Francis Chou Buys Home Capital Group

In his semiannual equity portfolio for the six months ended June 30, deep-value guru Francis Chou (Trades, Portfolio) revealed his Chou RRSP Fund (Trades, Portfolio) bought a small position (25000 shares) in banking company Home Capital Group Inc. (TSX:HCG, Financial). This may be a starting position as the stock has fallen further in Q3.

Chou is the founder and president of Toronto-based Chou Associates Management Inc. The guru, who has a CFA designation, ended his formal education at grade 12. While working as a technician for the Bell Phone Company in 1981, he started an investment club that would later become the Associates Fund. He has operated two of the country’s most successful funds, the Chou Associates Fund and the Chou RRSP Fund (Trades, Portfolio), for the last 30 years. In 2004, the Canadian Investment Awards named him the Morningstar Fund Manager of the Decade. His approach is to “find bargains and maintain discipline; if you cannot find bargains, stay in cash.”

Investors should be aware that portfolio updates for mutual funds do not necessarily provide a complete picture of a guru’s holdings. The data is sourced from the quarterly updates on the website of the fund(s) in question. This usually consists of long equity positions in U.S. and foreign stocks. All numbers are as of the quarter’s end only; it is possible the guru may have already made changes to the positions after the quarter ended. However, even this limited data can provide valuable information.

About Home Capital Group

While Canada is known for its "big six" banking oligopoly, it does have a handful of smaller banks that thrive in the niches ignored by the larger players.

Based in Canada, Home Capital Group is an alternative lender, meaning, 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 processes to assess credit worthiness and 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 as well as by its wholly-owned subsidiary, Oaken Financial.

The company's recent history has been quite interesting. In 2017, Home Capital Group experienced a bank run after an almost comical set of mistakes. First, it got into some relatively minor regulatory trouble, which started when the bank discovered some mortgage brokers it was dealing with had falsified income data for some of its borrowers. While the company dealt with that issue, albeit sloppily, and received a regulatory reprimand from the Ontario Securities Comission, it was attacked by a posse of U.S.-based short sellers who managed to stampede depositors into pulling their high-interest deposits by spreading rumours that the company was failing and drawing parallels to the US housing crisis in 2008-09. This panic induced withdrawals exposed the company to a severe funding shortfall between loans and deposits. The stock fell precipitously, as can be seen in the chart below.

As the last minute, Home Capital was rescued by an emergency very high-interest loan from a Ontario pension fund followed by a replacement loan (also high interest) from a unit of Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial). The Berkshire loan was paid off by the end of 2018 when the situation for the company stabilized.

The memory of this bank run still haunts some investors, and given Canada's frothy housing market investors remain on high alert.

Why is Chou buying Home Capital?

A likely reason why Chou is buying the stock is because it is quite cheap relative to other Canadian banks. It has a price to earnings ratio of below 7 and price to book ratio of 0.72. The return on equity is 11.6%, while book value has increased at a more than 14% compound annual growth rate over the last 15 years.

The stock has dropped substantially this year due to slowing in the housing market. In fact, Canadian housing prices have corrected over 10% this year, which has caused investors to fear that borrowers will default. Chou may be betting that this concern is overblown because the company appears to be well capitalized and the Canadian economy is still quite robust. The loan to value for its uninsured mortgages is about 54.9%. This means the housing market has to decline by over 45% for the company to become insolvent. While this is possible, it is a far-fetched scenario and there is no modern history of such a decline.

Another attraction for Chou might be the large buyback program Home Capital has instituted. The company just concluded a 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 is a phenomenal buyer of its own stock, as can be seen in the following table.

Conclusion

Home Capital Group is a well capitalized bank that is quite profitable and buying back shares at a fast pace. Even after the recent buyback the Tier 1 ratio is expected to around 15%. The share price declines over the past year are based on an overblown concern of large future mortgage defaults in Canada. The table below shows the stock is quite cheap compared to its larger peers.