Seeking High-Levered Home Run Stocks

 | Jun 12, 2013 | 1:00 PM EDT
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One of the recent discussions here at Chez Melvin revolved around the idea of starting a private equity fund. Several of us had talked about this idea back in 2010. Like so many good ideas, it died for lack of follow through.

The environment of low interest rates and cheap assets was perfect for such a venture. In many ways it still is. Although assets are not as cheap as they once were, one can still find a lot of companies that could boom when the economy finally does fully recover. 

It occurred to me that a lot of companies that are publicly traded already look like private equity investments. They have high debt loads and if the business can generate enough cash to service or pay down the debt, they could be potential home run stocks.

I ran a screen looking for highly-levered companies that might be potential private equity style home runs. To increase our chances of success I added a search criterion for Piotroski F-scores so the list included only those companies where the fundamentals of the company are improving. I found some interesting stocks that might have enormous long run potential for aggressive patient investors.

Consumer Portfolio Services (CPSS) uses high debt loads as part of its business models but still qualifies as a highly-levered company that could grow to many times its current stock price. The company provides auto financing to those with less-than-perfect credit. They deal with franchised auto contracts. This is not "the buy here, pay here" business often associated with subprime auto lending. Although the phrase subprime may scare some investors, this is a great business. In the U.S., the automobile is at the heart of our culture. You need a car unless you live in one of the few cities with excellent mass transportation.

The business is growing once again as the economy struggles and it is maintaining better, but not good status. The total loan portfolio shrunk during the credit crisis to less than $800 million from over $2 billion. At the end of the first quarter the total loan portfolio was back up to $969 million. Because they are dealing with subprime lenders the average yield on their auto loans is a whopping 22%.  Credit performance is much better that you would expect with charge offs running right around 49%. Loan recovery is about 49% as it is a simple matter to repossess a car and resell it, albeit at a loss. People not only need their car; they like their car and will do without other items to make the monthly payment.

The company will see an excellent environment for many years to come. The economy is not good, but it is better than it was. There is some pent-up demand for vehicles but many people have seen their credit score take a hit in the past five years. The pool of potential candidates of Consumers Portfolios Services' high rate loans has increased and will continue to do so for some time.

The average buyer for their loans has a profile far different from what you might expect. The average customer is 42-years old and has a household income of $54,000. They have had the same job for seven years and lived in the same residence for seven years. On average, they are financing $15,000 for 60 months at an interest rate of 20.3%. The average loan to value is 114%. The buyer needs a car and is willing to pay what it takes to secure some wheels.

The company uses few assets in the operation of the business, so it is not a traditional Melvin cheapie. But the stock is cheap on several metrics. The stock trades at roughly three times earnings and less than seven times the always highly accurate analyst estimates. The stock trades at less than four times free cash flow. The F-score is seven as fundamentals are improving rapidly.

It has used the securitization market to lower its funding costs and last quarter sold an asset-backed deal at the lowest level in corporate history. They lowered their total interest costs overall by 200-basis points in the quarter, all of which drop straight to the bottom line.

This is a highly-levered business that is likely to deliver very lumpy results. Over time, however, the company generates enormous returns on equity and capital. It should be able to grow at a rapid rate for the next three to five years at least. More aggressive long-term investors should start to accumulate the stock in hopes of private equity-like returns over the next five years.

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