Reasoning about Two Sub-prime Lenders

Early this month, I invested in two sub-prime lenders, Nicholas Financial and CompuCredit Corp. Nicholas Financial purchases sub-prime auto loans at a discount and services them. Nicholas Financial makes most of its money buying loans at a discount from dealerships and charging high interest rates on those loans. CompuCredit provides credit and related services to the sub-prime borrower market, those without access to conventional forms of credit. The majority of its revenues comes from credit cards with high interest rates and from fee-based cards.

I have not gotten a chance to do full due diligence, but have read very convincing analyses of these two stocks. Nicholas Financial has been recommended at the Value Investors Club multiple times. VIC is a really great resource for those looking for value picks. The analyses by members are much better than what I can present to you. Guest access to the site has a 45 day lag, but the most recent write-up of NICK recently appeared on the guest access page. As for CompuCredit, Tom Brown from Second Curve Capital and Bankstocks.com recommended it a few months ago, calling it one of his best picks in the financial sector. I have only done some cursory DCF analyses but the margin of safety for both stocks appears to be greater than 35%.

Folks have been very wary of sub-prime lenders because of the fear of rising defaults from the overextended American consumer. This is especially true for sub-prime mortgage lenders who have extended exotic loans to finance the housing bubble. It's unclear how all this will play out, but all sub-prime lenders are being punished in advance of a potential rise in defaults. Is this rational? If I were a sub-prime mortgage lender, I would be worried. Many adjustable rate mortgages (ARMs) will be re-adjusted soon and many borrowers will realize that they cannot meet the minimum payments. This will cause a rise in the default rate, sending many more of the sub-prime lenders into bankruptcy.

Given the likelihood of further pain in the sub-prime mortgage lender industry, how will this affect NICK or CCRT? I argue that there will be minimal impact. These companies service a different segment of the credit-strapped consumer and have demonstrated conservative loan operations. CCRT's clientele does not even qualify for credit cards, so taking on mortgages would be out of the question for these people. There may be more overlap between people borrowing money to buy a car and people borrowing money to buy a house. However no auto loan financier in their right mind would take on a loan from someone whose monthly income could barely pay off an ARM monthly payment. For these reasons, CCRT and NICK should not be batched together with other sub-prime lenders. The only major risk I see is the risk of a recession. Defaults are likely to rise during a recession and these two stocks will go lower (along with the whole stock market). If there is a recession, it will be the time to load up on these two stocks. Both companies have been around for at least one credit cycle and know how to run a tight ship when the going gets rough.

From this reasoning exercise, I conclude that NICK and CCRT are lower risk than they appear and are in fact significantly undervalued at current depressed/stagnant prices.