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, Barel Karsan (378 clicks)
Long only, deep value, contrarian
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Companies offering mortgages or related products are currently out of favor in the stock market, and often with good reason. Many companies spent the last few years borrowing money, and then lending it out carelessly, expecting to make profits on the spread resulting in high returns on minimal equity. When customers couldn't afford to pay back thanks to the downturn, the borrowed money remained due, resulting in strong chances of default for the lender. But not all mortgage companies find themselves in such high risk positions, but you wouldn't know it from their stock prices. Consider Quest Capital (QCC), a real-estate mortgage financier.

The company is owed $386 million from borrowers, all of which is secured by real-estate or corporate/personal guarantees. Based on the value of the underlying real-estate and the quality of these guarantees, the company estimates that it will recover $370 million of these outstanding loans. Even if you believe that management is not conservative enough with respect to estimating these losses, the losses would have to be 900% higher than management's estimates to justify the stock price of this company, as the stock trades as if the loans due are worth just $240 million.
The reason the value of QCC's loan portfolio can drop so much and still hold value for the equity holders is that extensive use of leverage is not in use. The company is financed with just $46 million of debt and $40 million of pref shares along with common equity of $290 million. But this equity trades on the market for just $120 million.
To reduce the risk of a cash crunch, the company has stopped originating new loans, and it issued the pref shares just six months ago to ensure adequate liquidity. So now the company will focus on collecting its loans receivable and paying down its debts and prefs, which should further reduce risk. For added flexibility, the company was allowed to pay pref shareholder dividends in the form of common stock, and did so for the last two quarters. Perhaps foreboding that the company's cash flow situation is now relatively safe, the company issued the following statement last week:

The Company currently plans to pay cash for any future dividends declared on the Preferred Shares.

Disclosure: Author has a long position in shares of QCC
Source: Quest Capital: A Diamond in the Mortgage Rough