Home Capital Group Inc.: Be Careful With This Stock

On the surface, Home Capital Group Inc. (TSX:HCG) seems like a terrific buy. Here’s why you need to dig a little deeper.

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Upon first glance, Home Capital Group Inc. (TSX:HCG) looks to be one of the cheapest stocks in the country.

The company, which is Canada’s largest alternative lender, trades at a P/E ratio of just 9.7, which is about 20% cheaper than Canada’s largest banks. But it’s also growing at a much faster rate, upping its loans under administration 13% in 2014. That’s the kind of growth that large banks can only dream of.

That’s not all. The company consistently posts return on equity numbers of more than 20%, and does so while posting minuscule loan losses. Considering how the company’s entire business involves lending to people who can’t get a mortgage at traditional lenders, those are some pretty impressive numbers.

I don’t want to underestimate just how well shares have done in the past 15 years. If you purchased Home Capital Group at the IPO price in 1999, you’d be up more than 4,500%. To put that in perspective, the average Canadian home is up just more than 100% since then, and that’s during one of the longest bull runs in Canadian real estate history.

Even if you factor in the inherent leverage when buying a property with a small down payment, Home Capital has still outperformed the average rental property in Canada by a huge margin.

But all that was during an improving real estate market. What happens when things go the other way?

The risks

Over the last couple of years, Home Capital has specifically taken its business away from insured mortgages. This is during the same period when traditional lenders started to tighten up and stick to loans insured against default. It’s obvious Home Capital’s management saw an opportunity in the market and seized it.

Taking that opportunity could have an unintended effect once the housing market starts to turn. In 2009, the company’s loans in arrears peaked at more than 1.3%. The only reason why write offs didn’t follow is because the real estate market quickly recovered, allowing many of those running into problems to either sell or find other arrangements. If the market would have continued to decline, Home Capital would have likely been in trouble.

And yet, even after that near miss, management still decided to move aggressively into riskier loans. At the end of 2014, only $8 billion out of $22 billion worth of loans were insured, all while the average loan-to-value ratio crept up. This is fine during a rising market, but will just make the pain worse when things start to go south.

The potential fallout

Home Capital has been trying to move away from southern Ontario, which is its core lending area. Still, more than 80% of the company’s loans are located there.

If the Toronto real estate market starts to decline, the company is in a world of hurt. It currently has $1.4 billion worth of equity and $1 billion in liquid assets on the balance sheet, compared to $22 billion worth of loans. If 1% of those loans go bad, 15% of the company’s equity goes with it. Anything more than 1% and it’s likely the company will be forced to raise capital, something no mortgage lender wants to do during a declining real estate market.

It doesn’t end there. Investors constantly underestimate the affect that sentiment has on the market. Look at the company recently—after just a sniff of bearish sentiment, shares sold off more than 20% and haven’t really recovered. Imagine what will happen when the company starts posting results that are a little worse than investors are used to?

For the last 15 years, Home Capital has been a levered play on Canada’s real estate market. As the market has moved up, it’s been a terrific performer. Once the market turns, it could get ugly.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Nelson Smith has no position in any stocks mentioned.

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