Cheap Stocks Wall Street Hates: Credit Acceptance Corporation

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Throughout its public history, Credit Acceptance Corporation  has been cheap by most valuation metrics. Today, it sells for just 11 times earnings, with expectations for five-year forward earnings growth of 11%. That gives it a PEG ratio of roughly one -- cheap indeed.

Is the valuation warranted? Let's do some digging.

Behind the business
Credit Acceptance is an automotive lender unlike most others. It focuses on subprime car loans, writing loans on cars that are often 10 years old or older. This makes it an outlier in the world of consumer credit, since as a nonbank lender it takes significantly more credit risk than a bank would.

To compensate for the risks inherent in lending against older model, used cars, to people with less-than-stellar credit, it charges high interest rates. The average loan yields 26.9%, according to the company.

And not surprising, many of its loans go into default. Credit Acceptance forecasts that it will receive only about 70% of contractually mandated payments on its average car loan. That's far worse than most other auto finance companies report.

Of course, most other auto lenders would never consider 10-year-old cars collateral, and even fewer would lend to the typical Credit Acceptance customer. High fees and interest more than cover missing payments.

Does Wall Street hate Credit Acceptance?
The low valuation might not truly reflect Wall Street's perception of the company. In truth, most lenders -- banks and nonbanks alike -- typically trade at cheap valuations. Even some of the best-run banks trade for multiples just a hair over 10 or 12 times earnings.

The low earnings multiple is largely due to the fluctuations in earnings. In a recession, bank earnings often tip the scale toward zero, even for banking institutions that are wildly profitable in periods of robust economic growth. The truth is, a lower multiple in boom years helps cover lower earnings in down years.

CACC Chart

CACC data by YCharts

In terms of finance companies, though, Credit Acceptance tends to rise when others fall. Its best years are some of the worst years for most lenders. Notice that the rally in Credit Acceptance didn't really start until the worst of the global financial crisis in 2008 and 2009.

Why is this? You might expect that in a massive recession, an automotive lender's business would get worse rather than better. And for a subprime lender, one would reasonably expect business to be significantly worse than a prime lender.

Expectations vs. reality
During improving economic times, banks tend to get loose with lending standards in everything from homes to cars. Lenders accept lower rates, and begin to approve people with lower credit scores. In essence, lenders encroach on Credit Acceptance's core business of lending to lower-quality borrowers.

In downturns, lenders reverse course. They seek out more creditworthy borrowers, and demand higher rates for loans, evacuating the subprime lending space.

So, what happened in 2008 and 2009, and in many cycles before that, is that Credit Acceptance effectively had the subprime market to itself. It wrote high interest loans to some of the best borrowers it had seen in its corporate history. Meanwhile, strained budgets meant used cars held their value, and Credit Acceptance's recoveries of collateral improved.

Fast-forward to today
So why does Credit Acceptance trade so cheaply today? For one, more and more lenders are getting in on the automotive business, meaning more competition and less favorable pricing for lenders like Credit Acceptance. In 2014, subprime auto lending volume could top prerecession levels.

New entrants may be stealing some of its loan volume. The company noted that average volume from its dealers fell 5.8% year over year. Car dealers bring the company 88% of its total originations.

Additionally, regulatory clouds remain. After tearing through the mortgage and credit card business, the Consumer Financial Protection Bureau now has time to monitor auto lenders more closely. Finally, in an issue unique to Credit Acceptance, it's founder and majority shareholder has been quietly selling shares into the market. So have his family members. 

Ultimately, though, the biggest factor is that Credit Acceptance Corporation is a lender. And lenders almost always trade cheaply on an earnings basis. If history is any guide, Credit Acceptance will deliver excellent returns over a credit cycle, rewarding those who buy and hold for the haul long.

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The article Cheap Stocks Wall Street Hates: Credit Acceptance Corporation originally appeared on

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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