You can hardly turn on the television lately without being bombarded by commercials for companies willing to lend you money. "If your bank says no, we'll say yes" is one familiar refrain.
To some, the growing number of consumers who are carrying high-rate debt and have limited resources to service it is cause for alarm. But for the specialty finance companies that help overtaxed consumers with "less than perfect credit" to consolidate their debt through home-equity loans, it's a $100 billion business. With earnings growth in excess of 20% a year and with price-earnings ratios that average a modest 12.1 for the industry, based on 1997 earnings--compared with the stock market's average of 18--specialty finance stocks are an interesting investment play.
SHUNNED. Indeed, for most of 1996, these stocks have significantly outperformed the market. The best-known home-equity lender, the Money Store, is up 75% in 1996 so far. However, an annual ritual known as "window dressing" has caused the share prices to drop recently. Since October, fund managers have been selling stakes in these types of high-growth companies to make their holdings appear more conservative for yearend reporting. The good news is that this "institutional behavior pattern creates a buying opportunity for the individual investor," says John Bailey, a vice-president at Friedman, Billings, Ramsey & Co., an investment bank in Arlington, Va.
Despite at least a dozen initial public offerings in the sector during the past year, the party is hardly over. These companies should continue to benefit from their ability to target a market that is shunned by traditional banks. For example, United Companies Financial claims to serve the "80% of the people who have only 20% of the assets." So while the roughly 8,000 U.S. banks and 1,500 thrifts target a small but wealthy slice of the population, the 15 publicly traded home-equity finance companies and the private ones, such as Champion Mortgage, lend to the remaining borrowers referred to as subprime.
Until the advent of securitization for such higher-risk loans in 1992, the growth of these companies was constrained. Securitization enabled alternative lenders to replenish their capital by selling large quantities of loans repackaged as asset-backed securities, explains Michael Diana, a Bear Stearns managing director. And that easier access to capital has meant rapid growth.
But because nonbank financing is a relatively new and poorly understood business, the stocks can be wildly volatile. "The prices can go up or down 20% in a week," says Rob Schwartzberg, a senior vice-president at Friedman, Billings, Ramsey. "When the Money Store reported higher-than-expected delinquencies in October, 1995, the whole group dropped in sympathy." In the long term, these stocks are cyclical, so they may be hurt by a faltering economy or a decline in credit quality.
Yet many analysts contend that housing-related specialty finance companies are actually less risky than their clientele indicates. "Just because they are lending to high-risk credits doesn't mean it is a high-risk business," Diana argues. Unlike conventional mortgages, these loans are secured by a house worth much more than the borrowed amount. And while a substantial number of bank customers refinance when rates drop, subprime borrowers have fewer refinancing alternatives. That means earnings are less rate-sensitive than those of traditional banks, which trade at comparable multiples, says Lehman Brothers analyst Michael Millman.
The recent explosion of new specialty finance companies means investors need to be selective. As with any financial stock, credit quality is paramount. The companies best able to manage credit risk are those with consistent earnings growth, Diana says. So it's a good idea to focus on those with a strong franchise or brand name and a diversified product line that may include home improvement lending or credit insurance.
BRIGHT FUTURE. Green Tree Financial, whose primary business is manufactured-housing lending, exemplifies the type of high-quality finance company advisers recommend. With one of the longest track records and best balance sheets in its class, Green Tree consistently beats its earnings estimates. Currently, the stock is trading around $39 per share, an increase of around 48% since Jan. 1, and it has a p-e ratio of 13.3. Its diverse product mix portends continued strong growth, according to analysts.
Indeed, the outlook for the industry as a whole is positive as the market expands, and future consolidation appears likely. Many of the smaller companies will benefit from takeover attempts by banks looking to get back some of the business they have ceded to specialty finance companies.
Sure, investing in companies that focus on high-risk customers that no one else wants may not sound like a very good formula for success. But the way debt has been rising in the U.S., the best of these companies should continue to prosper for a long time.