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.
Management
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.
Price
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.
Conclusion
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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