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1 Cheap Financial Stock With Risks

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Home Capital Group Inc. (TSX:HCG) is possibly one of the most divisive names on the TSX. People either love the company or hate it since its profitability is heavily tied to the success of the Canadian housing market and the Canadian consumer. For those who love the housing market and believe that Canada is going to keep growing, Home Capital remains an undervalued opportunity. For those who believe the housing market is on the verge of collapse, this company is a high-profile target.

This was certainly underscored with the company’s fall from grace in the spring of 2017. Short sellers leaped on the company, driving its stock price into the mid-single digits from the thirty dollar range in short order. In a sense, it is an example of the pent-up belief that the Canadian housing market is overpriced. With the very real threat of collapse, Home Capital saw its deposits dry up in a hurry. It was a run on the bank the likes of which is rarely seen today.

The interesting thing about Home Capital is the fact that it now sits at a crossroads. Depending on your opinion of the state of the Canadian economy, this company could either be poised to rise or fall. An argument could be made for either scenario.

Home Capital is cheap at the moment; that is not in doubt. Even after having a sharp rise in its share price following its Q3 earnings, the company is still only trading at a price to earnings multiple of 11 times trailing earnings and a price to book of 0.7. This is exceedingly cheaper than any of the large Canadian banks.

The stock’s cheapness also points to the fact that Home Capital has improved its profitability considerably since the collapse in its share price. Net income increased by 8.7% over the previous year, indicating a step in the right direction. Earnings per share increased by 37% over the same period. Revenue also increased a solid 10.2%.  If you are a value investor, these results could indicate a strong turnaround point.

Loan growth increased healthily over the same period the year before, with single-family loan originations increasing by 7% and commercial loans by a significant 49.5%. Even so, investors concerned with the Canadian residential housing market should be cautious, as single-family loans represented more than half of Home Capital’s total originations. It is possible that a downturn in the housing market would impact the company significantly. On the other hand, the company’s growing commercial loan book will most likely add stability to its portfolio.

Unfortunately, Home Capital does not currently pay a dividend. But while dropping the dividend might be a negative for many investors, it was probably the right move. Slashing the dividend allowed the company to conserve capital at a critical point. But for many dividend investors, getting rid of the dividend eliminated one of the main reasons for owning the stock.

Probably the biggest risk to the company is the continued stability of the Canadian, especially the Ontario housing market. Even with its growing commercial loan book, 90% of its on-balance sheet mortgages are single-family residential. Out of that percentage, 80% of its single-family residential mortgages are from Ontario. One thing is certain: If you want to invest in Home Capital, you had better be fully confident that the Canadian and especially the Ontario economy is going to remain in good shape for a long time.

With Home Capital, you need to know what you are getting into. It has the potential for serious gains, as it is very cheap and has made excellent inroads financially. After all, Warren Buffet didn’t invest in this company on a whim. But its success is tied to the success of the Canadian economy. This is a leveraged bet on the ability of Canadians to keep paying their massive mortgages, especially in Ontario. If you’re going to invest in Home Capital, keep the risks firmly in your mind before pulling the trigger.

 

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Fool contributor Kris Knutson has no position in any of the stocks mentioned.

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