Famed investor Peter Lynch said that he loved great companies in lousy industries. The popular industries generally get thrown a lot of investment dollars, making it hard to make a buck. On the other hand, Lynch said, lousy industries, which are growing slowly or shrinking, generally consolidate, and the winner usually has some cost advantage.
The mortgage origination industry is currently wrapping up a couple of great years, driven by the Fed's actions to support the economy in response to the pandemic. Looking ahead, rates will rise, volumes will shrink, and companies will fold. One of the survivors will probably be Rocket (RKT -4.46%).
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Mortgage origination can be a lousy business
Mortgage origination is a feast-or-famine business. It is one of the most cyclical businesses because refinanced loans are a huge chunk of the business. When rates are falling, everyone rushes to refinance, which means oodles of business. Conversely, when rates rise, everyone who refinanced earlier will stay put. We have already seen companies like Better.com and Freedom announced big layoffs.
Last year saw a plethora of initial public offerings (IPOs) in mortgage banking as companies took advantage of a robust market to raise growth capital. COVID obviously caught the industry off-guard, as it was staffed for moderate volumes. The massive refinance wave of 2020 meant the industry was stretched to capacity, and profits soared.
Rocket's app gives it a leg up on the competition
Rocket has the advantage of being the first mover in mobile technology and origination. Younger adults moving into the prime homebuying years prefer to interact with technology and not people. Rocket was the first to capitalize on this shift with mortgages.
Rocket's app is more than just an interface; it gives the company a huge cost advantage. Most banks and independent mortgage originators use loan officers to find business. These folks network with real estate agents, title companies, and closing attorneys to source leads for business. When loan officers find a loan, they are paid a commission that can amount to up to 2% of the mortgage amount. Commissions are, therefore, generally the biggest cost for an originator.
Rocket's app eliminates the need to pay that cost, and that savings drops right to the bottom line. According to the Mortgage Bankers Association, the typical independent mortgage bank earned 0.89% in pre-tax profit based on volume. Rocket earned 1.59% in pre-tax profit.
As rates rise, refinance volumes are going to dry up, and mortgage bankers are going to compete more intensely. Rocket's cost advantage and market leadership mean it will be able to withstand a price war and probably emerge the winner.
Cyclical stocks tend to trade with low multiples.
To give you an idea of how volatile the mortgage business is, check out the earnings per share (EPS) estimates for Rocket. It is expected to earn $2.30 per share in 2021 and $1.54 in 2022. This gives the company a price-to-earnings ratio of 6.8 times 2021 EPS. These low multiples are typical for cyclicals at peak earnings.
Highly cyclical industries tend to line up with Peter Lynch's description of lousy industries. Rocket will almost certainly be able to maintain its leadership position in the industry as the layoffs increase and smaller competitors get pushed out of business. For this reason, Rocket could be considered a Peter Lynch stock.
