It isn’t very often you run into a stock trading at 7.7 times earnings, 86% of book value, and that pays a dividend over 5%. Oh, and it bought back more than 2% of its total outstanding shares last year.
And yet, that’s the situation that investors in Genworth MI Canada Inc. (TSX:MIC) find themselves in. If they’re anything like me, they looked at the numbers, shook their heads in amazement, and then looked again to see if they somehow made an error. Considering the TSX Composite Index is close to all-time highs, Genworth sticks out like a sore thumb, but in a good way.
Is this stock the bargain of the year, or is there more to this story? Let’s take a closer look.
The business
Genworth, along with CMHC, essentially own the mortgage default insurance market in Canada. If a mortgage needs default insurance—it’s required for all loans with a down payment less than 20%—there’s a 99% chance that either Genworth or CMHC has underwritten that deal. Both companies offer the exact same products and charge the exact same fees. Essentially, the only difference between the two is lender choice.
CMHC enjoys the backing of the federal government, and Genworth has negotiated similar support. But instead of 100% of its insurance backed by Ottawa, it has to make due with 90% protection. This has made the mortgage default insurance business pretty lucrative.
As Canada’s real estate market has continued to creep up, so has the number of policies and the company’s earnings. Earnings increased from $3.18 per share in 2011 to $4.02 in 2014. Additionally, the company has rewarded shareholders, increasing its quarterly dividend from $0.22 per share to $0.39 during that time, adding a few special dividends along the way. That’s terrific dividend growth.
In short, the stock has been a terrific performer. So, why exactly are the company’s shares down nearly 20% so far in 2015?
Ominous clouds ahead
Astute observers already know where I’m going with this. There’s a huge reason why this stock trades at the valuation that it does.
The reason is Canada’s housing bubble.
There are plenty of reasons to be concerned about Canada’s housing, especially in oil-rich provinces like Alberta and Saskatchewan. With the exception of Toronto and Vancouver, Canada’s real estate market has actually been pretty tepid over the last year. And with debt levels hitting new record highs seemingly every quarter, Canadian consumers are getting really close to maxed out.
Here’s how it could potentially turn out very badly for the company.
To date, the company has more than $300 billion worth of mortgages it has insured. Some of those are undoubtedly pretty safe, since homeowners will have paid down a considerable amount of the mortgage. Let’s assume that the last two years’ worth of insurance written will be the most at risk, which is worth between $50 and $60 billion.
Look at it this way. The company gets a premium of between 1-3.5% of the value of the mortgage as a premium. If large-scale housing correction happens and some of these loans start going bad, the company will be out 10%, 20%, or even 30-40% of the total amount of the loan when it pays the claim. That’s a huge amount of liability, and it adds up fast.
If 1% of total loans go bad, it’s a storm that’s easily weathered. But if 5% of the company’s insured loans enter into foreclosure, it’s in deep trouble, even with the generous government guarantee.
That’s the crux in investing in Genworth. If the housing market experiences a U.S.-style crash, investors are likely in for a mountain of pain. But if we get the so-called “soft landing” everyone is hoping for, Genworth looks to be a screaming buy at these levels. Ultimately, it’s up to each individual investor to determine how much risk they can stomach.
