Friday, March 17, 2006

A tale of two cities (stocks): Value Investing

Perhaps I should subtitle this posting: why it pays to be a so-called Value Investor.

"Value Investing" isn't about trying to find a cheap used cigar, as it has sometimes been put. It's about trying to find a stock that seems economically-priced, relative to it's own earnings/balance sheet/revenue, i.e. its own prospects, and that also seems cheaply priced by the market, relative to competitors and even the broader market.

Companies that perform very well often become stocks that are 'priced for perfection', and hence subject to a fall. Which brings me to today's tale. About three years ago, I talked to several of my friends and colleagues about sub-prime mortgage lender Home Capital Group, on the TSX exchange as "HCG". I just loved the prospects of that stock; growing it's earnings at about 30-40% annually, and a PE ratio of about 15 or so. Great balance sheet, very low defaults - believe me, there wasn't much not to love. I bought a bunch and was quite happy with my gains as they unfolded.

However, I later sold out of the stock - it was still a great company, but it's PE kept expanding faster than it's earnings to the point where it was priced (at one point), at a PE of about 30 or so. In pretty short order, it went from $15 to nearly $40.

Readers here know that I generally don't like stocks with mind-bending PE ratios, and so I sold out my shares. With some of the proceeds I invested into a similar situation, the sub-prime lender, Xceed Mortgage Corporation (XMC). A very nice PE, below 10, similar very high earnings growth rate to HCG; not much not to like. It's gone from $4.50 or so, to recently over $10. And with a modest PE expansion to about 13.

Which brings me to Tuesday's news relating to Home Capital - they warned that earnings growth was slowing, but felt they may be able to make their long-time annual target of 20% EPS growth. And now why I don't like stocks "priced to perfection" - over the past two days, Home Capital has lost 23% of it's value, bringing it's PE down from 23 to 17.

Xceed? Well, the stock "fell in sympathy" as they say, but only by 7%. And the major reason for that is the much more reasonable PE - 13 or so. So the PE fell to just under 12. I'm sure that whatever the situation is as it unfolds for Xceed and Home Capital, and others in the sub-prime lending group, that my investment is better protected in the "value investment".

Value Investing: not just your father's investing!


The Confused Capitalist

No comments: