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How 1 Bad Apple Can Ruin the Basket

Over the past few weeks, shares of Home Capital Group Inc. (TSX:HCG) have been in the news for all the wrong reasons. The Ontario Securities Commission (OSC) announced an investigation into the company’s disclosures and knowledge of the falsification of mortgage applications made by approximately 45 brokers.

To compound the bleeding, the news of the OSC investigation crept into the daily operations of the company. Many savers who deposited money with the company in high-interest savings accounts (HISAs) or guaranteed investment certificates (GICs) began pulling their deposits on solvency worries.

Shares of competing firms Equitable Group Inc. (TSX:EQB) and First National Financial Corp. (TSX:FN) have both declined substantially since late April in spite of no bad news coming from either camp.

One potential reason for the pullback is the perception from investors in regard to the ability of each lender to finance the mortgage lending — the core business. Although the challenge of Home Capital Group was brought on by the company’s management, the result is the market is weighing this challenge very heavily across the board.

Having experienced a decline from over $60 per share to under $45 in fewer than 10 days, shares of Equitable Group are now trading at substantially less than the tangible book value per share of approximately $59. Tangible book value per share is measured as (assets – liabilities – goodwill) / shares outstanding.

The next major competitor, First National, saw shares decline significantly less. Shares slid from over $26 per share to under $23 over the same period. The tangible book value of this company is approximately $8.85 per share which is much less than the current share price. Clearly, the benchmark of tangible book value is less important to this competitor.

What may separate the valuations of both companies is the dividend yield. For shares of Equitable Group, the dividend yield is approximately 2% with a fiscal 2016 payout ratio of less than 10%.

Shares of First National, which now yield close to 7.5%, carry a payout ratio of 50% of earnings for 2016. For the first quarter of 2017, the payout ratio was 74%. Investors may have some trepidation about the long-term sustainability of this dividend. Assuming cash becomes scarce, the first thing to be put on hold would be the dividend.

The lesson for investors may be twofold. The first thing to note is just what happens to any business which is dependent on deposits to maintain daily operations. Major Canadian banks could easily restrict or stop deposits from going into any issuer. This is what has happened with Home Capital Group over the past fortnight. Shares tumbled.

The second lesson to be learned by investors is how the market can sometimes group companies together. Arguably the funding issues faced by Home Capital Group were caused by the OSC investigation and not the fundamentals of the business. Investors will have to make the decision for themselves before investing into any of the players in this space, no matter how much value is offered in the share price.

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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