Robert Gill is Vice-President, Portfolio Manager at Lincluden Investment Management, which owns shares in Home Capital.
The movie The Big Short, based on the book by author Michael Lewis, famously outlined the financial crisis of 2007-08, which was triggered by the U.S. housing bubble. In the movie, hedge fund managers notably bet against the American housing market before it crashed and made out very well.
More recently, hedge fund managers turned their attention north of the border hoping to profit from a potential pullback in the Canadian housing market by shorting Home Capital Group (HCG-T). The U.S. hedge funds zeroed-in on Home Capital because it is Canada's largest non-prime mortgage lender. Now, with more than 30 per cent of the float sold short, Home Capital is presently the most shorted stock in the S&P/TSX composite index.
But what exactly are the shorts saying? They make three arguments. 1) The Canadian housing market now resembles the U.S. housing market prior to the 2008 crash and is therefore due for a pullback. 2) The firm has had to deal with some mortgage brokers submitting incorrect income information for their mortgage applicants. 3) Home Capital makes loans to individuals deemed too risky by banks – mainly entrepreneurs and people new to Canada.
Now, let's take a critical look at these suppositions. First, a comparison between the Canadian housing market and the U.S. housing market is not appropriate. The Canadian housing market is far smaller, more regionalized and more influenced by local drivers than the substantially larger U.S. housing market.
Canada's housing market continues to remain strong, both in terms of volume and price. Arguments supporting a vibrant Canadian housing market include robust employment levels, low interest rates and an influx of foreign capital into our major regional markets. Home Capital has mitigated its risk to the Canadian housing market by predominantly conducting business in Ontario, which represents almost 85 per cent of its loan book. The firm has very little exposure to Vancouver's hot market or Calgary's housing market which is influenced by variable energy prices. The shorts seem to forget this critical statistic.
To address the shorts' second issue, in July, 2015, Home Capital announced that some mortgage brokers submitted incorrect information to support their mortgage applications. This caused a pullback in the stock price. Home Capital investigated the issue and cut ties with this small group of brokers. Seventeen months later, these loans have performed well and the event has proven to be an isolated issue. In the interim, Home Capital received a number of analyst upgrades and its share price has subsequently rebounded nicely.
With respect to Home Capital's risk profile, the company is very good at executing its business model. The firm concentrates on shorter term mortgages, primarily in Ontario, for borrowers that do not fit the template of the major banks. Despite lending to presumably higher risk borrowers, non-performing loans at Home Capital have averaged only 0.3 per cent of total loans over the past three years. This is a better result than the Canadian banks which score closer to 0.75 per cent. These results convincingly challenge the short's third concern.
But what else are the shorts missing? Home Capital has recorded a very impressive track record of profitability. Over the past 10 years, Home Capital's return on equity (ROE) averaged 25.5 per cent; over the past five years it was 23.4 per cent; and in the most recent year ROE measured 18.6 per cent. These numbers are remarkable for any company in any industry. By comparison, last year's ROE for two of Canada's largest banks was 16.4 per cent and 13.4 per cent respectively. The long-term average ROE for the S&P/TSX composite index is a much more muted 12 per cent. So, Home Capital is more profitable than both the banks and the S&P/TSX composite index average. As a long-term investor, I like to invest in companies with impressive profitability characteristics.
Home Capital also has excellent growth prospects. The Canadian mortgage market is about $1.2-trillion, of which the big six Canadian banks control roughly 65 per cent to 75 per cent of the market share. A market of about $400-billion remains for smaller lenders. Home Capital is the market leader for mortgages in this space. But, with only about 4.1 per cent market share, there is plenty of room to grow. As a wise investor once mentioned, "as value investors, we love growth … we just don't want to pay for it." Home Capital has plenty of growth, and at current valuation multiples, you're not paying for it.
Home Capital also pays a lucrative dividend that management has increased regularly over the past decade. The dividend yield is now 3.4 per cent versus the S&P/TSX composite index dividend yield of only 2.7 per cent. Further, management has also been returning cash to shareholders by buying back shares with excess capital. And the company just announced it plans to buy back up to 10 per cent of its public float. In such a low interest rate environment, who doesn't like to receive income?
We have demonstrated Home Capital's impressive quality characteristics. Now let's consider valuation. Trading under 1.2-times price-to-book value, and at 7.5-times trailing earnings, shares of Home Capital are very attractive. Valuation multiples are at a substantial discount to the big banks, which are closer to 2.0-times price-to-book and 12-times earnings, and the S&P/TSX composite index which trades at over 23-times earnings. By comparison, Home Capital trading at 7.5-times earnings looks outright cheap. Home Capital offers the "margin of safety" that Warren Buffett explains is so critical to an investment opportunity.
Finally, many investors look for a catalyst. So let's revisit that short position which measures more than 30 per cent of shares outstanding. Remember that every short-seller by definition must be a buyer. With such a big proportion of Home Capital's shares sold short, there will be tremendous buying in this name as the shorts try to cover their positions. This catalyst will cause a material rebound in the share price. No hedge fund wants to be the last one rushing to cover their short position when the buying starts.
With both impressive quality and valuation characteristics, Home Capital is not The Big Short. It is an attractive buy idea that deserves a place in every diversified Canadian equity portfolio.
Follow Robert Gill on Twitter: @RobertGGill
Editor's note: An earlier online version of this story incorrectly stated the value of the mortgage market remaining for small lenders.