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Home Capital Group Inc.

I first purchased shares of Home Capital Group Inc. [HCG Trend] at $41 in June 2015. In hindsight I should have waited another month as the price is now around $32. Over the past week shares have dropped almost 25%. I took this as an opportunity to average down twice. On July 13, 2015 I purchased shares at $36.21 and on July 14, 2015 I purchased more shares at $32.00.

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I tweeted these purchases the day of, so if you are looking for the most up to date portfolio updates follow me on twitter as I typically tweet first and then write the blog post later.

I’m not going to go into a full analysis of Home Capital Group Inc. as I already wrote two articles on the topic: Home Capital Group Dividend Stock Analysis & Bird Poop & Portfolio Update: Home Capital Group Inc. Purchased. Fundamentally I don’t think the company has changed much in the past month, so I took it as an opportunity to buy more shares. Time will tell if it was the right call or not.

So why the sudden drop in price?

The company pre-released second quarter results that were lower than expected. Specifically they provided an update on the Company’s single-family residential mortgage origination volumes that were well below analyst estimates. Here is some information from the Home Capital Group Inc. July 10th news release:

Home Capital’s single-family residential mortgage originations for the second quarter of 2015 were as follows: (a) traditional mortgage originations were $1.29 billion in Q2 2015, as compared to $1.53 billion in Q2 2014 and $0.96 billion in Q1 2015; and (b) Accelerator (insured single-family) residential mortgage originations were $280.0 million for Q2 2015, as compared to $619.6 million in Q2 2014 and $180.0 million in Q1 2015.

The Company does not intend to change its mid-term targets, as stated in the 2015 Q1 report, in light of the developments regarding mortgage origination volumes, reflecting the continued strength of the business and its diverse sources of growth. All other aspects of the business continue to deliver solid results and Home Capital expects to report Q2 diluted earnings per share of $1.03, in line with diluted earnings per share of $1.03 in Q1 2015 and down from diluted earnings per share of $1.05 in Q2 2014.

In the Company’s 2015 first quarter report, Home Capital disclosed that its mortgage originations had been impacted by, among other things, its ongoing review of its business partners, its conservative approach to growing its residential mortgage business and the competitive market for prime insured mortgages.

Home Capital’s ongoing review of its business partners led to the Company terminating relationships with certain mortgage brokers, which caused an immediate drop in originations. In addition, the Company’s continued conservative approach has slowed growth in the Company’s residential mortgage business. These factors, along with the competitive landscape, help explain the lower than expected mortgage originations in the first and second quarters of 2015.

“We are confident that the steps we have taken in the first half of 2015 were necessary to ensure the continued long-term profitability of our business, in spite of the short-term impact on originations,” said Gerald M. Soloway, Chief Executive Officer of Home Capital. “We have already seen a rebound in origination volumes towards the end of the second quarter, and our strong pipeline of mortgage originations gives us confidence that we will achieve our mid-term guidance. I have full faith in the ability of our team and business partners to realize improvements in originations through the rest of 2015.”

Keep in mind that the news release is coming from the company so there will be a natural bias, but there are a few points that I bolded above. In Q2 they are expected to have EPS of $1.03, and the quarterly dividend is $0.22. This means the payout ratio is 21%. They are currently targeting a payout ratio of 19% to 26% so 21% is in the lower end of the range. The company has been announcing multiple dividend increases each year and I wouldn’t be surprised to see another dividend increase announced at the end of the month. When I look at the numbers I can see that there was no growth compared to the last year’s quarter, but the dividend appears fine and it could be increased as the payout ratio is still low. I think the company will get back to growth and other analysts appear to agree, but at what level of growth? The company has reiterated that they do not intend to change their mid-term targets of 8 to 13% earnings growth, but analysts are sceptical that they can meet these targets. RBC has this to say about the company:

“High-growth story historically; now potentially a steady growth story. Long-term investors financially benefited from HCG’s successful growth (since 2000, 25% EPS CAGR and >20% ROE), but that success is making high growth more challenging, particularly given our view that industry mortgage loan growth will slow in the next 2-3 years. We think HCG can still deliver double digit EPS growth, but in the nearterm, growth is likely to be in the low to mid-single digits.

TD had this to say about the company:

“This is the second consecutive quarter of lower-than-expected origination volumes. Although we believe that Home Capital is being prudent by scaling back its risk profile, it does come at the expense of a lower growth outlook. We continue to value the firm’s limited exposure to energy-producing regions, benign credit trends, solid capital levels, and increasing dividend profile. Moreover, the company is awaiting a bank license approval, which could be a slight positive. However, as Home Capital matures, we believe that sustaining portfolio and EPS growth in line with its guidance will be challenging, and we believe that a lower valuation multiple is appropriate. Given the limited total potential return to our $46.00 target price, we are moving to a HOLD rating (from Buy).”

It is the reduced growth estimates that caused a series of downgrades and a large sell-off of the stock. If you look at the bolded part of the RBC quote above you’ll understand why as a long term investor I consider this a buying opportunity. I have a company with a strong dividend growth history that appears able to deliver double digit EPS growth in the long term with a low payout ratio. This should lead to good dividend growth which is what I look for in a stock. In the near term it could be a bumpy ride though.

Currently there is a lot of speculation surrounding this stock and not a lot of facts. Is this just a bad quarter, or is it the beginning of a collapse in the housing market? I think the stock price drop is more related to analysts pricing in lower growth expectations for Home Capital Group Inc. rather than a housing crash. If people were expecting a housing crash then the banks and other mortgage lenders would be coming down significantly in price too. The price drop has been isolated to Home Capital Group Inc. so I think this is specific to the company. The earnings call for the quarter comes at the end of the month and I’m really curious to hear what they say and whether they will announce a dividend increase.

So far I’ve mostly written positive spin on why I purchased more shares, but there are things that make me nervous about this stock. For instance they are the third most shorted stock in Canada right now. This has me a bit worried, what are others seeing that I am missing? I know this stock is shorted by people who are bearish on the Canadian housing market, but the 3rd highest? Another thing that makes me nervous is the concept of catching a falling knife. When a stock drops significantly in a short period of time it tends to continue to drop. Trying to guess a bottom is near impossible. While these make me nervous it wasn’t enough for me not to invest. Time will tell if it was a good decision or not.

What are your thoughts on my recent purchases of Home Capital Group Inc.?

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  1. Hi, Just wondering… You say that this is the third most shorted stock in Canada right now and I;m wondering how you found that out? What are the other two? Thanks

  2. Many short sellers are playing short-term momentum, nothing more insightful. I don’t fear that they have any more information than the general market does.

    The bad news has probably been fully priced into Home Capital. At $32 it could be considered a value stock, especially in light of the favourable comments by analysts. So, HCG is not a short-term prospect for capital gains, it is true, but remains an attractive long-term dividend-growth stock.

    I bought HCG because it had consistently increased dividends since 2004 — a period which I expect included the type of housing slowdown that is concerning some analysts at present. To be sure I wish I was buying at $32 rather than at pre-plunge prices, but if HCG manages to keep up its previous dividend-growth rates, my yield on cost will be 16% in ten years (10% YOC in ten years is my goal).

    Had I bought at $32, my yield on cost would have been 20%. I am happy with 16%, but the onus is on HCG to maintain its historical dividend-growth rates.

    Will the stock do so? Only time will tell. Nothing new here.

  3. I bought HCG 8 days ago because I believed the price is unreasonably down and since then the price drop significantly I’ll have admit I am worried but your report support it my view but it is so hard to see your money losing that fast

  4. http://www.theglobeandmail.com/repor…ticle25715455/

    In above article the Former hedge fund manager said the following:
    Calling Vancouver’s booming real estate market “a mix of money laundering, speculation [and] low interest rates.”
    That was until this summer, when Mr. Cohodes suddenly emerged as one of the most vocal critics of Canada’s housing market. While he no longer runs a hedge fund, he is actively making short bets with his own money. He has made several trips to Canada’s largest cities in the past year, walking the streets early in the morning to count the number of lights on in newly built housing as a way to gauge occupancy rates. The most common criticism of American U.S. investors who bet against Canadian real estate is that they erroneously consider Canada to be a smaller version of what the U.S


    then today in the above article he said the following:

    “I’m not short Canada’s banks, I’m not short the housing market, I’m short Home Capital Group and I have been for a while,” he said. “There are a lot of questions around what happened with their brokers and I think they handled disclosing that information poorly.”

    WOW in 5 days went from short the housing market using his own money to “I’m not short the housing market” he finally understand the CMHC and 10 to 20% down payment unlike the USA in 2008 zero down payment and the mortgage interest payment only

    the only hope for HCG investors is that the issue of what happened with the terminated brokers and how deep any potential problems with Home Capital might be

  5. The problem with the housing market is a reasonable interest rate hike is unsustainable here. People are putting themselves against a hard place and if there is a real recession there is no where to hide. All the country’s money is tied up in over priced real estate. Houses should be 3, 4 or 5x yearly income not 10x. The world financial system is looking pretty shaky – is that the time to take on record debt? Home Capital has always touted their strength being how solid their load approval process was. This latest news shows there may be some cracks in that sales pitch. There are a few too many questions for this to be a long term hold in my portfolio.

  6. @Tom;

    Knowing what we know now, I think I would put buying plans on hold for a while, but I would keep HCG on my watch list.

    The charge that Vancouver houses are being used to launder money seems absurd on the face of it, and I would dismiss that concern absent any specific proof. It is true that a lot of foreign money has come into the Vancouver housing market, but in the main it is Chinese money looking to get out of China. Is that counted as money laundering? If so, then it is benign money laundering that will NOT flee the market the moment interest rates rise. In fact, such money might be considered more reliable than the money invested by “normal” homeowners who over-stretched themselves to buy a house and will have to sell if mortgage rates rise too high.

    For me, the concern about HCG is that those mortgage brokers who falsified income statements to get CHG mortgagees .might have saddled the company with a lot of unstable payers. These might have taken on too-large mortgages, at variable rates to keep the payment down, and will default if / when rates rise. We don;t know that this is true, but it is a concern to investigate. If I had cash to invest, and found that this concern were largely unfounded, I’d invest gladly.

  7. Totally agree that the money laundering angle has little evidence of effect or size. One of the things that attracts me to dividend investing and dividend growth investing in particular is the fact that a company will have a hard time faking it. Even then while I think companies with wide moats are desirable, companies with potential rickety upstream dams tend make me look elsewhere. CMHC for me basically is a more stable version of the sub prime loan game we saw in the states. Banks can offload their risk for loans that they would not ordinarily make. When we see interests rates rise and employment go down it will be a test for that stability. I think the people with 5% down and a fat line of credit will be looking everywhere for help.

  8. Here’s a possible investment strategy — though many aspects remain to be investigated.

    When interest rates DO rise, and some homeowner default, the banks / lenders will foreclose. Those homes will be a buying opportunity. The homes can presumably be rented out to cover the cost of financing, because the purchase price was (will be) so low.

    But where to get the cash? By selling a few dividend growth stocks? Will these maintain their value in the face of rising rates, or will they decline as bonds tend to do, since the present value of their future income stream looks less attractive (i.e. is lower because the discount / interest rate is higher)?

    Has anyone researched this point, or should I do it myself?

  9. Jon:

    Are you directing the question to me?

    I’ve been in the hinterlands for a decade or more. What is a “Dutch Auction”?

  10. My question is directed to DGI&R:

    If you check HCG’s website, there is a corporate action description of the Dutch Auction issued on March 8, 2016.

    My question to DGI&R is:
    After April 15, 2016 (when the Dutch Auction expires), do you plan to buy more HCG if the price drops?

    Any DGI&R response is appreciated.

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