I wrote about Home Capital Group (TSX:HCG, Financial) just about a couple months ago following value investor Francis Chou (Trades, Portfolio)'s purchase of a position in the Candian banking stock. I had been also accumulating this stock for some time as I thought the stock was cheap relative to the big six Canadian banks.
Home Capital Group is an alternative lender. It specializes in mortgages for borrowers who have been turned away from the country's big six banks. These would include recent immigrants without an extensive credit history, self-employed individuals and owners of small businesses who do not have regular and verifiable income. Home Capital uses its own proprietary methods to assess credit worthiness in order to extend mortgages. While this may sound risky, its historical default rate is comparable to the big six banks and the company has carved out a niche for itself in the Canadian market. By focusing on this niche, Home Capital is able to charge a higher interest rate to borrowers. The company also offers secured and unsecured consumer credit and credit cards as well as takes in high interest deposits via brokers and its wholly-owned subsidiary, Oaken Financial.
The stock was pretty cheap
Before the announcement of the acquisition, the stock had a price-earnings ratio of below 7 and price-book ratio of 0.72. The bank's return on equity is 11.6%. Its book value has increased at a more than 14% compound annual growth rate over the last 15 years.
The stock has fallen substantially year to date, triggered by the rapid rise in Bank of Canada, overnight rates and mortgage rates which brought the Canadian housing market to a screeching halt after over a decade to torrid price increases. (BoC rates drive mortgage rates).
The company has been buying back stock a furious pace to take advantage of lower prices. The company just concluded a large buyback program where it purchased 1.54 million shares, which is about 4% of its outstanding stock. This is in addition to its previous buyback. The company has been a phenomenal buyer of its own stock, having halved its outstanding shares in the last five years.
About the acquisition
Canadian billionaire Stephen Smith reached an agreement last week to acquire Home Capital Group in a deal that values the alternative mortgage lender at $1.7 billion, placing a major bet that the Canadian mortgage market is undervalued. The cash offer of $44 per share from a subsidiary of Smith Financial Corp., which already owns 9.1 per cent of Home Capital, represents a 63% premium to its latest pre-agreement stock price. Smith plans to take the company private.
The agreement includes a “go-shop period” until Dec. 30 this year, during which Home Capital and its financial advisers can solicit bids and enter into negotiations with other potential buyers. If Home Capital terminates the agreement with Smith Financial to accept a better offer within that period, it will pay a $25 million termination fee. The fee doubles if Home Capital accepts a rival offer more than five days after Dec. 30.
The acquisition would add to Smith’s already substantial stake in Canada’s alternative mortgage industry. In addition to leading First National (TSX:FN, Financial), which is a prominent non-bank originator and servicer, he is chairman of Canada Guaranty Mortgage Insurance Co., one of the country’s largest private mortgage insurers. He is the largest shareholder in Equitable Bank (TSX: EQB), one of the main competitors to Home Capital in “Alt-A” mortgages, and he is chairman and co-owner of Fairstone Bank of Canada, which also offers mortgages among other personal finance products.
The acquisition highlights the value of Home Capital's franchise and the fact that the current downdraft in the home mortgage market in Canada will eventually be over. Demographic imperatives are strongly in the favour of this. There is a manufactured shortage of housing as the large millennial generation enters their family formation years, as homebuilders seek to keep prices going up. In addition, Canada has opened the door for immigration wide and is welcoming over 500,000 immigrants a year. All this creates a tremendous future demand for housing and mortgages. Smith recognizes this and has pounced on the opportunity to grab Home Capital.
Other Canadian banks might also be undervalued
Now that Home Capital has been taken out at such a high premium, it's a good chance to see which other banks in Canada offer good value. The table below lists the Canadian banks along with some important metrics on them:
| Ticker | Company | Market Cap($M) | PE Ratio withoutNRI | PB Ratio | PS Ratio | Equity-to-Asset | ROA % | ROE % | `ROE % Adjusted to Book Value` | Return on Tangible Equity | DividendYield % | CurrentPrice | GrahamNumber | Price-to-Graham-Number |
| TSX:HCG | Home Capital Group Inc | 1,207.22 | 7.12 | 1.66 | 5.92 | 0.07 | 0.81 | 10.49 | 6.32 | 10.94 | 1.06 | 42.55 | 57.44 | 0.74 |
| TSX:LB | Laurentian Bank of Canada | 1,101.01 | 25.08 | 0.58 | 1.46 | 0.06 | 0.15 | 2.53 | 4.36 | 2.94 | 5.24 | 33.99 | 38.96 | 0.87 |
| TSX:EQB | EQB Inc | 1,603.21 | 6.18 | 1.08 | 3.02 | 0.05 | 0.81 | 15.04 | 13.93 | 15.99 | 1.86 | 57.11 | 103.37 | 0.55 |
| TSX:CWB | Canadian Western Bank | 1,823.96 | 6.82 | 0.72 | 2.31 | 0.09 | 0.94 | 9.99 | 13.88 | 11.11 | 4.67 | 26.15 | 52.66 | 0.50 |
| TSX:RY | Royal Bank of Canada | 140,431.77 | 12.27 | 1.94 | 4.16 | 0.06 | 0.89 | 15.65 | 8.07 | 18.46 | 3.68 | 134.69 | 120.10 | 1.12 |
| TSX:TD | The Toronto-Dominion Bank | 123,525.68 | 11.54 | 1.73 | 3.70 | 0.06 | 0.82 | 14.43 | 8.34 | 17.72 | 3.91 | 90.94 | 86.39 | 1.05 |
| TSX:BNS | Bank of Nova Scotia | 63,366.00 | 8.48 | 1.30 | 2.76 | 0.06 | 0.84 | 14.58 | 11.22 | 19.05 | 5.73 | 70.91 | 87.44 | 0.81 |
| TSX:BMO | Bank of Montreal | 67,134.67 | 7.93 | 1.40 | 3.35 | 0.06 | 1.10 | 18.23 | 13.02 | 20.69 | 4.10 | 132.72 | 178.14 | 0.75 |
| TSX:CM | Canadian Imperial Bank of Commerce | 43,878.68 | 9.32 | 1.32 | 2.73 | 0.05 | 0.75 | 13.89 | 10.52 | 16.43 | 5.05 | 64.74 | 79.66 | 0.81 |
| TSX:NA | National Bank of Canada | 24,968.37 | 10 | 1.72 | 3.56 | 0.06 | 0.93 | 17.38 | 10.10 | 20.53 | 3.61 | 99.04 | 103.22 |
Examining the table above, among the smaller banks I like Canadian Western Bank, which is selling at a price-earnings ratio of below 7 and a price-book ratio of well below 1. Return on equity is decent at around 10%. EQB Inc., which is also partially owned by Smith, looks cheap and he may be tempted to take it fully out if the other acquisition proves to be a success and also if the government does not object to the acquisition. Among the big banks, Bank of Montreal and Bank of Nova Scotia look enticing to me as well.
Conclusion
The Home Capital Group deal highlights the value in the Canadian banking sector. Canada's demographics and immigration points to a robust future for the sector. The country is going to need a lot of new housing and mortgages in the future and housing demand and prices will continue to rise in the medium term. The following chart shows the Canadian houing index over the last several decades. Canada has one of the most robust housing market in the world and is a magnet for immigrants who want to make this peaceful and prosperous country their home.
source: tradingeconomics.com
