Monday, December 10, 2012

Stocks to Play a Recovery in US Lending

One of things that the Motley Fool is trying to encourage investors to do is to dig deep into underlying industry or economic trends and see how that impacts specific stocks and investment ideas. In this post I’m going to give my take on current economic conditions with a focus on consumer credit because I believe conditions are getting better within the US -- but not for the reasons that most people presume.

Consumer Credit Expanding

Almost imperceptibly, consumer credit in the US has been expanding. Here are the figures from the Federal Reserve for outstanding consumer credit.

It is a slow and steady rise commensurate with the kind of slow-growth economy that the US has been stuck in since the 2008-09 recession. Indeed the fragility of the recovery has not gone unseen, and frankly I think anyone thinking that this isn’t a slow recovery should look at this chart I created for an earlier post.  The data was interpolated from the Bureau of Labor Studies payroll statistics. The x-axis represents months since the payroll data turned positive (for two months in a row) after the recession. The y-axis represents the percentage of jobs lost in the recession that have been regained in the recovery.

Meanwhile we have corporate profits rebounding nicely.

In summary, the US economy is experiencing a historically poor rebound in jobs growth, but corporate profits are doing well and lending is starting to come back.  So with employment gains being so slow, why am I bullish about consumer credit expanding?

A Two Tier Economy

I’m not going to make any value laden social commentary here; my job is to focus on the facts and how investors might profit from them. I’m not advocating a two tier economy where the relatively wealthy get low interest rates so they can refinance and take out debt, but I am saying it exists in countries like the US and UK. They are top heavy economies, and what is interesting about them is that it is the wealthy that tends to hold the bulk of the debt. They do so because they are asset rich and take out debt on the back of their assets.

Be aware that I am focusing on the high net worth segment but this is mainly to make a point. If you are a securely employed person in the US or UK with assets in hand (which are now rising in value as central banks pump money into the economy) then you are in pretty good shape. If you are an unemployed person desperately looking for work or a small business loan from a bank, you are in terrible shape.

Of course, as the economy generally improves and more wealthy people's asset positions improve accompanied by incremental gains in middle class employment, then we can expect consumer credit and spending to expand. I hate writing this, but in the scheme of things the unemployed masses don’t matter so much in the US. They don’t do much of the spending because they don’t have enough income/assets anyway, even if they did have a job.

Stocks/Sectors Set to Benefit

All of which leads me to the idea that the US is set for slow, sustained credit expansion. I was reminded of this thesis when credit bureau Equifax (NYSE: EFX) recently gave results. I’ve summarized the growth in their various business segments below.

As a credit bureau, Equifax benefits from an expansion of consumer credit. I hold the stock for the reasons outlined above and because the company has created new products in order to generate growth alongside strengthening mortgage activity. In fact, its commentary on the strength in mortgage origination and new home sales says a lot about the improving economy in the US. It is a two tier economy, but that doesn’t mean that it isn’t improving.

USCIS stands for US Consumer Information Services, and in the last results revenues were up 15%, with mortgage solutions up a whopping 35%. The company generates huge amounts of cash flow and I think is well positioned to do well.

Other Stocks and Sectors to Look At

Another sector I’ve long liked in this theme is that of credit card companies like Discover Financial Services (NYSE: DFS), American Express or Capital One. I’ve discussed Discover in more depth in an article linked here, and it is doing everything to confirm better credit conditions within the US. Net charge offs are falling, and total credit card loans are on a clear uptrend. You don’t necessarily have to buy Discover, but I think it makes sense to understand that credit conditions are getting better and when they do then spending on certain types of items goes up.  At least I hope so, because I am overweighting my portfolio with this theme.

If you take the argument further, it makes sense to go out and buy some home improvement companies; I think Home Depot (NYSE: HD) works very well in this regard. Lowe’s might be more attractive to the value hunter, but it needs to turn things around operationally. Meanwhile Home Depot is starting to report sales strength in the more cyclically aligned parts of its sales operations. This is a very good sign. Another good way to play improving credit quality and housing prices is Wells Fargo (NYSE: WFC). The stock will also benefit from reduced loan loss provisions and has heavy exposure to the US mortgage markets. Analysts will always worry about falling net margins due to low interest rates, but lending (which is the banks business after all) will expand given a stronger economy. Always has, always will.

The last suggestion I have is to look at companies benefiting from increased credit issuance and, for the reasons outlined above, I would suggest focusing on the mid to high end rather than the mass market.  In other words, favor specialty stores like Whole Foods over something like Kroger. Or look at something like a higher end, US-focused retailer like Nordstrom (NYSE: JWN). It has its own credit arm, which is reporting better results while its comparable same store sales growth is showing good momentum. I’ve covered it in more detail linked here, and I think it fits well within the theme.

The Bottom Line

In conclusion, things are getting better in the US, but you need to be stock selective and try to focus on companies with exposure to the mid to high end of incomes/assets. The recovery is uneven, but as investors it’s better to recognize its unfairness rather than pretend it doesn’t exist and invest in the wrong sectors.