The Best and Worst
Stocks of 1997
Loser -- Specialty Finance Cos.
Loser -- Jayhawk
Loser -- Mercury
Loser -- CityScape
Specialty finance firms are a type of company that some investors may never want to hear from again, especially those Wise investors that either didnt want to understand these companies or were hoping that others didnt understand them. The investment thesis went something like this:
1. Specialty finance companies are unregulated because they dont take deposits insured by the government. Anything that is unregulated is better.
2. Specialty finance companies have well-developed distribution channels, lining up dealers of manufactured homes or cars to keep up growth of loans and income.
3. These distribution channels are low cost, not like the higher-cost bricks-and-mortar branches that banks have to run. Specialty finance companies could produce loans cheaper than banks.
4. Specialty finance companies can grow assets at a greater rate than big banks simply because these companies are small and because banks dont want to fiddle with higher-risk borrowers that these finance companies are only to happy to service for an interest rate thats high enough.
Unfortunately for investors, unseasoned management and operations teams, bad business plans, and accounting that left a lot to be desired came to haunt the specialty finance sector almost from the dawn of 1997 through the rest of year.
Some of the years most spectacular implosions include Jayhawk Acceptance Corporation, which lost 89.43% of its value; Mercury Finance, which declined 95.55%; and Cityscape Financial, which dropped by 97.99%. Manufactured home and commercial lender Green Tree Financial, a strong company that had been one of the fastest-growing members of the sector and that had typified the formula for success in the industry, has lost nearly 60% of its value since its peak price after reporting that it would have to beef up reserves for securities it held on the balance sheet. The company said these reserves represented a non-cash addition to reserves and not a charge to earnings, which incredibly some analysts have repeated faithfully: One-time, non-cash addition to reserves, not a charge against earnings.
To the investor in financial companies, Green Trees explanation rings hollow since all additions to reserves and reductions in asset valuations to account for a diminution in the economic value of those assets are "non-cash." When a finance company makes a loan, it knows that a certain percentage of people arent going to repay the loan. On making 100 loans, a company will mark down the value of those loans by one to five percent, depending upon the credit quality of the borrower and the companys historic experience with such loans. When those valuation reductions are made, they are non-cash charges and are tantamount to expenses on the income statement. They represent the companys judgement that it will lose that money.
Green Tree and some of the companies identified above use gain on sale accounting, which allows them to get loans off the balance sheet before theres a problem with slow payment or a default on a loan. The process by which a company gets loans off the balance sheet is called securitization. When a company securitizes loans, it bundles hundreds or thousands of loans into securities, which are sold into trusts. Those trusts issue shares that are then bought by institutional investors who buy these shares for their yield, which is often higher than the bonds or securities with similar maturity dates.
When these companies sell loans, the gain on sale of the loans comes about as loans are sold into trusts for cash and securities called excess mortgage servicing rights, mortgage servicing receivables, or "interest-only securities." The cash part is roughly equal to the value of the loans as stated on the books of the seller, while the gain on the sale is represented by the receipt of these excess mortgage servicing rights. These rights are put on the sellers books as assets and represent the net present value of cash to be received in the future for servicing -- collecting payments and remitting them to the trusts, tracking down bad loans, keeping records -- the loans sold into trusts.
A problem arises, though, if interest rates decline and more pre-payments on loans are made or if more defaults on loans are made than the company has planned. If there is no loan to collect on, whether that loan blows up through bankruptcy or re-financing with another finance company, then the net present value of cash the company expects to receive for servicing those loans will decline.
The re-valuation of securities -- the so-called non-cash addition to reserves -- is simply a reversal of non-cash earnings the company has booked in past periods. Since the company doesnt now expect to receive future cash flows as large as it had thought when it booked earnings in past periods, it has to run that re-valuation of mortgage servicing rights through the income statement as a reduction to earnings. By marking down the value of these securities, its saying, We expect cash flows from these rights to be less than expected. With companies doing securitizations, the old maxim about a bird in hand being worth two in the bush has been turned on its head. Companies securitizing their finance receivables are counting a bird in the bush as two in hand.
In some of the cases of our biggest losers for 1997, the companys assumptions regarding the economics of the loans underlying their mortgage servicing rights were just plain wrong. In the case of Jayhawk Acceptance Corp., the company declared Chapter 11 bankruptcy protection against its creditors when it couldnt meet its debt servicing requirements. Part of Jayhawks problems lay in the fact that its credit standards had gone out the window. One car dealer said the only requirement to get a loan from Jayhawk was passing the breathing test. That is, if the person was breathing, they got a loan. By lending to sub-par borrowers who were using the loans to buy used cars with little resale, or collateral, value, many of the companys loans simply blew up. While Jayhawk didnt use gain on sale accounting, the company was rather shortsighted about what sort of customers it was dealing with.
An investor looking Jayhawks 10-Q filing for the third quarter of fiscal 1996 would have seen some real problems developing with credit quality. The first sign that trouble was brewing was found in the companys charge off figures, which is a standard term used by banks and finance companies and means that a company doesnt expect to see much of that loan repaid. The loan is then said to be charged off or written off. Jayhawks charge offs have risen more than 1,000% -- a ten-fold increase -- from the third quarter of 1995 to the third quarter of 1996. That doesnt compare favorably to the companys 264% growth in loans.
Elsewhere in that 10-Q, the company also said that loans in non-accrual status, meaning they were non-performing loans, had increased to 29% of loans from 19% the year before. Experience with financial companies would tell many an investor that this sort of non-performance factor is a number of mind-boggling magnitude. Commercial banks usually show 0.5% to 1.5% of loans as non-performing while credit card lenders with high default rates show about 6% of loans as non-performing. 29% is off the chart and makes it incredibly hard to make money on the rest of your loans.
To top it off, credit loss reserves were almost non-existent at Jayhawk. While it looks as though the company would take credit losses out of the hides of the dealers from whom it bought loan contracts, the disclosure in the companys reports on liabilities to dealers made it extremely difficult to tell which accounts bad loans would be charged off against. In the absence of this sort of information, the prudent investor would just stay away from a company whose loan delinquencies are rising to absurd levels but which is somehow still miraculously creating earnings.
When you cant decipher the financials of a company (and dont worry, the hotshot analysts covering Jayhawk couldnt either, though they expressed shock when the company exploded), its best just to stay away. That doesnt necessarily mean, however, that one should go out and short these companies. If its not clear what sorts of earnings and off-balance sheet risks these companies pose, a more productive use of your capital could be found elsewhere, leaving the gains and losses in such companies to those who think they know what theyre doing.
Mercury Finance is similar story in that it is finance company specializing in auto loans, but in Mercury's case there appears to have been outright misinformation conveyed to securities authorities and investors. Before we get to the seamy part of the story, well take a look at the fundamentals and how one could have seen the deteriorating financials.
One of the standard ways of measuring a finance companys financial performance is to look at Return on Equity (ROE) and Return on Assets (ROA). ROA is important to look at because it isolates financial performance before taking leverage (debt-juiced) performance into account. A company with conservative leverage that can earn the same ROA as a highly leveraged company is nearly always preferable. In Mercury Finances third quarter, one could see this measure of performance deteriorate from historical levels and from the trend earlier in the year. While the quarter's ROA of 3.97% was still indicative of a company with high-risk, high-interest credits, that primary measure of performance had declined precipitously from prior periods during which ROA had come in around 9% annualized.
ROE, a measure of the efficiency of a company given all the net capital at its disposal, had also dropped off the edge of the earth -- falling from the 40% range to below 20%. Since a well-managed bank with much lower risks than a sub-prime auto lender can achieve those results, the risk-adjusted return on capital at Mercury had fallen below desirable levels. At that point in the game, it looked like the companys management was losing control of the business model.
Those arent the important parts of the story, though. According to a Mercury Finance press release on January 29, 1997, the company discovered accounting irregularities: Mercury Finance announced the discovery of accounting irregularities which caused an overstatement of the previously released earnings. According to [the companys CEO], the accounting irregularities appear to be the result of unauthorized entries being made to the accounting records of the Company by the Principal Accounting Officer. That accounting officer was reported by the company to be missing, and for a couple days this bizarre news was reported as a lead story. The accounting officer finally showed up in the care of the FBI, with whom he was cooperating. Without good data from a company, an investor (or management) is flying blind and cannot assess the fundamental risk posed by the investment.
As it turns out, credit quality, auto repossession data, and earnings were all misstated, which threw Mercury into insolvency when its debt was downgraded, and locked the company out of the commercial paper markets. Incredibly, Mercury had restated past earnings before on accounting rulings, but the shares had come back in the months before this January revelation. Even in the face of sharply deteriorating performance (at the time, one assumed that the numbers were not false), some analysts continued to back the company until its admissions and the ensuing vaporization of the shares, as one trader who talked to Bloomberg Business News put it. The stock traded down to the $2 range after the New York Stock Exchange held it for two days, and it has pretty much stayed at that level since that time.
One somewhat sad story this year that doesnt look like management incompetence was Cityscape Financial, which has seen a painful decline in its shares from a peak of $32 to their current price of $5/8. Cityscape uses the dreaded gain on sale accounting, which not only means that its cash income is substantially different from its reported income, but that all kinds of off balance sheet risk (risk that can't be identified on the balance sheet) can come along and smack you in the face. Cityscape is a lender that makes high loan to value home equity loans, meaning a customer can borrow more than 100% of his home equity. The company's strategy of acquiring lenders in the U.K. was working quite well until the Labor Party in Great Britain came in and said that Cityscape Financials practices were improper.
To avoid the balance sheet problems that companies had experienced when borrowers paid off loans too quickly, Cityscape charged a high penalty for a borrower to get out of the loan early. That raised the ire of the Labor government, which didnt charge the company with illegalities, but exercised its rights of subjective judgement against the company. Righteous indignation arose from British newspapers, one of which the company is suing for libel. Rather than borrowing from a regulated entity, British consumers with bad credit records or who have little borrowing power will now have to return to the loan sharks, because the risks associated with making such loans will thin out the ranks of companies that are willing to make them. In the face of the government forcing the company to change its practices, Cityscape took a large re-valuation of its mortgage servicing receivables, which substantially reduced shareholders equity and killed the income statement.
Though some would say that the companys gain on sales accounting would eventually land it in trouble, as operations were eating more cash than they created, it was really a political change in a market where the company had spotted lending inefficiencies that sank the company.
The tale of specialty finance companies in 1997 is a sad one, made up of one part accounting that didnt portray the cash-generating characteristics of these businesses, one part overcapacity through increased competition, one part decreased credit standards, one part increasing defaults from high consumer debt levels, one part incautious investors, and at least a couple parts incautious management.
When confronted by financials that are just plain hard to understand, an investor has two options: Increase his or her understanding of finance company financials or just stay away. If a companys cash flow statement and balance sheet show a continuing stream of debt and stock issuance, thats also a great sign that a companys management is too aggressive. Great businesses generate cash, not consume cash, even in growth phases. Take analysts ratings on these sorts of companies with a grain of salt. After all, these were the so-called experts with buy ratings on these companies even as their basic businesses were falling apart.
-Dale Wettlaufer (TMF Ralegh)