Home Capital’s rejected bid sends bullish signal for beleaguered housing market

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Canadian financial stocks are struggling this year as investors fret over the health of the housing market. But the bid for Home Capital Group Inc. HCG-T, a mortgage lender, suggests that at least one sophisticated investor thinks that the downside risk has been priced in.

That may offer a bullish signal for investing in the stocks of other lenders, too.

“If you wait for all the macroeconomic stars to align, then it will probably be too late from a valuation perspective,” Robert Gill, portfolio manager at Goodreid Investment Counsel, said in an interview.

The bid for Home Capital, which the company rejected on Monday, was made amid a rough stretch for financial stocks as investors weigh the threat of soaring inflation and aggressive central-bank rate hikes.

The diversified S&P/TSX Financials index is down nearly 13 per cent from its recent high in early February.

Financial firms that lend money have been struggling even more. The biggest banks have fallen about 15 per cent, on average, over this six-month period.

The share price of Home Capital, which specializes in underwriting mortgages for homebuyers with spotty credit histories, fell about 47 per cent from its recent high in November to its low in July.

The fear underpinning this dismal performance?

Since rising interest rates are driving up mortgage rates, home ownership may be falling out of reach for more Canadians and potentially slowing mortgage underwriting activity. A recession could turn a bad situation worse, and drive delinquency rates higher as monthly mortgage payments rise.

Home sales are already slumping: The number of sales fell 5.3 per cent in July, from June, on a seasonally adjusted basis. Sales are down 29.3 per cent from a year ago.

But this challenging backdrop makes Monday’s bid for Home Capital interesting for investors wondering if financial stocks are already reflecting the dismal outlook and may be set to rebound.

Little is known about the takeover offer, including who made it. But given that it is reportedly an all-cash bid for the entire company – Home Capital is valued at more than $1.2-billion, based on the total of outstanding shares – it likely comes from a well-heeled investor.

Jaeme Gloyn, an analyst at National Bank Financial, listed several potential suspects.

One is Fairstone Bank of Canada (formerly Duo Bank), which is owned by Canadian mortgage entrepreneur Stephen Smith, New York-based private investment firm Centerbridge Partners and the Ontario Teachers’ Pension Plan.

Other potential buyers, according to Mr. Gloyn, may include Onex Corp., Brookfield Asset Management Inc. and La Trobe Financial, an Australian non-bank lender.

These names share an important link: They are all sophisticated players with deep knowledge of financial markets, and they may recognize a deal here.

With Home Capital’s share price down sharply over the past nine months, the stock’s valuation is low.

In mid-July, Phil Hardie, an analyst at Bank of Nova Scotia, estimated the stock’s price-to-book ratio at just 0.66, down from a recent high of about 1. The stock traded then at just 4.3 times his estimated earnings per share for 2023, down from a price-to-earnings ratio of about 9 in November.

Even after the stock’s gains on Monday, it remains cheap. And though Home Capital has been beaten up more than other lenders, valuations have fallen elsewhere, too.

The average P/E ratio for the biggest banks has slumped to 8.5, according to RBC Dominion Securities analyst Darko Mihelic. That’s significantly lower than the 15-year average of 10.8.

“We view valuations as attractive,” Mr. Mihelic said in a note this week, adding that the current average price-to-book ratio of 1.6 suggests that the banking group is already reflecting a shallow recession.

There are still compelling reasons to remain cautious toward the financial sector. Valuations could fall more if stocks reflect a deeper recession. And the Canadian housing market remains highly uncertain as rates rise.

But the bid for Home Capital suggests that bargain hunters are stepping in. What’s more, the company’s rejection suggests that Home Capital’s board of directors also believes that the current share price is too low.

“The volatility that these stocks are experiencing right now presents an opportunity for sophisticated long-term investors who can look beyond this pullback,” Mr. Gill said.

No, the interest in Home Capital doesn’t mark a turning point in the economy. But it could be an encouraging sign for investors willing to make a contrarian bet.

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