Monday, July 13, 2009

Diamonds In The Mortgage Rough

Companies offering mortgages or related products are currently out of favour in the stock market, and often with good reason. Many companies spent the last few years borrowing money, and then lending it out carelessly, expecting to make profits on the spread resulting in high returns on minimal equity. When customers couldn't afford to pay back thanks to the downturn, the borrowed money remained due, resulting in strong chances of default for the lender. But not all mortgage companies find themselves in such high risk positions, but you wouldn't know it from their stock prices. Consider Quest Capital (QCC), a real-estate mortgage financier.

The company is owed $386 million from borrowers, all of which is secured by real-estate or corporate/personal guarantees. Based on the value of the underlying real-estate and the quality of these guarantees, the company estimates that it will recover $370 million of these outstanding loans. Even if you believe that mangement is not conservative enough with respect to estimating these losses, the losses would have to be 900% higher than management's estimates to justify the stock price of this company, as the stock trades as if the loans due are worth just $240 million.

The reason the value of QCC's loan portfolio can drop so much and still hold value for the equity holders is that extensive use of leverage is not in use. The company is financed with just $46 million of debt and $40 million of pref shares along with common equity of $290 million. But this equity trades on the market for just $120 million.

To reduce the risk of a cash crunch, the company has stopped originating new loans, and it issued the pref shares just six months ago to ensure adequate liquidity. So now the company will focus on collecting its loans receivable and paying down its debts and prefs, which should further reduce risk. For added flexibility, the company was allowed to pay pref shareholder dividends in the form of common stock, and did so for the last two quarters. Perhaps foreboding that the company's cash flow situation is now relatively safe, the company issued the following statement last week:

The Company currently plans to pay cash for any future dividends declared on the Preferred Shares.

Disclosure: Author has a long position in shares of QCC

16 comments:

Anonymous said...

this blog is so awesome man. really fun to read your stuff. please keep it up!

Saj Karsan said...

thanks, anon!

Law student + NCAV investor said...
This comment has been removed by the author.
Law student + NCAV investor said...

I'm a little not-so-impressed with your linking to QCC.. you have a stake in this company.. I guess I respect your views too much to simultaneously see aggressive linking to equities in your own portfolio..

The conflict of interest combined with my appreciation for what you have to say does not make for a very easy reading of this web-site

Law student + NCAV investor said...

oh, the linking I'm referring to is the links you put in your posts that say "there are still some diamonds in the rough"... you will obviously be in a potential to realize profits if your readers buy stocks that you have already purchased, presumably at a lower price... your blogs again are extremely informative and provide good insight, I enjoy them very much and have for several months and will continue to.

Anonymous said...

law student + ncav investor:

conflicts of interest abound in every walk of life......be glad there is someone out there willing to do the work and put up quality posts.....this is WAY better than a broker pitching you a stock at 20x forward earnings because comps are trading at 25x.......as an investor it is your job to make sure you do your home work......i know it is easier said than done as i have myself blindly followed great investors and found the pothole......Bill Ackman gets a lot of respect when he gets on stage and pitches an idea.....what do you think he is doing? Going long (or short) and going loud. No different.

Karsans, keep up the good work.

ted said...

Law student, get a life. If he really thought it was a good idea, good enough to write an article about, why the hell wouldn't he own it?

He offers the idea and his thesis, you do your own DD. You should be saying thank you thank you thank you.

And I am- thanks for the idea, I'll look into it, I think it has promise!

Law student + NCAV investor said...

I like the ideas very much.. there is a reason Morningstar analysts are prohibited from owning positions in stocks they cover..

I think its important to be overly critical of any argument for a position when the arguer has a financial interest in that position..

I'm not sure why this is being rude or abnoxious, its just being overly cautious..

There is genuine and significant short-term profit potential for marketing a micro-cap stock with a prior position at a very low price.. I'm sorry if I was rude in my posting.

Law student + NCAV investor said...

Maybe I forgot to give Saj Karsan credit.. this web-site has been absolutely wonderful, and I have no doubt that there will be TENS of thousands of subscribers before you know it.. I also know that Saj Karsan will be tremendously successful in his fund, although I cannot invest in it despite wanting to because I live in the wrong side of the US Canada border..

It's obvious that he's got a strong fan following around here, and I didn't mean to rub anyone the wrong way.. my whole point is this - it is very important, absolutely critical, to always keep in mind the other party's position, in particular when you are intellectually processing an argument or hypothesis they forward.. again - I AM SORRY if I was too rude, or didn't give this blog enough credit..

Saj Karsan said...

Hi Law,

No offence taken whatsoever. As you and the other commenters stated, it's important for all readers to do their due diligence. It's also something I've promoted explicitly myself (example here) but obviously I can't write that in every article or it would be a bit much for frequent visitors.

Regarding the links within articles to other articles, I would find that a bit weird too if I was a reader, but there is a very specific reason for that. I grant permission to site aggregators (like Seeking Alpha) to display my content on their site, in order to attract new readers to this site. But only when I include links within my article back to this site do I see meaningful traffic coming back from these aggregator sites. If you look at my articles in general, you will find links in almost all of them, but only a handful are to stocks I own, because I'm trying to provide value to the readers of the aggregators so that they are more likely to become readers of this site.

Hope that makes sense!

-Saj

Aaron Stackhouse said...

I think this is a very interesting idea, but I also have a couple of questions that I would be curious to hear your perspective on.

1) How confident are you that their allowances for bad loans are reasonable? Has the Canadian real estate market suffered as much as the US? I did a quick search and didn't find any statistics but it sounds like it had a rough couple of years.

2) Their loan portfolio is carried on the books at amortized cost, but I think for investment purposes we are more interested in the VALUE of their loan portfolio. Yes, it would be nice to get all of the principal back, but if the interest rates on those loans are below market rates we wouldn't want to pay amortized cost for them. From their latest 40-F filing with the SEC, most of their loans are fixed rate:

"As at December 31, 2008, the Company had 7 variable rate loans priced off the bank prime rate with an aggregate principal of $50.2 million and 50 fixed-rate loans with an aggregate principal of $337.4 million"

Also in the 40-F, they list their estimate of the fair value of their loan portfolio at $372M as compared to the book value (before allowances) of $374M. It seems a little odd that the fair value of a predominantly fixed-rate portfolio is that close to cost given what interest rates and risk premiums have done over the last couple of years. NOT insinuating that it is wrong but it does make me want to look a little deeper...

The fair value section is accompanied by the language below.

"The fair values of loans reflects changes in the general level of interest rates that have occurred since the loans were originated, net of any allowances for loan losses. These instruments lack an available trading market and are not typically exchanged. They have been valued assuming they will not be sold. The fair values are not necessarily representative of the amounts realizable in an immediate settlement of the instrument."

I have to admit I haven't read similar language for other lenders. Is this standard or are they being overly "hands-off" in their valuation? How hard can it be to value bank loans? Even if they aren't traded, market rates for loans are readily available, all you need to do is discount the cash flows back...

On the positive side, it looks like most of their loans are short-term so at least if they are below market they aren't locked in for too long, which might explain their fair value as well...

3) Finally, I believe the 386 Million principal of loans is in Canadian Dollars - which at today's rate (.908 US$ per C$) is about 350 MM US, which eats into the equity value a little.



Maybe it is all a moot point since the equity value seems to have a large margin of safety built in.

Love the website and would love to hear your thoughts.

Aaron

Saj Karsan said...

Hi Aaron,

Unfortunately, it's hard to say whether their allowances are reasonable. The Canadian real estate market has not suffered as much as has the US market, but it is not robust by any means.

I agree with you that the short-term time frame of the payments due may be contributing to the fact that the fair value of the loans is not materially different than their carrying values.

If you are buying the US-listed security, yes you are correct that you have to adjust for the fact that the company's portfolio is in CAD.

Good luck with your analysis!

Anonymous said...

any update on this?!

Anonymous said...

+24% as of 10/2/09 since the OP! how's that for an update lol

Saj Karsan said...

Hi Anon,

I've written more about this company here: http://www.barelkarsan.com/2009/10/interim-updates.html

tscott said...

I was a tiny bit surprised by the increase in reserves for Q4, but they have tons of cash monetizing in the future. $40-50m in the next 6-8 months, good news for the buyback! lets see that discount narrow.

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