Reco today by Fabrice Taylor in G&M
https://www.theglobeandmail.com/globe-investor/investment-ideas/a-foundation-with-room-to-grow/article1455694/
The best investments are businesses with real and durable competitive advantages. Buy them at the right price and you'll make a fortune over time. They don't grow on trees, unfortunately, but I think Home Capital Group Inc. might be one.
Home Capital (41.690.631.53%) is a lender. Its primary line of work is offering mortgages, although it also issues credit cards and other types of loans and takes deposits.
Let me start with some tantalizing numbers. For the nine months ended Sept. 30, Home Capital made $104-million on revenue of $368-million. You don't have to be Einstein to see that profit margins in lending are fat. The bottom line is getting bigger, too. The company made a little more than $3 a share in the same period versus $2.31 a year earlier.
This is no flash in the pan, either. Home Capital has been a consistent outperformer since at least 1998, based on the historical financials I've looked at. Return on equity over that period has never fallen below 20 per cent. It has been higher than 35 per cent. Revenue has grown every year, and so have profit and dividends. These historical results are something to behold. And 2009, which was supposed to be the year of reckoning, wasn't.
And yet investors don't seem willing to pay more than roughly 10 times earnings for this gem. Ming Lam, a principal at Silver Heights Capital Management, has been a personal holder of the stock for a decade. He says investors worry about the value of the real estate underlying the portfolio. He also says they've been asking the same skeptical questions for a decade.
Home Capital, he says, does retail banking - the most profitable part of the Big Banks' business - and earns similar returns. Mr. Lam finds it hard to understand why investors are skeptical of Home Capital, yet are happy to own the big banks, which have wholesale businesses that are far more accident-prone.
"Taking deposits at next to nothing and lending it out in mortgages is a great business," he says.
Mr. Lam is no slouch himself: His firm's returns trounced the S&P/TSX composite index in the past year with a 47-per-cent gain. An investment in Home Capital, to which he added at $15 in March, helped, but was by no means the only winner. He's handily ahead of the index since his fund's inception three years ago, too. (And that's with no gold or mining stocks, which don't fit his criteria, and a 13-per-cent cash holding last year.)
So what gives Home Capital a strong competitive advantage that allows it to earn such high returns on equity with a relatively conservative balance sheet? I think there are a couple. Home Capital started out lending mainly to the Alt-A crowd - rejects from the banks because they had unconventional sources of income (notably the self-employed). It's doing more conventional lending now, which is often insured by Canada Mortgage and Housing Corp. and earns nice fees or safe interest rate spreads, depending on what it does with the loans. I see CMHC's - and therefore the government's - growing role in supporting the housing market as a benefit. Mr. Lam views it as a risk because it could lead to a bubble in housing prices.
Another advantage, though, is that mortgage brokers have an incentive to drive business Home Capital's way. Many are also financial planners or offer other services. Because a mortgage is the cornerstone of a consumer's financial plans, winning that business is important for a big bank, as it can then get the credit card, the registered retirement savings plan, or whatever.
Home Capital doesn't offer most of these other products but offers the same mortgage rates. So the broker, given a choice, will opt to send the business to Home Capital because it won't try to steal the rest of the client's business away from him.
Here's the upshot: Home Capital has grown very quickly and will, in my opinion, keep growing. Its assets are less than $10-billion, a fraction of the mortgage market in Canada.
So earnings are going up and I'd guess briskly. On top of that, I think the multiple will expand. It used to be in the healthy double-digits. If profit goes up and the multiple does too, you're driving a twin turbo and you're going to move the needle.