We report on a financial stock that has built a profitable niche in the mortage business. Home Capital Group provides home loans to borrowers who don’t meet the big banks’ more rigorous standards. The company protects itself from the greater risk in this segment of the market by identifying problem loans early and reserving cash to cover potential loan losses. Although Home Capital’s revenues have fallen on weaker demand for residential loans, its recent purchase of Canadian First Financial Bank will help it qualify as a Schedule 1 lender whose deposits could be insured by Canada Deposit and Insurance Corp. In the meantime, Home Capital took quick action when it uncovered $1.7 billion in falsified loans and expects minimal credit losses. We continue to view Home Capital as a buy for aggressive investors.

Canada’s big five banks (including Bank of Montreal, see page 118) make up the bulk of most investors’ finance-sector holdings. However, we feel it’s prudent to diversify beyond the banks with stocks like the one we analyze below.

It is a leader in its niche market, which helps it thrive in good times and hold its own when the economy weakens.  We believe Home Capital is best suited to more aggressive investors.

HOME CAPITAL GROUP INC. (Toronto symbol HCG; www.homecapital.com) is a mortgage lender that serves borrowers who don’t meet the stricter standards of larger, traditional lenders, like banks.

The company offers most of its loans through 4,000 independent mortgage brokers. In July 2015, it cut ties with 45 of them after it uncovered inaccurate information on loan applications. Specifically, these brokers falsified borrowers’ annual incomes but not their credit scores and property values.

Dividend stocks: Quick response should help Home Capital overcome falsified loans with no significant credit losses

So far, though, Home Capital has reviewed 25% of these loans. Based on the results, it doesn’t expect significant credit losses. It expects to complete these reviews by the end of 2016.

These questionable mortgages, which now total $1.72 billion, add to Home Capital’s risk. Investors also fear that a sudden drop in home prices, particularly in Toronto, could force some borrowers to stop repaying their loans.

The company keeps its credit losses down by identifying problem loans early and adjusting the repayment terms. In the three months ended September 30, 2015, Home Capital set aside $2.8 million to cover potential loan losses, down 18.9% from $3.5 million a year earlier.

Even so, Home Capital’s earnings fell 1.8%, to $72.4 million, or $1.03 a share, from $73.6 million, or $1.05 a share, a year earlier. The decline is partly due to $1.4 million of extra costs related to its loan reviews.

Revenue fell 3.1%, to $247.2 million from $255.0 million, as higher demand for commercial building mortgages offset weaker residential loans. The company recently paid $17.8 million for Canadian First Financial Bank, which offers a variety of services, such as deposits, mortgages and wealth management, through 37 branches across the country. Home Capital also injected $35 million of additional capital to help stabilize this business.

Buying Canadian First Financial will give Home Capital access to more funding for its lending activities. The move will also help with its plan to become a Schedule 1 lender, which would let it accept deposits and have them insured by the Canada Deposit and Insurance Corporation.

The company will probably earn $4.18 a share in 2015, and the stock trades at a low 7.9 times that estimate. The $0.88 dividend yields 2.7%.

Recommendation in The Successful Investor: BUY  

For a recent report on how aggressive investors can manage risk, read: How to profit as an aggressive investor with the least amount of risk.