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Don’t Fall for the Genworth MI Canada Inc. and Home Capital Group Inc. Value Traps

If investing was as easy as picking stocks with low P/E ratios, we’d all be millionaires by now.

Unfortunately, for those of us who like to do things the easy way, investing is a lot more complicated than that. I’m not saying P/E ratios are useless—on the contrary, they’re often quite useful—but there’s a lot more digging you have to do than just looking at a company’s P/E ratio and declaring it a worthy stock for your portfolio.

Take Genworth MI Canada Inc. (TSX:MIC) as an example. At first glance, the stock looks insanely cheap. Shares currently trade at just 8.3 times trailing earnings, and that’s even after rallying some 15% from recent lows. The company trades at under book value, and has recently announced it will match its government-backed competitor CMHC by raising mortgage insurance premiums for home buyers with less than 10% down, effective June 1st. These increases will be as much as 15% for the highest-risk buyers.

These are all good things for an investor looking to put money to work in the name. But there are also some major risks that aren’t so easily identified.

First of all, there’s the Canadian housing market. Pundits, economists, and even those of us here at Motley Fool Canada have been warning about real estate being overvalued for years now. We all think the market is being propped up by a combination of ultra-low rates, bullish sentiment, and a general mistrust of stock markets. Just one look at metrics like the price-to-income or the price-to-rent ratio makes it obvious that we’re in uncharted waters.

Even though hot markets in Toronto and Vancouver continue to make headlines, many other cities in Canada are starting to show signs of cracking. Markets like Montreal, Ottawa, and Winnipeg are tepid at best, and both Calgary and Edmonton are starting to really slow. It sure looks like price declines could start to be the big story soon, especially in the prairies.

Even though Genworth does have a 90% government guarantee on its insurance portfolio, it hardly makes it immune to a decline in housing. And with the exception of two major markets, it looks like that situation may be upon us fairly soon. Remember, during the last real oil bust of the 1980s, Alberta’s mortgage arrears of 90 days or longer peaked at 3.5%.

There’s also sentiment working against Genworth. If the market starts to slow in any serious way, big traders will rush out to short it, thinking it will take the brunt of the decline.

But at least Genworth has geographic diversification on its side, with only 17% of its total insurance in force from Alberta. Home Capital Group Inc. (TSX:HCG) is really dependent on not just one province, but one market—Toronto.

Approximately 85% of the company’s loans outstanding are in the Greater Toronto Area (GTA), with more and more of them moving away from being covered by default insurance. Out of $22 billion in outstanding loans, only $8 billion are protected. That’s not much, especially considering the concentration in Toronto.

Home Capital bulls will point to the company’s ultra-low default rate as evidence that its underwriters are especially skilled at identifying bad potential loans. Perhaps, but I think there’s a different explanation. After all, a rising market covers many sins. If a homeowner falls behind, it’s pretty easy to sell the place at a profit, and quickly, too.

Even though the company has $14 billion in loans at risk, it has just $1.35 billion in tangible equity. Or, to put it another way, for every dollar in assets at risk, there’s 90 cents worth of debt. What happens if values in the GTA fall 10%? I can’t answer that, but one thing is certain. I wouldn’t want to be holding the stock when that happens.

So, even though both Genworth and Home Capital look cheap on the surface, there’s plenty of reasons to stay away. If Canada’s real estate market keeps on chugging, these companies will do fine, but I sure don’t want to take that risk with my portfolio.

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

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