We’re back with 3 more new stock ideas. Surprisingly, in a year marked by tech names drawing down by 60-90%, our managers in this issue are finding value in a much simpler industry: financial services. Could we be in the midst of a period similar to the early 2000s where tech underperforms for years until the scar tissue subsides?
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Let’s get to the pitches.
After years of strong gains, used car pricing finally rolled over. Merion Road Capital sorted through the wreckage and found value in America’s Car-Mart (CRMT), a subprime-focused used auto dealer (shares down ~40% YTD).
During the quarter I initiated a position in America’s Car-Mart (“CRMT”). CRMT is a used auto retailer and financing company serving low-end consumers. Given their focus on rural areas with limited public transportation, CRMT offers an essential service – a way for poor credit quality customers to get to work. As you might expect, loan charge-offs have averaged 25% annually and typically occur when a customer loses their job or the car breaks down. To offset this risk, CRMT charges a hefty 16% annual rate.
You might wonder why I would buy this given the economic sensitivity of the low-end consumer and falling auto prices. Should unemployment pick-up we will likely see increasing loss incidence rates. And with falling auto prices it would be logical to assume that their upfront margins would compress and loss recovery rates would fall.
Over the past two decades CRMT loss reserves peaked two times to the 32-35% range. In both of these periods CRMT loss expenses exceeded actual charge-offs of 30-33% as the company had to increase their balance sheet reserves. The good news is that, today, balance sheet reserves are already at the high end 3 of the range at 22.4%. Even considering those previous catch-ups, CRMT has been profitable in every year over this time frame. Of course, it is entirely possible that we enter another period of high charge-offs. But these are relatively short-term loans (42 months on average) where the majority of defaults occur within the first twelve months. Given the quick turnaround, CRMT has the opportunity to adjust its underwriting standards in real time. As of last quarter loan’s delinquent 30 days or more stood at 3.6%, slightly below the long-term average. Furthermore, in April of this year the company financed half of their loans via a non-recourse securitization. Not only does this diversify their funding sources, but it also helps ringfence some risks to the enterprise.
Regarding used auto prices, deflation is not necessarily bad for the company. CRMT’s customer is extremely price sensitive. Given the recent lack of supply and run-up in prices, CRMT took the strategic decision to sacrifice on upfront margin to get people on the road. Additionally, some customers were simply priced out of the market. While it is possible that falling prices will hurt near-term margins as the company works through old inventory, long-term lower prices are preferable.
CRMT has a strong history of creating shareholder wealth through organic growth and capital returns. This is no surprise as management and directors own 12% of the company. Over the last decade they have shrunk shares outstanding by 32% while increasing tangible book value by 150% (tangible book value per share has increased 270%). Their unique approach to auto sales and loan generation has allowed the company to generate ROEs in the mid-teens. We can buy this company today at just 0.85x TBV (i.e. 17% “normalized” annual returns exclusive of multiple expansion), an attractive entry point when we look out beyond the immediate term.
Heartland Advisors purchased cheap-for-a-reason Texas Capital Bancshares (TCBI). Can a new CEO, brought in from JP Morgan, fix the problems and get the shares to re-rate?
We do not force deep value exposure into the portfolio, preferring instead to identify self-help opportunities and act when progress is evident and headwinds are clearing. One such example is Texas Capital Bancshares (TCBI), a Dallas-based middle market commercial lender with a particular focus on the four major Texas markets of Dallas-Fort Worth, Houston, San Antonio, and Austin.
We initiated a position in the third quarter because the company could be on the verge of improving its returns and market perception. TCBI is a classic self-help story: Prior management ran the bank as a “growth at all cost” institution. When the bank was small and interest rates were at historic lows, it was easy to sustain growth by booking new loans and growing deposits regardless of the quality of either relationship. Credit problems began to percolate after the company downgraded several levered loan credits in 2019.
As the bank grew and approached a critical asset level that triggered a greater degree of regulatory burden, management engaged in a merger-of-equals between TCBI and another Texas-based bank, Independent Bank Group. While the merger was pending, the pandemic struck and the deal was called off exposing, Texas Capital’s problems to the market.
Last year, a new CEO was brought in from J.P. Morgan Chase. He quickly exited risky loans and reoriented TCBI as a local Texas commercial lender with a niche focus on deep customer relationships. The stock trades at around 1.1 times tangible book value, compared to 1.8 times for regional banks in general. While its return on assets is below the average for its peers, in our opinion, over time TCBI will close the return gap with valuations likely to follow suit.
We finish with another car-related pitch, this one from Moon Capital Management. During the quarter, they initiated a position in Ally Financial (ALLY), an auto lender spun out from GM that is transitioning into a full-service digital bank.
We recently purchased shares of Ally Financial (ALLY), the world’s largest digital-only bank. Ally’s legacy dates back more than 100 years when it was originally launched as GMAC, the in-house financing arm of General Motors. The company was spun out from GM and rebranded as Ally more than a decade ago, but has retained an automotive focus on the lending side, where it holds the largest position in prime auto lending.
Since the spinoff, Ally has transformed from an auto loan company into a comprehensive, independent finance provider for borrowers and savers of all types. The company has completely restructured the liability side of its balance sheet and has created a deposit-gathering engine that is now more than 85 percent depositfunded. (Compared to issuing traditional corporate debt, deposits are a significantly less expensive capital source for banks.)
Due to the lower overhead associated with the digital bank’s lack of brick-and-mortar locations, the bank produces one of the best efficiency ratios in the industry. This low-cost position, combined with a relatively high loan portfolio yield of approximately 6.75 percent, has helped the company earn net interest margins well above those of many leading banks. These high margins translate into high returns on equity, which the company targets at 16-18 percent over the medium term. (Actual ROE in 2021 was 24 percent. When the company came public in 2014, its ROE was a paltry four percent.)
Compared to a selected group of financial firms, the only institution with a better ROE is Synchrony Financial (SYF) – a stock we already own.
Ally’s management team is taking advantage of its attractive share price. Since the inception of its buyback program, the company has repurchased more than 35 percent of its outstanding shares. The company has also increased its dividend by more than 300 percent over that same timeframe. At current prices, the company is set to repurchase more than 15 percent of its outstanding shares in this year alone.
At Ally’s current tangible book value per share of $35, a normalized ROE of 16 percent generates earnings of roughly $5.60 per share, or less than six times the current trading price. The stock trades for less than its tangible book value – an incredible bargain for a bank that earns a mid-teen ROE and is rapidly growing its deposit base.
Until next time! - EP