of safety - which offers both downside protection, and upside opportunity.

My original investment analysis of Home Capital Group is here.

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