Home Capital Group - The Case For A Misunderstood Lender

| About: Home Capital (HMCBF)

Many people fear the Canadian housing market is doomed to crash, and those fears are reflected in the stock price of Home Capital Group (OTC:HMCBF), Canada's largest non-traditional mortgage lender. The stock trades over the counter (OTC) in the U.S., but is listed on Canada's main stock exchange -- the Toronto Stock Exchange - under the symbol HCG.

The Toronto-based firm is trading at bargain levels of less than 7.5 times earnings. Several U.S. hedge funds are said to be shorting the stock. However, I have a far more positive outlook. I own shares in Home Capital and I think there's a compelling case for this misunderstood lender.

It's not that I'm denying Canadian real estate is pricey. My own research indicates Toronto, Vancouver, and a few other markets may be overvalued. For instance, I calculate that the Toronto market is about 30% overvalued relative to incomes and 40% overvalued relative to rents. Other markets, however, seem much more reasonably priced. Location matters as real estate prices are driven primarily by local factors.

What does this mean for Home Capital? Roughly one-half of the company's mortgage book consists of securitized mortgages that are fully insured by Canada Mortgage Housing Corp. or other mortgage insurers. Canadian taxpayers are on the hook for any losses, not Home Capital. I can now understand why Mark Carney, governor of the Bank of Canada, and Canada's Federal Finance Minister Jim Flaherty are urging caution.

Click to enlarge images.

Source: Company reports, GreensKeeper.

The other half of Home Capital's mortgage book is composed of uninsured mortgages on owner-occupied properties made to people that our Big Five banks (BMO, BNS, CM, RY, and TD) won't touch. Borrowers include recent immigrants who have not been in Canada long enough to establish a credit history and business owners whose personal financial situations are intertwined with their businesses. These are situations that don't lend themselves to being underwritten by the big banks' automated scoring systems.

That's why Home Capital has its underwriting officers review every file to understand the credit risk and make sure the property is one that they are prepared to lend against. These are not "liar loans" or "no doc" mortgages like the ones made during the U.S. subprime fiasco, but well-researched credits.

Another plus: These uninsured mortgages have a loan-to-value (LTV) at origination of less than 70%. In other words, the borrowers have 30% or more equity in their homes. They have every reason to avoid default.

Home Capital's habit of lending to people with substantial equity is one big reason it has historically achieved relatively low default rates. Add in Home Capital's dominance of its niche, its low-cost deposit base, Canada's lender-friendly laws, and the company's pricing power and you can understand why it has been a profit machine.

If Canadian home prices did fall by half, the company's uninsured book would be hit, but not to a devastating extent. Using default rate and loss assumptions that are significantly higher than Home Capital's historical experience, I calculate that the company would lose two to three quarters' worth of earnings. Home Capital's risk management team conducted its own internal stress test assuming a 45% drop in real estate prices and 10% unemployment. They concluded they would lose about one year's worth of earnings -- a conclusion not dissimilar to my own.

Now, I don't believe that a 50% correction is the most likely outcome. It's a possibility, but a gradual slowing of the market or a modest decline is more probable.

Home Capital's CEO Gerry Soloway has been through several real estate corrections, and I believe that he still bears a few scars that remind him to position the company to weather storms. Case in point: During the recent Great Recession, the company ramped up its originations of fully insured mortgages and curtailed its traditional uninsured mortgage book.

The company has continued to find profitable niches where it has grown its business without directly competing with Canada's major banks. In fact, the recent pullback by the Big Five in certain segments has created new opportunities for Home Capital, and the company should continue to grow.

Home Capital is an excellent lender. It has built its business around the premise that people who have a meaningful equity stake in the homes they live in will tend to have low default rates. The company's common sense approach to lending, combined with due diligence procedures that confirm the financial position of the borrower and the quality of the asset they are lending against, has served it well.

The company has generated an impressive return on equity that has been in excess of 20% for 14 consecutive years. It has increased its dividend 14 times over the past eight years. Its proprietary lending procedures, when combined with the company's deposit-taking license, provide the firm with a sustainable competitive advantage.

Source: Company reports, GreensKeeper.

The company matches the duration of its assets and its liabilities via term deposits as opposed to demand deposits (e.g., savings accounts), a risk-reducing strategy that few other lenders employ. Home Capital keeps its operations lean by accessing the deposit broker network instead of operating expensive retail branches. With the adoption of IFRS accounting, I believe that the quality of Home Capital's earnings has improved as well.

At less than 7.5 times current earnings, I believe the stock is significantly undervalued. Home Capital should continue to grow its earnings in the future.

Source: Company reports, GreensKeeper.

If we see a major Canadian real estate correction, I suspect its management will see it coming before we do and manage the business defensively. The stock could trade lower, but with a book value per share that should approach $30 by early next year I see limited downside risk. More importantly, the firm's strong capital position means it will live to fight another day.

In the words of famed value investor Mohnish Pabrai: "Heads I win, tails I don't lose too much." To my mind, that adds up to an attractive investment and I am very comfortable owning a meaningful position of the stock in the Value Fund.

Disclosure: I am long OTC:HMCBF.

Disclaimer: Shares of Home Capital can be purchased on the Toronto Stock Exchange under the symbol HCG, or in the U.S. on the over-the-counter market. OTC Markets Group and pink sheets trading can be highly risky and aren't suitable for all investors. If you decide to invest in Home Capital, I recommend that you do so via the much more liquid Toronto Stock Exchange. Additional information on the company can be found on its website and its public filings can be found at Sedar.com, Canada's version of Edgar.