The Motley Fool

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.

Just Released! 5 Stocks Under $49 (FREE REPORT)

Motley Fool Canada's market-beating team has just released a brand-new FREE report revealing 5 "dirt cheap" stocks that you can buy today for under $49 a share.
Our team thinks these 5 stocks are critically undervalued, but more importantly, could potentially make Canadian investors who act quickly a fortune.
Don't miss out! Simply click the link below to grab your free copy and discover all 5 of these stocks now.

Claim your FREE 5-stock report now!

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.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss an important event.

Iain Butler and the Stock Advisor Canada team only publish their new “buy alerts” twice a month, and only to an exclusively small group.

This is your chance to get in early on what could prove to be very special investment advice.

Enter your email address below to get started now, and join the other thousands of Canadians who have already signed up for their chance to get the market-beating advice from Stock Advisor Canada.