Credit Acceptance (CACC) is a subprime auto lender. Glenn Chan has written a series of posts in which he describes CACC's business model and how it has produced strong historical returns, calling it a wonderful business. He writes that CACC is good at underwriting and debt collection and has developed mutually beneficial partnerships with car dealers.
Chan is an astute investor - his articles about mining are essential reading for anyone who invests in that sector-- but I think that CACC is a bad investment for several reasons.
CACC is a successful lender, but high-quality lenders differ from the typical high-quality business in a couple of important ways:
• Loans are essentially a commodity, and underwriting them has few barriers to entry. During a boom, it's easy for new companies to flood into the financial sector and depress margins, even if those companies can't match the high-quality lenders' returns over a full economic cycle.
• Even if a lender is structurally more efficient than its competitors, loan losses can still sink it. This happened to Golden West during the housing bubble, and it was far from being the bubble's most aggressive lender. Lenders face existential risks that the typical high-quality business doesn't face. (Edit: mitigating this, much of CACC's debt is non-recourse).
Although lower-income Americans' wages have stagnated or fallen since 2007, subprime auto loan volumes are close to reaching their 2006-07 peak. According to the CFO of America's Car-Mart, another subprime auto lender, "We believe that our customers have never been more stressed financially and, at the same time, have never been presented with more aggressive financing options for their vehicles."
This may be suppressing CACC's loan losses: if subprime borrowers can easily get a car loan despite being financially stressed, then many of CACC's borrowers who would normally default can find other, more aggressive lenders to refinance them.
Glenn Chan points out that the documentation for subprime loans is very stringent, as opposed to low-doc loans that were common during the housing bubble. I don't find this reassuring because 1) the housing bubble was so excessive that auto lending doesn't have to reach the same extremes to be a problem, and 2) subprime auto loans have their own dangers. They're typically issued at LTVs above 100%, in many cases above 120%, even though cars depreciate quickly. The high LTVs let lenders get around usury laws and trick borrowers into paying higher effective interest rates, but they also lead to huge losses on the loans that go bad.
Eric Falkenstein, in his application of Batesian mimicry to the business cycle, argues that investors always fight the last war: if a certain class of securities does well during a bust, this convinces investors that the securities are intrinsically low-risk or high-quality, which paves the way for a bubble to develop.
I think this has occurred with subprime auto loans. Used car prices were very strong during 2009, thanks in part to Cash for Clunkers, and the Fed's efforts to stimulate lending were particularly effective with auto loans since they have relatively short terms. These things kept loan losses relatively low, and that's given investors a false sense of security regarding how bad they'll get during the next downturn.
Valuation and margins
If CACC meets analysts' estimates, it will earn a ROE of 40% this year with relatively low leverage. This really isn't sustainable. Would-be competitors may not be able to match this ROE, but they don't need to match it to earn high returns.
CACC trades at 4x TBV. This also isn't sustainable IMO. Not a lot has to go wrong for the multiple to fall, and CACC is buying back stock, which is a waste of money at that valuation.