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Is This Stock a Deep-Value Opportunity Poised to Outperform the Market?

The shares of beaten-down alternative mortgage lender Home Capital Group Inc. (TSX:HCG) continue to languish and are down by 14% for the year to date, despite its liquidity crisis ending and Warren Buffett’s significant investment. This has led to some pundits claiming that the mortgage lender is now a deeply undervalued investment opportunity. 

Now what?

Most of the claims that state Home Capital is significantly undervalued are focused on the lender’s book value, which, at the end of 2017, came to $22.60 per share. This is a massive 56% higher than its last traded price of $14.50, indicating that there could be considerable upside on offer for risk-tolerant investors.

Nonetheless, while a stock trading at a sharp discount to its book value could be undervalued, it can also be an indication that something is amiss with the company.

While Home Capital has seen its financial position improve significantly since the liquidity crisis, its financial strength is weaker than what it was at the end of 2016. For 2017, the alternative lender’s risk-weighted assets, a key measure of financial strength, were 24% lower than a year earlier. That has the potential to curtail its lending activities and hence its plans to rebuild its loan book.

The impact of the crisis on Home Capital’s lending operations becomes clear when it is considered that mortgages advances in 2017 were almost half of what they were in 2016. This, along with the significant costs incurred to avert the liquidity crisis and the lender’s collapse, has had a marked impact on earnings. Net interest income for 2017 was almost 38% lower, and net income plummeted to $7.5 million — more than 30 times lower than 2016.

There are signs, however, that Home Capital’s liquidity is improving. On-demand deposits by the end of the fourth quarter 2017 were up by 22% quarter over quarter to $539 million, although time deposits were down by 10% to $11.6 billion. Home Capital was more than adequately capitalized at the end of 2017 with a common equity tier-one capital ratio of 23.17%, which was more than 6% higher than the end of 2016. That ratio is also roughly more than double many of Canada’s major banks.

Meanwhile, the quality of the mortgage lender’s loan book remains high. Net non-performing loans as a percentage of gross loans at the end of 2017 were a mere 0.3%, while net loan write-offs only came to 0.6%.

These aren’t the only figures that indicate that the degree of risk attached to Home Capital’s loan book is low. The alternative lender also has 24% of its mortgages insured, and the portion of its loans that are uninsured have a low loan-to-valuation ratio of 69%, indicating that there is plenty of wiggle room should Canada’s heavily indebted households suffer from an economic downturn.

The key to understanding if Home Capital is significantly undervalued is whether or not there will be sufficient demand for its mortgages. Canada’s housing market has cooled significantly over the last year, as the government and regulators took steps to prevent a property bubble from forming, including tightening underwriting standards.

Data from the Canadian Real Estate Association showed that February 2018 home sales had declined by 6.5% compared to the previous month, and that the national average sale price had fallen by 5% year over year.

That, however, should be a boon for alternative mortgage lenders like Home Capital. Mortgage brokers claim that there has been a 20% decline in mortgages being accepted by mainstream lenders since the new regulations came into force.

So what?

There is a long way to go before Home Capital can convince the market that it has turned its business around. The numbers, along with a regulatory investigation and lawsuit being resolved, show that the worst is over for the lender. There are also signs that its operational performance should continue to improve.

Legendary investor Warren Buffett, who owns roughly 20% of Home Capital, made his investment because he was confident of the opportunities that exist in Canada’s alternative mortgage market. While he is not infallible, he has a long history of making sound investments, even in distressed businesses that have delivered solid returns.

For these reasons, now is the time for risk-tolerant investors to consider obtaining exposure to the alternative mortgage lender.

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

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