There are plenty of folks who see Canadian housing as dangerously overpriced, with a serious correction in the future. Just as many, it seems, believe Canada’s housing market is in for a “soft landing” – that if there is to be a decline, it will be measured in the single, not double, digits.
Prefer the latter view? Look past the big banks, then, for a handful of stocks that are nearly pure plays on Canadian housing, and are currently undervalued, assuming all goes well from here.
Two lenders – Home Capital Group and First National Financial Corp. – and home-mortgage insurer Genworth MI Canada Inc. all have price-to-earnings ratios below 10, a bargain level in today’s market where many stocks trade at double that multiple of profits.
Adding to their allure, First National and Genworth deliver income – their dividend yields are 8 per cent and 5 per cent, respectively.
Home Capital pays less – 2 per cent – but is an analyst favourite, and the industry’s overlooked growth story.
The analysts who are positive on these stocks are also positive about Canadian housing. Generally, they believe that barring significant job losses in Canada, there should not be significant mortgage defaults, since much of the jump in prices of the last decade can be explained by income growth and low interest rates, not the poor underwriting seen in the United States. These analysts say that Canadian lenders have been far more discerning in their lending policies than their U.S. peers. “It’s like comparing a Corvair to a Volvo … Mortgages in the U.S. are defective,” says analyst Michael Goldberg of Desjardins Securities Inc.
Mr. Goldberg particularly likes Home Capital, which makes mortgage loans the big banks will not through its subsidiary Home Trust Co. He recently named it his “top pick” in the universe of financial-service stocks he covers. (That includes eight banks, four insurers and Brookfield Asset Management.) He has a target price of $68, compared with recent trades around $53.
He believes the federal government’s recent tightening of mortgage rules and lending standards are a positive for Home Capital. “Prime lenders like the banks earn so little on the mortgages themselves, they can’t afford to lose any money on mortgages. So they’re very, very risk-averse … and when they tighten up, it means there’s a greater volume of loans that have just missed the cutoff for approval, and the quality of those loans is better than the ones that just missed previously. Home’s business is skimming the cream off the loan applications the banks turn down.”
Despite its business model of taking on borrowers turned away by others, the company’s mortgage portfolio seems healthy. The company says it only writes uninsured mortgages at a loan-to-value ratio, or LTV, of 80 per cent or less, meaning there’s equity of 20 per cent or more when the loan is taken out. The average LTV in the uninsured portfolio was 66 per cent at year-end 2012, says Fitch Ratings analyst Joseph Scott, who follows the company’s debt.
The company’s 2013 targets are a return on equity of 20 per cent, net income growth of 13 per cent to 18 per cent, and loan growth of 10 per cent to 15 per cent, all of which the company is on track for after the first quarter. Says National Bank Financial analyst Shubha Khan, who has a $72 price target, “In spite of the enviable growth outlook, the shares are trading at only 7.4 times 2013 earnings per share.”
The growth prospects are not as great at First National Financial, in part because of its size; with $14-billion in new mortgage loans in 2012, and $67-billion in mortgages under administration, it’s Canada’s biggest non-bank mortgage lender. (The numbers for Home Capital are $6-billion and $20-billion, respectively.)
As well, the company seems to be in the doghouse for an underwhelming first quarter, in which mortgage “originations,” as new loans are called, declined and revenue and earnings came in below some analysts’ expectations. According to Bloomberg, all five of the analysts covering the company currently have “hold” ratings.
Mr. Khan, who has a $19 target price, a couple of dollars above recent trades, nonetheless believes First National can gain market share at the expense of lenders who have exited the business. That, in turn, means that the firm’s 8-per-cent dividend yield is “well supported,” he says.
Yield is also part of the story at Genworth MI Canada, the Canadian arm of U.S. giant Genworth Financial Inc. Unlike Home Capital and First National, which make mortgage loans, Genworth insures them. That puts it on the front line of risk in the Canadian housing market.
It’s a risk that CIBC analyst Paul Holden says it can handle, even as the company’s multiples, including a forward P/E around seven, seem to be “pricing in a correction.”
He believes Genworth could increase its reserves for losses “significantly, without any real permanent impairment in value of the company.” And he estimates Genworth has $300-million of excess capital, plus another $100-million at the Canadian holding company level. “That’s another thing that gives me comfort – any hypothetical amount they’d be under-reserved would be far less than $300-million amount.”
In the near term, Genworth may post revenue declines, but the longer term may bring annual gains of 2 per cent to 3 per cent, Mr. Holden says. That may not be a growth story, but the company has increased its dividend every year it’s been public, Mr. Holden notes, and its book value, a driver of valuation, has been increasing about 6 per cent per year. He has “sector outperform” rating and a 12- to 18-month price target of $30.75, compared with current prices around $25.
Analyst Tom MacKinnon of BMO Nesbitt Burns believes Genworth has been hurt by concerns over the Canadian housing market as well as “overhang” from its majority owner, U.S.-based Genworth Financial, which, despite being up more than 1,300 per cent from its financial-crisis lows, still trades for a fraction of Genworth MI Canada’s price-to-book multiple.
Mr. MacKinnon believes the Canadian subsidiary will gain as its U.S. parent’s health improves, and concerns over the Canadian housing market diminish, noting that a dividend boost would help as well, since the company’s payout rate is low by financial-industry standards. “You may not get a [revenue] grower, but you get a fine dividend yield and a company that buys back stock.”
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