When you start your investigation into the investment merits of Carfinco you will be stopped dead in your tracks by the word "non-prime."
"Non" is not quite "sub" but that's a thin disguise and you won't be fooled. Nor should you be because that is precisely the target market for this gem of a business.
Carfinco, as you might guess from the catchy name, finances car purchases. The Edmonton-based firm does so for people of suspect credit quality. And it makes a pile of money doing it.
About 55 per cent of Canadian consumers have A-plus credit ratings. About a quarter are rated D, and this is Carfinco's turf - lending to people who can't get a loan from a bank to buy a used car.
It's a good business: the loans earn 29.5 per cent interest. The loan book has more than doubled in the past five years, as have revenues. The company is earning 72 cents on every dollar of equity invested right now. Over the past six years, its return on equity has averaged more than 36 per cent.
The company lost money in 2008, and the units dropped to penny status as investors fretted about its survival. That ended up being a golden buying opportunity, however, and a cheap lesson for management on how to minimize risks by, among other things, refining the system of checks and balances in making loans. Distributions, which were eliminated briefly during the financial panic, are now two cents a month. And there are routine quarterly special distributions.
So far this year investors have been paid 45 cents per unit, so don't let that normal yield number fool you. It's not 4 per cent, it's more like 8 per cent - not bad for a growth-oriented business.
That growth is likely to continue. Car loans correlate with economic growth and particularly employment, which is slowly improving. The ranks of the unemployed are thick with potential Carfinco customers, once they find work.
Carfinco is also set to expand in other ways. It has agreements with 1,300 used-car dealerships. There are more out there, particularly in Quebec, where the trust has no presence yet but plans to in short order. That will be a big boost to the loan book.
And that's not all. Carfinco is adapting what's called "risk-priced" lending, which means offering more loans to a bigger variety of customers. As things stand Carfinco only lends to the non-prime borrower. It's the lender of last resort. But there's big business in lending to better credits, even at lower rates.
Of course, moving up the food chain means competing with banks, Toronto-Dominion Bank and Bank of Nova Scotia in particular, which have advantages in terms of a lower cost of funds. But they're also banks, meaning they're not necessarily that nimble.
Risks
The fund targets a 20-per-cent growth rate - a number that its lenders are comfortable with - and it's hitting that target. It could grow faster but that's a conservative number. Grow too fast and you can lose sight of credit quality.
That's the biggest risk in this business. The non-prime consumer is rated D for a reason. He stands a much better chance of defaulting on his payments. But as long as the economy holds up, that risk isn't nearly as high as it seems - indeed, CEO Tracy Graf told me that his biggest frustration is convincing investors that their impression of non-prime is too severe.
Judging from the numbers, he's right. Payments late by more than 30 days were only 3 per cent of Carfinco's loan book on Sept. 30, down from almost 5 per cent at the end to 2009.
Few drivers want to lose their cars - and in any event, technology comes to the rescue. Carfinco uses a device that can prevent a car from starting if payments are in arrears.
Insiders own more than a quarter of the units and it shows in the way the business is run. Mr. Graf tells me he does little business in the Greater Toronto area. Why? Because given all the mass transit in the city, it's easier to walk away from a car loan - and a car. So as tempting as the Toronto market is, he won't go there (until he starts lending to better credit risks anyway).
To sum up: investors in Carfinco get a piece of a fast-growing, well-run operation. The trust faces little competition and any new entrant will encounter barriers (it's not easy to build relationships with 1,300 dealers). For the trouble of owning such a business, investors are paid 8 per cent while the units march gradually higher.
The easiest money has already been made, but it still looks like a prime investment, which is why I own the stock.