Value investing is all about investing for growth, but paying depressed value prices. Under the Radar Small Caps is the one place where you can always find opportunities to do that. Shares in Silver Chef (SIV) were beaten up when we tipped them recently in mid-April this year and have climbed 21% since then, while Money3 (MNY)’s stock is climbing. The banks might be feeling pain, but Under the Radar's Small Caps in financial services are thriving. Funny that.
THE FINANCIAL SERVICES BUSINESS: WHAT’S NOT TO LIKE?
Financial services companies are often good to invest in because it’s a good business model; where else can profits be made solely from using other people’s money? But try telling that to someone who put their hard earned into CBA when the price was above $90 a few years ago after her financial planner told her about the miracle of Australia’s dividend franking system. Now that CBA’s price is below $70, the yield and those franking credits provide little comfort.
Investing successfully in the stock market is about achieving growth in your initial investment. Dividends alone cannot bring you that. It’s about the price you pay and whether you can extract value from there.
The big banks look to be much better value these days, but it’s clearly largely a bet on the long-term viability of the Australian residential housing.
SERVING THE UNBANKED MASSES
In lending, 86 per cent of the market is plain vanilla such as home loans, overdrafts and credit cards, which is amply serviced by the big banks in their oligopolistic way. But lending and borrowing elsewhere is a tutti fruit world and often it’s in niche or under-served markets where value can more often be found.
I’m talking about the companies which service the unbanked masses that don’t fit through the hoops require by traditional lenders. These include consumers with chequered credit history, start-up small businesses that need equipment financing, consumers who want to buy now and pay later that can’t get access to credit cards, or expats who want to send their money to relatives overseas in small denominations.
HIGH DEMAND FOR THE REMAINING FIRMS IN SHADOW BANKING
It’s worth noting that these days there are less listed financial services firms than prior to the financial crisis, due to consolidation. CBA purchasing Bank West comes to mind. The shadow banking sector as a whole has shrunk. At the peak of the boom in 2007 it represented 15 per cent while now it’s only 7 per cent.
Even though there are less operators, there is more demand for their services than ever as the big banks pull their giant heads in and become risk averse. Although on this point, clearly there is no shortage of risk, as evidenced by this week’s delay of the small business lender Prospa, which is having some difficulty living up to its name.
A BUYER BEWARE SECTOR
The Prospa float seems to have been postponed because someone spotted that borrowers might be paying a rate of 40% if you borrow from them. It is true that some of the lending operators do seem very close to being usurious, which isn’t to say Prospa is. Lending to start up businesses is inherently risky. But for me, it’s important not to invest in the so-called “pay-day” lending businesses, formed to grasp money from customers who don’t have any other options. There is a fine line to providing a service to a relatively unbanked customer, to adopting usurious and credit shark behaviour because you can get away with it.
RISKS THAT DON’T CORRELATE TO HOUSE PRICES
On a more positive front, I like the fact that you can invest in a financial services firm that offers risk that is uncorrelated to housing related risks faced by the big banks. Plus, as I said, you can often find much better value. There are a couple of examples that come to mind.
TWO UNDER THE RADAR FAVOURITES: SILVER CHEF AND MONEY3
Look at the hospitality equipment financing specialist Silver Chef (SIV). You’re exposed to a business with a 30 year history in Australia and the possibility of translating domestic success into the Canadian market. Unlike the big banks, whose travails offshore has been abysmal, success here will generate sufficient scale to move the needle.
Silver Chef’s shares have climbed over 20 per cent since mid-April. Earlier that month it had spooked the market by breaching its senior debt covenants. When its debt negotiations were successfully concluded Under the Radar’s analyst Ravi Reddy honed in on its core operations and outlook: “The key growth opportunity comes from the Canadian market, which is 50 per cent larger than Australia. The company has taken a patient approach, having been there for three years. Similarities between the Australian and Canadian markets such as dining trends and strong dealer distribution, bolster the company’s chances of success.”
Another stock Ravi likes is Money3 (MNY), which last week re-affirmed that it expects fiscal 2018 net profit after tax to come in at $31 million, the top end of its 13-17 per cent guidance range.
Money3 stands out because it is successfully transitioned out of payday lending and into automotive lending, providing credit for people buying used cars. As you can imagine, the big banks aren’t in this sector of the market. This company’s market share is only 2 per cent out of an estimated addressable market of 700,000 loans a year. This provides a good opportunity for growth, with management aiming to achieve 3 per cent market share over 12 months.
If it’s successful Money3 will have to increase the number of loans it writes from 14,000 to 21,000. That’s an increase of 50 per cent! Try looking for that kind of growth in home loans.