We define the word "prejudice" as "an adverse judgment or opinion formed beforehand or without knowledge or examination of the facts." Prejudice is a bad thing, and we see its effects on society one day after another, year in and year out.
We also see prejudice in the stock market. It usually takes the form of a stock cratering on very heavy volume because of a news release. Sometimes, people sell in a panic without even having all (if any) of the facts. This kind of prejudice can work to the investor's favor. It may allow him or her to buy a stock at a substantial discount to its intrinsic value. So, while prejudice in the real world often results in violence, in the stock market it can actually create wealth for the astute investor.
This brings us to my thesis: Are some stocks selling at a discount because of prejudice? The answer is yes, of course. I have a few of them in mind, but I'll focus on a sector I've been writing about. It's the payday lender (PDL) industry. This includes First Cash Financial Services (NASDAQ:FCFS), EZ Corp (NASDAQ:EZPW), Cash America International (NYSE:CSH), QC Holdings (NASDAQ:QCCO), Advance America (NYSE:AEA), ACE Cash Express (NASDAQ:AACE), and Dollar Financial Corporation (NASDAQ:DLLR).
I've received tons of hate email about my previous PDL articles. Most attack me for even discussing an industry so "immoral," one that "takes advantage of an unsophisticated and desperate population" by offering loans with "outrageous APRs." These aren't just voices in cyberspace, either. The perception of PDLs as being "the same as loan sharks" has driven consumer groups to lobby for laws curtailing the PDL industry. Many states have laws on the books, and others are joining the movement.
So, given the wave of negative media coverage on PDLs (which includes both a 60 Minutes II piece and tons of newspaper articles), and the fact that numerous people who abide by the concept of Socially Responsible Investing are avoiding these stocks, I wondered how much of this was the result of prejudice and whether there might be hidden value in these companies as a result.
So I did some research. I called payday lenders in several states, spoke to some customers, and checked out a few surveys. Here are a few things I found out about PDLs:
1. The industry does not prey on poor, desperate, and/or unsophisticated people.
Two diametrically opposed views have surfaced regarding the people who comprise the PDL customer base. Consumer advocacy groups argue that PDL customers are desperate, low-income individuals, while the supporters of payday lending insist that customers are average middle-class folks. So I bypassed both views and asked several PDL owners themselves. Here's what they said: The majority of PDL customers have incomes between $25,000 and $50,000, and the fastest growing segment is customers making between $50,000 and $75,000 a year. More than half of PDL customers have college degrees. More than 90% are aware they must pay a fee. When I asked about consumer protections, they reminded me that almost every state with a PDL law has strict requirements regarding collection methods, disclosure, and rollover renewal limits to protect consumers.
2. Look at the fee, not the APR.
The biggest complaint consumer groups have leveled against PDLs is that the annual percentage rates charged can range as high as 780%. The problem is that translating the fee for a short-term loan into an APR is not an accurate or fair way to judge the industry, despite requirements by every state that APRs be stated on every loan. Here's why:
Say I take out a $100 loan from a PDL and it costs me $10 to do so. I pay back the loan in two weeks. The APR on that loan is 260%! But let's look at other types of fees at other merchants. Say I go to an ATM that's not affiliated with my bank and withdraw $20. I get hit with a $3.50 fee. Well, on an APR basis, that's 455%! Suppose you bounce a $100 check. You get hit with a minimum NSF fee of $25 by your bank. The APR is 650%! Suppose I pay my $100 credit card balance late? The company charges me a $28 fee for doing that, making the APR a staggering 728%!
Now, is there legislation to curb this kind of highway robbery? Do consumer groups get up in arms about ATM fees and NSF fees? No. Why? Prejudice. Anti-PDL ideology makes people inclined to view fees inappropriately as APRs because the product is called a "loan."
3. Payday lenders provide a needed service.
In interviewing both customers and PDL store owners, this one really hit home. There is no other business that provides those in need of a $500-$3,000 loan with a quick and convenient method of obtaining one. Heck, I have outstanding credit, but if I need a loan in that range, my primary choice is to go to a bank. That means hours of my time filling out reams of paperwork, having to put up collateral, searching for all kinds of bank statements, and having to wait days or even weeks for the loan to be approved. With a payday lender, I can walk into a store and walk out in 15 minutes or less with my unsecured loan.
Also, the way our banking system is set up is that those with good credit can go to a bank and get a loan at a favorable interest rate. Since it's not fair to force a bank to make a high-risk loan, people who have poor credit must have somewhere to go if they need a loan. PDLs fill that need.
4. Nobody is forced to take out a payday loan.
In each instance above -- payday loan, ATM fee, bounced-check fee, credit card late payment fee -- the consumer has made his or her own choice about whether or not to use the product. If I had kept enough money in my checking account, I would not have bounced a check. If I had withdrawn $300 from my ATM instead of $20, my APR would have been only 173%. If I'd paid my credit card on time, I'd have paid no fee. Likewise, PDL customers are not required to use the service. Some PDL owners even said they would negotiate a lower fee depending on the customer. Yes, contrary to popular belief, there are actually human PDL owners, who operate stores in residential areas and receive gifts on Christmas from customers. The horror!
5. Not all PDL customers get into endless rollovers, and not all rollovers generate fees.
Some PDL customers renew or roll over their loans with great frequency. Some, but not all, of these rollovers generate a fee as if the loan were new. Currently, 36 states regulate the number of rollovers and the associated fees to some degree. Also, remember that endless rollovers are not necessarily in the PDL owner's best interest. Collecting a 15% fee is no good if the customer ultimately defaults on the principal. Believe it or not, PDL owners don't lend money to everybody who walks in, nor will they allow customers to consistently roll over their loans. It's not in their best interest. One owner told me, "You think I'd loan money to someone who already had three loans outstanding at other shops? That's a bad risk." Many owners and state regulations also require customers to have some minimum income threshold.
Much of this was a surprise -- even to me, because I, too, thought PDLs did all the nasty things they've been accused of doing. The difference was that it didn't matter to me, and I'm glad it didn't, because it allowed me to find some great investments.
So, as we can see, prejudice does exist in the market, and it can create opportunity. Unfortunately, it can also destroy an industry. PDLs are under siege in many states, and the stocks have suffered mightily as a result. It remains to be seen just how detrimental this tidal wave of prejudice and misperception will be to the industry. At the moment, I am cautiously optimistic for some of the players, especially those who are diversified into pawnshops.
Oops. Pawnshops. There's another dirty word, right? Better check for yourself....
There's much more to read about payday lenders:
- I discuss why investors shouldn't panic over the new FDIC guidelines.
- Why I like First Cash over other players in the industry.
- Why I'm not so hot on ACE Cash.
Disagree? Want to share your opinion? Check out our Fool Community discussion boards. Fool contributor Lawrence Meyers owns shares of First Cash. If you find other stocks you think are undervalued as a result of prejudice, tell him and he'll consider writing about them. The Fool has a strict disclosure policy.
