I just finished reading SA contributor Michael Vellucci's bearish analysis of Credit Acceptance Corporation (CACC), and I disagree. While he raises some good points about potential trouble in the subprime auto finance industry, I think that he is wrong to single out CACC as a potential underperformer. The company has a proven track record as a superior operator and capital allocator. I intend on eventually writing articles on each company in this space, but in this article I will limit myself to a discussion of valuation and portfolio strategy. Time is short and the schoolwork is piling up.
Let us begin. One of the key points that Mr. Vellucci makes in his analysis is that CACC is overvalued relative to its peers in the subprime auto space, such as Nicholas Financial (NICK), Regional Management (RM) and Consumer Portfolio Services (CPSS). He uses P/E and P/B ratios as his valuation metrics. I believe that these metrics are flawed for this purpose because capital structure and loan performance varies considerably from company to company. For earnings, I prefer EV/EBITDA because it is capital structure neutral: this metric rightly disadvantages companies that need to leverage up to achieve the same earnings as more conservatively financed companies. When we compare the companies across EV/EBITDA, we see that CACC is not the priciest of the bunch:
CACC is valued similarly to NICK, my other favorite in the space. RM and CPSS are quite expensive because they take on much more debt to achieve earnings. While CACC is not as conservatively financed as NICK, it is much more conservative than CPSS and a bit more conservative than RM.
As for the P/B premium CACC commands relative to its peers, I think that comparisons must be made in the context of portfolio quality and historical performance. CACC consistently achieves higher returns on its assets:
Note that CPSS is typically unprofitable and that RM has insufficient time as a public company to ascertain how it will fare in more adverse industry environments. Personally, I would require a steep discount to book relative to CACC to own CPSS or RM.
Driving this outperformance is the best risk management regime in the industry. Other companies do not even share with shareholders their internal projections of portfolio performance, but in this area CACC is admirably transparent. Here's how the company did in the last decade at navigating changing industry conditions:
The key point is the red box, which shows the extent to which loan performance diverged from the company's original estimates by year of origination. In an industry notable for capital misallocation, these results are nothing short of astounding. Shareholders have benefited handsomely from this superior risk management combined with disciplined stock repurchases when Mr. Market gets in a bad mood:
Compare this with its peers:
Note: I did not use percent change for CPSS because the company had negative EPS for much of the period and percentage changes in EPS therefore do not make a whole lost of sense. I also omitted RM because its track record is so short. In a nutshell, I have little reason to think that CACC's outperformance relative to peers will disappear.
Two other points that Mr. Vellucci makes in his analysis are more about the industry itself than CACC in particular. They are: 1.) Regulatory risk from the CPFB 2.) Heightened competitive pressures will push down margins. While I'm a bit more sanguine about the industry than he is, let us assume that he is correct for the sake of argument: the CFPB will impose additional regulatory costs and yields will decline as capital floods into the sector. Now I believe that CACC will weather such storms better than its peers, but even if it does not, it has an additional buffer in stock repurchases. CACC is the only company that consistently reduces the size of its float:
RM and CPSS do not currently return capital to shareholders, probably in part because they are more leveraged and need to retain any earnings to keep the business stable. NICK offers a decent dividend of about 3% with a low payout ratio, so there is a decent likelihood that the dividend will increase over time.
So what does all this mean to portfolio managers? I think there are opportunities for alpha in credit services regardless of a manager's opinion about the industry. If managers are slightly bullish on the industry like myself, then they can adopt a pairs trade with net long exposure: long CACC, short RM and CPSS. If managers are neutral to bearish on the industry, they can adopt a market neutral or net short basket trade by buying the more conservative, consistent and profitable CACC and NICK and once again shorting RM and CPSS. Perhaps Mr. Vellucci's short CACC trade will work, but I believe that there are better companies in the industry to short and lower-risk long-short trades that include CACC on the long side.
Additional disclosure: Most of my risk capital is in tax-deferred vehicles that do not allow shorting, so I can’t walk the walk, I can only talk the talk. However, CACC is on my watch list for my retirement account