Gerry Soloway has just discovered the downside of popularity.
They sing folk songs in the mountains about the man, and why not? You would, too, if you'd been shrewd enough to buy Home Capital Group when it was just a pimple on the banks' posterior. A $1,000 investment in the mortgage company on March 1, 1996, would be worth $129,000 now.
The only problem is that people expect more of the same, and will cut your stock loose if you so much as pause in your ascent. Home Capital warned Tuesday that pretax profit this quarter will likely come up about $5-million short of last quarter's. Since then, the stock has fallen 17.5 per cent.
So the focus is back on Home Capital's multiple, the subject of much debate among Bay Street types. This is an expensive stock. Before the selloff, it traded at more than six times book value (or shareholders' equity). Now it's 5.2 times, quite a bit higher than every big Canadian bank, every life insurer and, for that matter, most other companies on the TSX. But then, some have argued for years that it's overpriced, and the stock continued to go up, up, up. Will it be different this time?
Any analysis of financial stocks begins with return on equity (ROE), and on this score Home Capital is a rare beast: a company that grows quickly, reinvests most of its earnings, and still produces rising returns. The company's ROE has gone up every year since Stephen Harper was a Preston Manning clone in short pants, and was 32 per cent last year. Amazing.
Mr. Soloway deserves a lot of credit for this, though he had plenty of help. Falling interest rates brought out the home buyers and allowed Home Capital to book larger gains when it sold pools of mortgages to investors. But interest rates have turned, and those mortgage securitizations aren't as profitable as they used to be, the biggest cause of Tuesday's warning.
More important, management expects this will continue. Home Capital's target is still 20-per-cent earnings growth, but "we're going to have to run like hell" to get there, Mr. Soloway said. Run, Gerry, run, because your stock price depends on it.
Let's say Home Capital manages to grow 20 per cent this year and next. In each year, it keeps 90 per cent of its profits, using the rest to pay its modest dividend. That would bring Home Capital's book value to $10.70 a share by the end of 2007, and ROE comes in at 27 per cent. That would be impressive, and barring a negative turn in investor sentiment toward financial stocks, ought to be enough to keep Home Capital's price-to-book multiple where it is now. Share price: about $53.50, or $20 higher than it is now. Gerry Soloway is awarded the Order of Canada.
Now watch what happens if the growth rate in profits falls to, say, 10 per cent. (That may seem implausible today -- but it's not unthinkable if rates keep climbing and there's a correction in real estate prices in Ontario, where most of Home Capital's customers are.) Book value rises, and ROE remains very strong, at nearly 24 per cent.
By any standard, that would still be a great performance -- just not great enough to keep the stock going higher. What's a 24-per-cent ROE worth? Great-West Lifeco earned a 21-per-cent return on equity last year and trades at three times book. Applying a slightly higher multiple to Home Capital gets you a stock price in the $33 or $35 range at the end of 2007. The current price is $33.45.
So there's a wide range of possible outcomes, but not a lot of room for error. Home Capital has lived with little competition from the banks, but there are signs they are warming up to the riskier customers that Home Capital lives on. Toronto-Dominion bought VFC, which sells auto loans to people who've been rejected elsewhere, and Bank of Nova Scotia bought Maple Trust, a mortgage provider.
Their reasons are clear. All the large Canadian banks have more capital than they need and few places to spend it. They see the high returns that companies like Home Capital are making. It will take them years to catch up, and investors are still giving Mr. Soloway the benefit of the doubt, because he has earned it. But the high multiple ensures they will be merciless if his company stumbles again.
© The Globe and Mail
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