Blessed by the Potato

Home Capital Group (TSE:HCG) is an interesting company that draws very polarized views. On the one hand, there are a great many people out there who love it without digging any further into it than “it pays a growing dividend.” One of my favourite bits of astounding logic from a HCG bull when researching it was “there is no housing bubble because house prices didn’t go down last year.” On the other hand, many bears seem to stop their analysis at “there is a housing bubble, and they’re an alt lender, therefore short.” I wanted to dig into it a bit more to see if it might be worth shorting.

My main questions were: How vulnerable is it to a housing correction? What does the mortgage mix look like, what’s the credit profile and payment history of their borrowers? How are they funded, are there any debt covenants, and what capital reserves do they have? I’m not terribly comfortable with the idea of shorting something, so if I’m going to start to get really bearish on housing, I want to make sure that this is going to blow up good and proper before betting against it. Basically, reduced earnings and growth won’t be good enough: they’ll have to be forced to eliminate the dividend at the very least under a modest correction scenario for me to be comfortable shorting it — as only after they kill the dividend will the pool of surface-analysis dividend growth investors move to sell it.

What I found in a preliminary investigation is a company that is growing like stink. “Ah-ha,” I thought, “they must be spending crazy amounts of cash to advertise and give the brokers enough kick-backs to send all the business their way.” No — they have a ~30% efficiency ratio, which they claim is industry-leading (spot check: half that of BMO’s — lower is better).

Hmm, well, if they’re drumming up business and not spending money to do it, then I thought “they must have poor credit quality as they’ll just take everyone who shows up at the door. So their default rates must be awful, especially if they’re not paying any appraisers.” Wrong again: their default rate is quite low (on par with the banks right now), and even in 2009 barely breached 1% (good for an alt lender, about 3X worse than the national average at the time).

Only one option left I can think of: they’re attracting the best alt credit risks to them by discounting their rates, and people are seeking them out on a price basis. No again: they have a higher return on equity and net interest margin than BMO, despite holding more capital in reserve. A spot check on mortgage comparison sites puts them at about 3.5% for a 5-year rate vs BMO at 3.6% and the lowest-price entry at 3.4%; they’re amongst the most expensive on variable rates.

Well, it’s an enigma. I know they’re small (~5-10% of a big bank) which leaves more runway for growth, but this is unbelievable: they grow fast, without seeming to pay for it in any way (profitability, portfolio risk/defaults, leverage). Any insights into the secret of taking market share from the big 6 banks without spending money to do so? Part of the really low efficiency ratio is that they just do mortgages: branch staff to sell mutual funds and take deposits cost a lot for not much revenue; on the flip side, they don’t have the economies of scale for advertising (but that first factor will dominate). Maybe their business plan is too inherently wonderful, their management team is full of wizards, and I am a fool to even consider shorting such a beautiful business, housing bubble or no.

Or maybe there’s something I just don’t understand. I’m leaning towards ignorant skepticism at this point, and welcome corrections and explanations.