Is Home Capital a buy?

Norm Rothery examines the merits of this one-time All-Star stock after the mortgage lender’s rapid fall from grace

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The entry to the Home Capital Group's headquarters is seen at an office tower in the financial district of Toronto, Ontario, Canada May 1, 2017. Picture taken using a wide angle lens. (Chris Helgren/Reuters)

The entry to the Home Capital Group’s headquarters is seen at an office tower in the financial district of Toronto, Ontario, Canada May 1, 2017. Picture taken using a wide angle lens. (Chris Helgren/Reuters)

To say that Home Capital’s stock (HCG) has disappointed shareholders in recent weeks is an understatement. After a high profile tumble and partial rebound, it closed at $9.14 per share on Friday, May 12. That’s down 74% from its 52-week high of $35.67 per share.

The firm’s travails were detailed by Maclean’s writer Joe Castaldo in a recent piece called “The war for control of the Home Capital story.” In a nut shell, the firm ran into problems with the OSC, which cascaded into a run on its banking operations and a severe liquidity crisis.

While it now seems more likely than not that the firm will survive, such a positive outcome remains far from certain and even if it does come to pass, it will probably involve a large amount of pain.

Unfortunately, Home Capital managed to squeak into last year’s Top 200 All-Star Team. As a result, the firm’s fall from grace has been less than pleasing.

Here’s what I said about the company last fall: “They’re joined by mortgage provider Home Capital Group, which hails from Toronto. Savers might know it better for the high interest savings accounts offered by its Oaken Financial brand. The stock trades at just six times earnings due to worries that the company might be hard pressed should the Canadian real estate market tumble.”

It turns out the firm was hard pressed without a real estate collapse. Mind you, there is chance the lender’s troubles will spark a more general real estate tumble. After all, liquidity crunches that aren’t addressed promptly by regulators have a habit of spreading in an unexpected ways. Needless to say, a real-estate decline could put severe stress on the Canadian financial system and the country’s economy more broadly.

The firm’s decline leaves yours truly eating a generous helping of humble pie. While the stock might climb before it’s replaced by the new All-Star team later this year, it has been a disaster so far.

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Home Capital has fallen 63.3% since it’s inclusion in the All-Star portfolio last fall. But, before becoming too morose, it is important for investors to take a step back and to look at the overall results. The All-Star team is up by an average of 3.3%, including Home Capital’s poor showing, since last October. That isn’t a wonderful overall result but it’s hardly calamitous.

The past is one thing, but if the All-Star team was reformed today, would Home Capital make the cut? It’s difficult to say for sure without some heavy duty number crunching, but a little back of the envelope work provides approximate result.

Would Home Capital make the All-Star team today? Perhaps surprisingly it still holds up on several key measures, but there are new questions that undermine it’s value and growth proposition. You’ll find my final analysis at the end. But first lets reexamine the various factors used by the Top 200 to determine a stock’s grade, and how Home Capital currently stacks up.

Home Capital By The Numbers

Measuring Value

Value Factors 1 & 2: “Value investors are bargain hunters at heart. They like solid stocks selling at low prices. That’s why we prefer companies with low price-to-book-value ratios (P/B). This ratio compares a firm’s market value to the amount of money that could be theoretically raised by selling its assets (at their balance-sheet values) and paying off its debts. A low-P/B ratio provides some assurance you’re not paying much more for a company than its parts are worth. To get top marks for value, a stock must have a low price-to-book-value ratio compared to the market and also compared to its peers within the same industry.”

Given it’s acute distress, it shouldn’t come as a surprise to learn that Home Capital trades at a very-low price-to-book-value ratio both in an absolute sense and compared to its peers. Mind you, the quality of its assets has been thrown into some doubt by recent developments.

Value Factor 3: “We also track price-to-tangible-book-value ratios. Tangible book value is like regular book value, but it ignores intangible assets like goodwill. It’s a more rigorous test of how much a company would be worth if it had to be sold for scrap.”

The firm’s intangible assets (goodwill, etc.) are fairly low in comparison to its tangible assets. As a result, its price-to-tangible-book-value ratio is also low.

Value Factor 4 & 5: “Assets are one thing, but it’s also important to examine a company’s bottom line. We prefer profitable companies and award higher grades to firms with positive price-to-earnings ratios based on their earnings over the past 12 months. We also reward a company when analysts expect it to be profitable and have a positive P/E over the next year. (This number is known as the forward P/E ratio.)”

The company is currently profitable on a trailing 12 month basis. While industry analysts have sharply reduced their profit expectations for the firm over the next 12 months, they still think it will be profitable.

Value Factor 6: “Because we know investors like to rub more than a couple of pennies together, we award extra marks to firms that pay dividends. As it happens, dividend-payers have generally outperformed miserly firms that don’t pay dividends.”

Home Capital recently announced the suspension of its dividend. That’s a big deal and it puts a dent in the firm’s value grade.

Value Factor 7: “For safety sake we also want to make sure a company hasn’t loaded up on debt. That’s why we award better grades to firms with low leverage ratios (defined as the ratio of assets to stockholder’s equity) relative to their peers.”

Matters are tricky on the debt side of the equation. The firm’s leverage ratio isn’t particularly high compared to the big banks but it is high enough for the firm to suffer from a liquidity crunch. As a result, it was forced to issue some pricey debt in recent weeks.

Grading Growth

Growth Factor 1, 2 & 3: “Growth investors love firms with increasing sales and earnings. That’s why we award higher marks to companies that have achieved reasonable sales-per-share and earnings-per-share growth over the last three years. We also track each firm’s growth in total assets over the last year to get a sense of the momentum in its business.”

Thanks to a big share buyback program the firm still sports a modest amount of revenue-per-share growth over the last three years. Its total assets have grown slightly over the last. But it fails outright on the earnings-per-share growth front.

Growth Factor 4: “While fundamental growth is great, we like it when the market takes notice. That’s why we give higher marks to stocks with solid returns over the past year.”

Home Capital’s stock has generated anything but solid returns over the last year. Indeed, it traded at $9.14 per share at the close of Friday, March 12. That’s well below its 52-week high of $35.67 per share, but up from a 52-week low of $5.06 per share it recorded just a few trading sessions earlier.

Growth Factor 5: “In addition, we want to make sure that companies use their capital wisely. To do so we track each stock’s return on equity, which measures how much a firm is earning compared to the amount shareholders have invested. Return on equity is a measure of business quality and we give higher marks to those firms that outperform their peers.”

Since its earnings remain high—for the moment—return on equity is also high. But both are likely to fall over the next few quarters.

Growth Factor 6: “Since no one wants to skate out onto thin ice, we weigh up each stock’s price-to-sales ratio, which as you might expect, compares its price to its sales. We figure stocks with low-to-moderate ratios are reasonably priced while those with extreme ratios run the risk of collapsing.”

Given its low share price, the firm’s price-to-revenue ratio is not extremely high. Mind you, it could go lower.

The verdict

So is Home Capital a buy? I’ll leave that for you to decide. I estimate that Home Capital would get a B for value and a C for growth at the moment, which would leave it out of the All-Star list. Mind you, as is our practice, the stock will continue to be held—for good or for ill—until the portfolio is officially reformed later this year. With a little luck it will recover somewhat before then but such a happy result is far from certain.


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