Books on investments usually talk about the importance of buying good companies and sticking with them for the long run. Rarely do they discuss the virtues or the importance of selling a company that may have been good when acquired, but in time either lost its way or the initial thesis under which it was purchased is no longer valid.
At times, selling is considered harder than buying. After working so hard and long on a company, investors sometimes develop a bond to such company and are unwilling to let go. If a stock goes down, it is sometimes even harder to sell as this is akin to admitting one was wrong and by selling, one crystallizes such losses. If a stock goes up, many investors extrapolate the increase into the future, thus fearing they might miss out by selling too soon.
At McLean & Partners, we have a very strict process that requires us to sell or reduce our holdings when either the initial thesis has broken or the current valuation of said company is no longer compelling, thus rendering the risk/reward unfavourable.
Our underweight of the Canadian banks has been well discussed in several of our publications as we believe that at their current valuations the risk/reward is not favourable. However, due to the heavy weight that banks carry in the Canadian benchmark, we will always have some exposure to them, but we will ascertain that we own the best banks with the most compelling valuations. In addition, we will try to supplement our bank exposure with other lenders that generate better returns than the banks, yet trade at relatively more attractive valuations.
The story of Home Capital Group (HCG) is a strong example. Home Capital is a Toronto-based company that engages in providing mortgages to clients who do not qualify for conventional bank mortgages for such reasons as they are immigrants, are self-employed, or have weak credit.
HCG always met most of the criteria in our investment process, namely competitive advantage, stable return on equity, appropriate balance sheet and a proven management team. However, HCG never met our last criterion - valuation - due in part to their large exposure to the Toronto housing market.
In July 2015, the Company announced that some of the brokers that refer clients to the Company did not properly verify income documents. After a lengthy investigation, the Company severed all contacts with these mortgage brokers. Following the announcement, the Company had a conference call in which it detailed how the breach occurred and the measures the Company was taking to ensure that such breaches do not reoccur. The Company warned that these measures will result in slower loan growth.
In addition to this news, the Office of the Superintendent of Financial Institutions (OSFI) imposed two regulations, B-20 and B-21, that require more prudence from mortgage lenders which forced Home Capital to revamp its business model.
Due to these developments, and especially the mortgage brokers issue, the stock deteriorated materially until it became substantially cheaper than the banks. As we felt that the brokers issue was handled properly and the stock’s valuation was compelling, despite the overheated state of the Toronto housing market, we purchased the stock around $31 CAD.
We can’t say that the investment in HCG was smooth sailing (Figure 1). Due to HCG’s heavy concentration in the Toronto market, any news on slowdown in that market or rise in interest rates resulted in a declining stock price. Also, since the Company’s growth was slowing, the Company reduced its ROE target twice. Despite these revisions, the new ROE target was higher than what the banks generate, therefore the price decline improved the risk/reward, so we increased our position and lowered our average cost to $29 CAD.
Figure 1: Home Capital Stock Price Chart
About two months ago, the Company reported its annual results. Following these results, we updated our financial model of the Company. After conducting analysis that included earnings and balance sheet simulations, we concluded that even though the Company reduced its ROE target by 1% now to 15%, a level equivalent to the banks, in a quarter or two it will be forced to reduce it to a level lower than the major banks. At this point we determined that if the Company’s ROE does decline further below the level of the banks, it was no longer compelling for us to hold this investment. We would get less than a bank return yet with a substantially higher risk due to HCG’s clients’ credit profile and, above all, lack of diversification in its lending business. In addition, at that time rumours surfaced that the Ontario government was mulling measures to cool the Toronto housing market. Lastly, the Ontario Securities Commission (OSC) launched an investigation into the Company’s disclosure regarding the mortgage brokers issue. Taking all these developments into account, we determined that our thesis on the stock was now broken, so we exited this investment around $26.50 CAD (recording a loss of 0.24% on the position through our entire holding period).
Over the past two months, several developments have taken place at the Company. Ontario did announce new measures to cool down the Toronto housing market; HCG’s CEO was terminated immediately and a director was put in his place until a new one can be found; HCG’s founder, Mr. Gerry Soloway, announced that he will resign from the board when a replacement is found; the CFO was removed from his position and moved to another non-financial reporting related position; Lastly, the OSC released its findings regarding its allegations surrounding the Company’s disclosures of the mortgage brokers issue.
At this point, depositors started to get nervous and began pulling deposits out of the Company. As trust in the Company and its management eroded, a bank run turned from a concern to reality, leading the Company to seek an emergency loan from a Canadian pension fund on very onerous terms. The result was a 65% decline in the stock price. Since markets are mostly concerned with contagion that will lead to funding problems in the entire banking system, bank stocks declined as well over the same week (Figure 2).
Figure 2: Canadian Banks vs. Home Capital Price-to-Book Ratio
We are still concerned about the health of the Canadian banks. It remains to be seen how this saga will end as the exit of such a large lender from the market can have significant ramifications for the housing market. This could be particularly problematic for Toronto as many borrowers who cannot obtain a mortgage from the major banks will have to either give up purchasing a house, thus reducing demand, or resort to alternative, possibly unregulated financing organizations.
We cannot claim that we sold HCG because we predicted that such a collapse will occur, as we cannot predict such extreme events. We sold the stock due to our belief that the risk/reward was no longer in our favour due to valuation and our assessment that the market’s perception of the management’s quality was higher than what we believed it to be.
In our investing, we always remain humble students of the market and even though we successfully exited this investment with a loss to our Canadian portfolio of only 0.24% (loss of 5.6% on the position) compared to a potential loss of 3% (loss of 73% on the position), this experience will serve as further learning on how strictly adhering to our investment process can protect our clients from significant losses.