Encouraged by a legion of financial pundits, today’s investor has become a dividend fanatic. If a company pays a generous dividend, investors will overlook the blanching global economy and buy its stock. Otherwise, it will be orphaned, no matter how much money it makes. Investors won’t trust it.
The natural inclination of a chief executive officer is to hold fast to earnings, reinvesting them in the hope of making more money down the road. Some do it well, some are serial value destroyers and the majority are average. (Boards of directors ultimately decide but tend to give management final word.)
One CEO who’s done it very well is Gerald Soloway, the head of Home Capital, (HCG-T47.270.992.14%) which sells mortgages to people who have trouble getting a bank loan. Mr. Soloway has a lot going against him these days. First, he’s technically in the non-prime arena. With the housing recession still top-of-mind, that’s a tough sell. Second, Home Capital pays a paltry dividend that yields 1.7 per cent on the current share price – not enough to get anyone excited.
The upshot? Home Capital is quoted at a pathetic multiple. The stock’s earnings yield – earnings divided by price – is 14 per cent. Bonds yield a small fraction of that. To be sure, that cheap valuation is not only because of the small dividend. Some investors might be worried about these non-prime borrowers getting into financial trouble and missing payments or walking away if house prices plunge.
Both are unlikely. The loan-to-value ratio for these loans is about 70 per cent, meaning home prices could fall 30 per cent before the mortgage is underwater. Also, the borrowers tend to be the self-employed, whose tax returns, which are required to get a bank mortgage, can understate their earning power. They may not pay themselves all of their business’s income every year, for example.
As a lender, it takes highly specialized knowledge to understand their finances, which comes with trial and error. The banks, with their cookie-cutter approach, aren’t particularly interested in acquiring it. Home Capital has more than 30 years’ experience. Mr. Soloway knows what he’s doing, and he earns a nice premium for putting that knowledge to work.
Asked about his company’s small dividend, Mr. Soloway said he can earn excellent returns by keeping the money and lending it out to more borrowers.
The numbers bear him out: Home Capital earns astonishing rates of return on equity. In the past quarter, the company earned 27 per cent on the money entrusted to it by shareholders, or 27 cents in profit for every dollar.
Even at 7.5 times earnings, the current multiple, that means the company’s value goes up more than two bucks for every dollar reinvested, easily passing one of Warren Buffett’s criteria for capital allocation.
If Mr. Soloway gives his investors $1 of dividends (which soon becomes 75 cents after the taxman carves out his share), they will be hard pressed to earn that kind of return.
Home Capital has earned, on average, more than 20 per cent annually on equity for years. It might in fact be a mistake to pay any dividend. Earnings per share have also multiplied, rising 26 per cent in the latest nine-month period.
To play the devil’s advocate, there’s no guarantee that a history of allocating capital properly means a future of doing so. But that’s where judgment comes in: Mr. Soloway has the vast majority of his hard-won wealth tied up in company stock. His company survived the housing recession of the early nineties, barely. Many of his competitors didn’t make it. He’s learned his lessons. That gives investors added security (it’s ironic that the market views the big banks as less risky; yes, they are diversified, but they also have a knack for making huge blunders).
Home Capital is always somewhat cheap. But the stock is being severely marked down right now. I am long because I think investors are ignoring it largely because of a low dividend.
To ignore any stock for that reason is a mistake. Not only do you miss out on bargains, but the fact is, as Sun Life investors are learning, dividends can be costly – when they disappear or it appears they might.
Dividends are important. But there are lots of companies like Home Capital out there. If you don’t absolutely need income, you would do well to find them.
Fabrice Taylor publishes The President's Club investment newsletter, focusing on off-the-radar small to mid-cap companies trading at a discount to net asset value. His letter and The Globe and Mail have a distribution agreement. He can be reached at fabrice.taylor@gmail.com.
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