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5 ways to play the credit shift
Americans are moving away from housing-related borrowing to instruments like credit cards. Here are five companies that'll benefit from this change.
By Jim Jubak
Its just about as certain as death and taxes: The American consumer will keep on borrowing come hell or falling personal incomes, job worries and rising interest rates.
But while the borrowing impulse is constant, the type of borrowing shifts as consumers look for the cheapest credit.
Now that the Federal Reserve has started to raise interest rates again, the borrowing tide is shifting away from mortgages and home equity to credit cards. The stocks that should do best as this trend unfolds are credit card companies that can expand the number of cards in circulation without increasing the bad debt on their books.
For the last four years or so, the cheapest way to borrow has been a home mortgage or a home equity loan. The market value of homes soared, rising to $15.7 trillion in June 2004 from $9.4 trillion at the end of 1998, according to the Federal Reserve. This increase created a huge pool of home equity for consumers to tap into. Falling interest rates, as the Federal Reserve cuts the federal funds rate to 1% in June 2003 from 6.5% in May 2000, made it ever cheaper to borrow against that equity. And the U.S. appetite for goods and services, rising even when incomes didnt, wrote the rest of the story.
Real estate debt -- thats mortgage, home-equity loans and home equity lines of credit -- climbed to $7 trillion this June from a little over $4 trillion at the end of 1998. (That has driven residual home equity, the equity thats left after deducting mortgages and other home loans, to 55% despite the climb in home prices, which continues a 20-year decline from 75%.)
For investors, thats made the stocks of companies specializing in home loans the horse to ride in recent years. From the day after the Federal Reserve raised short-term interest rates to a peak of 6.5% on May 16, 2000, to the day before the Federal Reserve reversed four-years of interest rate cuts and raised rates on June 30, 2004, shares of mortgage lending giant Washington Mutual (WM, news, msgs) soared by 148%. The gain trounced the 58% return by credit card lending giant Capital One (COF, news, msgs) for that period.
Out of one saddle, into another
But it looks like it's time to change horses from mortgage to credit card lenders. You can already see the shift in the performance of Capital One and Washington Mutual since the Federal Reserve started raising interest rates. Since June 30, Washington Mutual is up 4%, but Capital One is up 10%.
Why the shift? Rising short-term interest rates have been slow to push up mortgage and home equity rates but they will eventually. The increase will probably not be enough or rapid enough to choke off the mortgage market or to put much of a dent in home values, but it will slow the pace of mortgage originations and the increase in home values available to back home equity loans. Lehman Brothers, for example, is calling for declining mortgage originations through the end of 2004 and into 2005 and a significant decline in mortgage refinancing.
That will improve the relative competitive position of credit card companies. Consumers have been busy using lower cost home equity loans and lines of credit to pay off higher cost credit card balances. With home equity costs climbing and steady or declining home valuations capping many homeowners ability to borrow more against their homes, credit cards will again become the borrowing tool of choice for many consumers, despite their high interest charges.
The challenge facing the credit card companies is to make sure that these borrowers arent so far in hock on home equity loans and other outstanding debt that theyll default on their new credit card charges. Investors should look for lenders with a history of keeping tight controls on credit quality and with signs of recent improvements in credit quality among outstanding loans.
In my Wednesday appearance on CNBCs "Morning Call" I recommended these three stocks:
Separating good from bad
Capital One cut the number of delinquent accounts so radically in the second quarter that the company was able to reduce its reserves for loan losses and add that money to reported earnings per share. At the end of 2003, 4.5% of total loans were 30 days or more past due, down from 5.6% at the end of 2002. Part of this improvement is due to the companys credit-quality tools, which have built a strong track record of separating good from bad credit risks.
But some of it is due to a conscious shift in company strategy to move its card offerings toward high-quality, higher-average balance products even if that meant a decline in product margins. You can see that strategy at work in the companys overall card and loan numbers: Customer accounts fell to 47 million at the end of 2003 from 47.3 million in 2002, but the loans outstanding climbed to $71 billion from $60 billion.
Capital One shares trade at 12.5 times projected 2004 earnings per share. On Oct. 6, our StockScouter rated the shares an 8 out of a possible 10.
Where size provides an edge
MBNA (KRB, news, msgs) is big. Its the worlds largest independent credit card lender and the leading issuer of affinity cards. And size counts in the credit card industry. Higher costs for marketing and to manage credit risk give an edge to the bigger card issuers. MBNAs size also puts it first in the race to create new products. For example, now that the Supreme Court has ruled that Visa- and Mastercard-issuing banks can also offer products from American Express (AXP, news, msgs) and Discover, look for a battle to break. MBNA is already out of the gate with its American Express branded card.
It doesnt hurt either that MBNA has a history of getting credit quality right: Only 4.4% of accounts were delinquent at the end of 2003, down from 4.9% in 2002. MBNA calls any account delinquent if the minimum payment hasnt been received by the date on the statement, a tough standard. The shares trade at 12.5 times projected 2004 earnings per share. On Oct. 6, StockScouter rated MBNA shares an 8 out of a possible 10.
Room to grow
World Acceptance (WRLD, news, msgs) will see its business of making small loans to consumers heat up as the home-equity boom slows down, and the temperature is likely to rise faster than at Capital One or MBNA. Thats because World Acceptance is a small company with a market cap of just $440 million and $186 million in sales over the last 12-months, so its easier for it to grow earnings faster than at Capital One (market cap $18 billion) or MBNA (market cap $33 billion). Not that World Acceptance has been an earnings sluggard: Earnings per share climbed 25% in 2003 and 20% in 2002.
The shares trade at 13.7 times projected 2004 earnings per share. On Oct. 6, our StockScouter rated World Acceptance a 7 out of a possible 10.
2 exclusive picks for CNBC.com on MSN
Portfolio Recovery Associates (PRAA, news, msgs) is really a re-pick: I initially recommended it here on May 26 and its up about 9% since then. The company buys and then collects on defaulted consumer loans, credit card charges, auto loans and the like. Since the company usually buys loans that have already been charged off by the original lender after repeated attempts to collect, Portfolio Recovery buys loans at a big discount to their face values.
The shares trade at 17.7 times projected 2004 earnings per share. On Oct. 6, our StockScouter rated Portfolio Recovery a 7 out of a possible 10.
CIT Group (CIT, news, msgs) isnt in the credit card business and in fact its lending mix is skewed toward commercial rather than consumer loans. But it shares the credit quality improvement story with the other four stocks Ive recommended here.
A decent performance by the economy in 2005 will improve the credit quality of the commercial loans CIT, a July 2002 spin-off from Tyco International (TYC, news, msgs), makes on equipment and receivables and lead to increased demand for the companys loans for working capital. Total managed loans approached $50 million in the second quarter, up 4% from a year earlier. The stock is cheap, trading for 11.3 times projected 2004 earnings per share. On Oct. 6, our StockScouter rated it a 9 out of a possible 10.
A performance report
Every week, just about, I go on CNBCs "Morning Call" and recommend three stocks that I think will outperform the market for the next six months. I post another two recommendations for CNBC.com on MSN readers in my column.
Viewers and readers alike are entitled to a report on how these stocks have done since Ive picked them. I started recommending stocks on CNBC on Jan. 16. As of Oct. 6, my closed positions are up an average of 6.9%. The Standard & Poors 500 broke even in that time period. My open positions, as of Oct. 6, are up an average of 6.4% during a period when the S&P 500 is up just 1%.
How did I arrive at these numbers and what do I mean by closed and open? My CNBC recommendations are six-month picks. Readers with longer time horizons can find a link to my 12-18 month Jubaks Picks and the five-year 50 Best and Future 50 portfolios in the left-hand margin of any of my columns.
To get my performance numbers I assume that every recommended stock is sold six months after the recommendation. Those positions are therefore closed. Any recommendation that's less than six months old is still open, but will be sold when it reaches six months. The performance figures for my CNBC picks don't include dividends or transactions costs to keep the recordkeeping to a manageable size. The Oct. 6 performance report is the second Ive done, and Ill try to keep readers up to date on my CNBC track record every quarter of so.
To see the complete listings, click here.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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