In my most recent article, I described how installment lender World Acceptance Corporation (NASDAQ:WRLD) illustrates the risks and rewards of investing in the alternative finance industry. On the one hand, the company embodies many of the industry's best traits, such as rapid growth, high returns on investment, and pricing power. On the other hand, the company's main business line of installment lending has come under increasing competition. Moreover, it has been accused of building its entire business upon the misbehavior of improper lending.
Most seriously, World Acceptance Corporation is currently under investigation by the Consumer Financial Protection Bureau, or CFPB. The company received a Civil Investigative Demand, or CID, from the CFPB in March 2014 asking for information about the company's business practices. Some short sellers believe this investigation will lead to severe penalties, or even bankruptcy. On the other hand, it is possible that regulators will only give the company a slap on the wrist, such as a small fine, or let the company off altogether.
I believe the large distance between these two possibilities offers an opportunity for investors. World Acceptance's current situation has left the company and its share price in a sort of "limbo." On the one hand, the company's share price is far too high if regulators are going to shut down its business, as the short sellers believe. On the other hand, it is too low if the company's business model is fundamentally sound. Because of this, I feel there is an opportunity here for an investor who believes he or she knows what will happen to World Acceptance Corporation and is willing to back that belief with money.
The Current Situation
Not much has happened with World Acceptance Corporation and its share price in the months since it announced the CFPB's investigation and its shares plunged nearly 30%:
Source: Yahoo Finance
It is true that because of this drop in the company's shares, a number of class action lawsuits were filed against the company. However, it seems unlikely that these lawsuits will amount to much. In the words of Bloomberg View columnist Matt Levine from an article appropriately titled "There Will Always Be Stock-Drop Lawsuits":
Every once in a while a company will announce bad news and its stock price will go down. When this happens, enterprising lawyers will sue the company, saying that it should have announced the bad news earlier and that innocent shareholders were tricked into buying stock because they didn't know about the bad news. These lawsuits are informally called "stock-drop lawsuits," and a lot of people think they're Bad, because they mostly are.1
1. The Supreme Court sums up the arguments [why people think that way]:
'Such class actions, they say, allow plaintiffs to extort large settlements from defendants for meritless claims…'
Regardless, after the initial excitement of the fall in the company's share price and the subsequent lawsuits, not much has happened. In the company's fourth quarter fiscal 2014 conference call, CEO Sandy McLean said that soon after the CFPB send its CID, the company "provided [the CFPB] with all of the information [the company believes] they have asked for." Since then, World Acceptance has not heard back from the CFPB. Perhaps because of this, the company's shares have been almost entirely flat. The only significant movement was in September 2014 when World Acceptance's shares dipped after the company's auditor resigned close to the six month anniversary of the company's response to the CFPB. According to the auditor, this resignation had nothing to do with any accounting problems with the company. However, I noted in my last article that it might have had to do with the material weakness in the company's financial controls in its fiscal 2013 annual report, which I discussed in more detail there. Regardless, the company's share price recovered soon after, probably because it was clear that the CFPB would not be replying within that six month time frame. As Sandy McLean put it in the company's second quarter 2015 conference call:
I was under the impression that they were supposed to respond to us within six months of the point in time if we submitted our response. And that as we got closer to the October day, we went back and found out that is not a written rule. It was - that was kind of their general practices, but it's certainly not anything that they are required to do.
There are two ways to interpret this silence from the CFPB. On the one hand, there is the optimistic view that the silence means there is nothing wrong with the company's business practices. This view certainly makes sense - if the data from World Acceptance Corporation contained obvious evidence of inappropriate practices, the CFPB would probably act immediately to end those practices. Thus, according to this view, the lack of response from the CFPB means that there is nothing overwhelmingly problematic about the company's operations. Certainly, the market seems to have taken this view, given that the company's share price rose when the six-month deadline came and went without action.
On the other hand, the CFPB's inaction can also be viewed pessimistically. The silence may mean that regulators are planning punitive action against World Acceptance Corporation and need time to compile evidence. After all, if the company was plainly innocent of all wrongdoing, it would similarly make sense for the government to respond immediately and announce that.
Thus, the CFPB's silence on World Acceptance Corporation's response to its CID may reflect ambiguity as to whether the company has misbehaved or not. On the one hand, the company's practices might not be so obviously bad that the government can act immediately against the company without further investigation. On the other hand, the company might not be so innocent as to avoid all penalties. If such an interpretation is correct, that means that the company might receive some sort of fine or other regulatory penalty without being put out of business.
This ambiguity in the company's future extends to the company's own pronouncements. On the one hand, management seems optimistic about its regulatory issues. In Sandy McLean's words in the company's most recent conference call, "[through the company's] inquiries, it appears that [the CFPB was] pleased with the response, the timing of [the] response and the [earnestness] of that response." On the other hand, the company recently issued a regulatory filing outlining its most recent credit facility agreement. That agreement includes a specific amendment requiring the company to promptly tell its lenders about any government action against it. At the very least, it seems as if the company's lenders aren't entirely sanguine about the company's regulatory prospects and want to make sure that they are kept informed about any regulatory issues.
Regardless of which interpretation of the company's future is correct, it is clear that the company's share price does not reflect the final outcome for the company. At 7.6 times earnings, World Acceptance Corporation's shares are almost certainly too cheap for any regulatory outcome that doesn't leave the company's business model totally crippled. On the other hand, if the company's business is going to be totally crippled by regulators, then its shares probably don't have any value at all. I believe this situation creates an opportunity in the company's shares.
I first realized that there was an opportunity in World Acceptance Corporation's current situation when I realized that situation reminded me of an anecdote from The Big Short, Michael Lewis's book on the financial crisis. In that book, aspiring hedge fund managers Jamie Mai and Charlie Ledley invest in subprime credit card company Capital One Financial (NYSE:COF) after the company announces that it is being investigated by the Office of Thrift Supervision and the Federal Reserve for hiding losses. At the same time, the company's recently resigned CFO was also under investigation for insider trading for selling shares before that announcement. As a result, the company's share price collapsed from about $60 a share to $30 a share. Mai and Ledley came to the realization that, in Lewis' words:
Thirty dollars a share was clearly not the "right" price for Capital One. The company was either a fraud, in which case the stock was probably worth zero, or the company was as honest as it appeared to Charlie and Jamie, in which case the stock was worth around $60 a share.
As it turned out, the two were right, the company was perfectly fine, and because they used options to leverage their investment in the company, they made 20 times their investment.
The parallels between Capital One's situation and that of World Acceptance are obvious. As with Capital One Financial, $77 a share is obviously not the right price for World Acceptance Corporation's stock. If the CFPB clears the company of wrongdoing - or levels any regulatory penalty that doesn't shut the company down altogether - the company's share price will probably return to its previous high of about $100, if not higher.
On the other hand, if the government shuts the company down, as the shorts believe will happen, the company's shares are likely worthless. This outcome is certainly possible, even for a company as large and well established as World Acceptance Corporation. As I described in my article about misconduct in the alternative finance industry as seen through Broke, USA, in late 2013, the government shut down Fesum Ogbazion's Instant Tax Service, a tax preparation company, for egregious misbehavior. That company had over 1,200 locations, just like World Acceptance, though it wasn't publicly traded.
Regardless, if one is willing to do the research necessary to develop an opinion about World Acceptance's future, then the company's current situation offers a perfect opportunity. One of the most important parts of investing is finding a mispricing in a company's securities. As famous hedge fund manager David Einhorn puts it, "he [starts every investment] with a story, a thesis of why it's misvalued." However, with World Acceptance Corporation, it is not necessary to find why the company's shares are misvalued because it is obvious why they are misvalued.
The misvaluation comes from the fact that opinions about the company are largely divided into two camps. One believes that the company is essentially fine; the other believes that it has a fundamentally broken business model and is probably on the edge of bankruptcy. As a result, the company's share price reflects an average between these opinions.
However, what is interesting is that it is almost impossible for the company's actual situation to be an average between these two opinions. The company can't be "half-fine," or "halfway on the edge of bankruptcy." After all, the people who think the company is on the verge of bankruptcy think that its entire business model is illegal, and there is no way that the company's operations could be "halfway illegal." Moreover, the company has only one major line of business-installment lending. Thus, if that business is found to be predatory, as the shorts believe, then the company has no future.
Thus, World Acceptance Corporation's current situation allows investors to essentially bypass the first step of David Einhorn's investing process-finding where there might be a misvaluation. The misvaluation in the company's shares is because the company's share price reflects an average between two opinions, even when the company's actual situation can't be an average between those opinions. Moreover, the company's current situation even allows investors to skip the second step of Einhorn's process. That step is in Einhorn's words:
We want to find out what the misunderstanding is... We like to identify something in which the public has been misinformed.
What's nice about World Acceptance's current situation is that it is already clear what the misunderstanding is - or rather, there is an obvious potential source of misunderstanding for both camps. Those who are long the company's stock think that the company's detractors are wrong to think that the company's business model is improper, or that they are wrong to think that the government will shut the company down. Those who are short the company's stock believe the exact opposite - that shareholders are wrong to be optimistic about the company's prospects in the face of government action. Obviously, both of these opinions can't be simultaneously true, so someone has to be misunderstanding the situation.
Of course, even if the sources of the company's misvaluation and the public's misunderstanding are clear, that still leaves the question of which camp an investor should join. In Einhorn's words:
How do you know you're right? That's what the work is. We find out what everyone thinks, and then what we think, and then we test it. What we need to know to convince ourselves that we understand it.
Even with the first two steps of the investing process bypassed, this is still a challenge. In The Big Short, Michael Lewis illustrates how hard it can be to determine whether a company under government investigation has actually misbehaved. He describes how much due diligence Jamie Mai and Charlie Ledley did to support their thesis that Capital One was acting properly:
Charlie and Jamie studied the matter, which is to say they went to industry conferences, and called up all sorts of people they didn't know and bugged them for information: short sellers, former Capital One employees, management consultants who had advised the company, competitors, and even government regulators.
What's interesting is that Ledley and Mai's conclusion seems similar to what I think a detailed investigation would reveal about World Acceptance Corporation. Specifically:
"What became clear," said Charlie, "was that there was a limited amount of information out there and we had the same information as everyone else."
The same seems true about World Acceptance. Every short seller of the company I have encountered has criticized it using the same information - the company's public filings, plus media reports such as the ProPublica article that has been cited by a number of short sellers. Moreover, in some ways, World Acceptance Corporation will actually be easier to study than Capital One was for Charlie Ledley and Jamie Mai. The two of them needed to determine whether the company's management was honest, since the accusations against the company rested on a belief that management was secretly defrauding shareholders. This is unnecessary with World Acceptance because the accusations against World Acceptance are largely based on the company's publicly stated business practices. If there is misbehavior here, it is likely open and obvious, not secret and hidden.
Of course, that is not to say that investigating World Acceptance Corporation for a potential investment will be easy. The company's short sellers have accused it of predatory lending and improper sales of add-on products to its loans such as credit insurance. Thus, any potential investor will need to understand the government's definition of predatory lending and the government's rules about what sort of products can be tacked onto a loan. Such investigations will be particularly difficult because the CFPB is a new agency and there is not much precedent that can be studied to predict its actions.
The question of whether the company is guilty or innocent is not the only question the potential investor must study. An investor must also understand what kinds of penalties might be imposed if the company is found to have misbehaved. For example, in his articles about World Acceptance, Abdalla al-Ayrot calculated the amount of restitution that the company would need to pay if it did mis-sell credit insurance to customers. Based on past precedent, he argued that even if the company only misbehaved in that area of business - ignoring the company's primary business of installment lending - it would be enough to bankrupt the company. Of course, I cannot say if his conclusions are correct. However, his work does show the kind of detailed research the enterprising investor will need to do to determine what he or she thinks will be World Acceptance's ultimate outcome.
On the other hand, what is interesting about World Acceptance Corporation's situation is that an investor does not need to have very strong convictions about the company's situation in order to make an investment. This is clear if you consider a simplified model of the company's possible outcomes:
Is the company essentially sound?
Long or Short at Share Price of $75?
Gain $25 / share when company's share price returns to previous value.
Lose $75 / share when company goes bankrupt
Lose $25 / share when company's share price returns to previous value.
Gain $75 / share when company goes bankrupt
Obviously, this model doesn't capture all of the nuances of the company's situation. However, I believe it does capture the essential upside and downside to taking a stand on the company's future, either long or short.
Based on this model, you only have to be more than 75% sure that the company's business model will prove sound to be long the company's shares at roughly its current share price. This is based on the calculation of the expected gain in the company's shares for long investors:
Interestingly, you only have to be more than 25% sure that the company's business model will take it to bankruptcy to be short the company's stock. That is because the expected gain calculation for short investors is as follows:
Of course, these calculations do not perfectly represent the company's situation. For one thing, some short sellers believe that World Acceptance Corporation's business model is unsound, but that the company won't necessarily go bankrupt. For example, Whitney Tilson argued in September 2013 that the company's share price would fall at least 67% because of its misbehavior. Using that 67% fall and the company's peak share price of about $100, World Acceptance's shares would fall to $33 if the CFPB rules against the company. On that basis, long investors would only need to be about 63% sure that the company's business model is sound to invest in the company while shorts would only need to be about 37% sure to bet against the company.
Moreover, the calculations become even more interesting if one considers the use of options. A look at the company's option chain for April 17th, 2015 shows a number of possibilities:
Source: Yahoo! Finance
I chose an expiration date of April 17th, 2015 since it seems likely that the CFPB will reply to World Acceptance Corporation regarding the CID by then. As you can see, you can buy calls with a strike price of $75.00 that expire on that day for about $10 per share. If the company turns out to be fine and the stock goes to its pre-investigation price of $100, then you will earn a profit of $25/share. Thus, based on the calculation above, it makes sense to buy such calls if you think there is a greater than 29% chance that will happen. Similarly, puts with a strike price of $75.00 can be purchased for about $8 per share. Thus, as long as you think there is at least a roughly 10% chance that the company's share price will fall to close to zero by April 17th, 2015, it makes sense to buy those puts.
Of course, options come with their own risks. For one thing, it is quite possible that World Acceptance Corporation's fate won't be determined by April 2015. In the company's most recent conference call, Sandy McLean noted that in response to the company's reply, "either [the CFPB will] ask for additional information or they will move forward." If the CFPB levels disciplinary action against the company or drops the investigation, that will likely cause the company's share price to move dramatically, making the correct option trade highly profitable. However, if the CFPB simply asks for additional information, the company's share price may remain in its current state of limbo, causing the options to expire worthless, potentially wiping out the options investor's money.
I don't use options in my investing because of this sort of risk, so it is quite possible I am missing something. That said, I believe my overall point holds. World Acceptance's current situation offers a very interesting investing opportunity, and options might make that opportunity even more profitable, either by reducing risk or increasing the potential gain.
Moreover, even if you don't use options in making an investment in World Acceptance Corporation, I still think such an investment has interesting characteristics. As I've noted, David Einhorn has described the first two parts of his investing process as figuring out why there might be a mispricing in a security and what that mispricing might be. With World Acceptance, an investor can bypass those first two steps because the why and what of the mispricing in the company's shares is obvious. Because of the company's unique situation, even if you're only moderately sure what will happen to the company, it would still be rational to make an investment.
Thus, at 7.6 times earnings, it is highly likely that World Acceptance Corporation's shares are mispriced given the two most likely outcomes for the company. The shares are too low if the company's business model is legal and sustainable. Conversely, they are too high if the company is fundamentally unsound, as the short sellers allege.
This situation creates an opportunity for investors. Investors who are even modestly confident that the company's business is sound can take advantage of a large discount in the company's share price. Conversely, short sellers can short the company knowing that a catalyst - in the form of the CFPB's reply to the company - is only months if not weeks away. This obvious impending catalyst also makes the use of options an appealing possibility.
Of course, it is possible that the company's current multiple is appropriate for the company in the long run. For one thing, on an EV/EBITDA basis, the company's stock is much less undervalued. However, even if this is true, the company's shares will still likely move significantly in the near future once the CFPB issues its final decision on its investigation.
Of course, if the CFPB does not shut down World Acceptance Corporation, then the long term value of its shares will be determined by the company's operating results. As I showed in my most recent article, the company has had incredible operating performance over the past decade. However, some of the recent news from the company seems to indicate that the company may be running into some difficulties. Those difficulties will be the subject of my next article, "Recent News From World Acceptance Corporation Indicates Worrying Operating Trends At The Company."
Disclaimer: The content here is not meant as investment advice. Do not rely on it in making an investment decision. Do your own research. The content here reflects only the author's opinions. Those opinions might be wrong. This content is meant solely for the entertainment of the reader and its author.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.