A Case Study in Survival

While many specialty finance companies went out of business or suffered permanent impairment during the credit crunch beginning in mid-2007, subprime auto lender  AmeriCredit's  stock price recently rebounded more than 600% from its early 2009 lows to nearly pre-crisis levels. In light of this outstanding performance, and with the benefit of hindsight, we set out to determine which factors were responsible for the company's (and its shareholders') success. In our opinion, the company is now fairly priced, but we feel there are valuable lessons to be learned from the recent experience of its investors.

Though tarred by association with subprime mortgage lending, loans made by AmeriCredit differed in several important ways. First, AmeriCredit's loans were priced far more appropriately. Subprime mortgages were often offered with extremely low "teaser rates," allowing borrowers to temporarily afford homes far beyond their price range. AmeriCredit's auto loans, on the other hand, carried midteens APRs, compensating higher default rates among high-risk borrowers. Despite high credit losses and liquidity troubles, the company lost money only in fiscal 2008. Furthermore, the collateral behind AmeriCredit's loans (used automobiles) held its value far better than residential housing did. The company's recovery rates on repossessed automobiles typically fluctuate with the Manheim Used Vehicle Index, which was remarkably stable over the past 15 years, at least in comparison to the Case-Shiller index of home prices. Without a boom in used car prices preceding it, the bust was much less painful. As a result, losses in the current cycle occurred for the same reasons they always have--mainly job losses as the general rate of unemployment rose. Loss rates in auto loans were therefore far more predictable than in subprime mortgages. Thus, AmeriCredit was less subject to an unpredictable macroeconomic downturn than it might have appeared. The same might be said for other lenders, like  American Express (AXP) and  Capital One (COF), whose extremely high profit margins cushioned them against similar increases in credit losses.

AmeriCredit's experienced management team also helped the company weather the storm. After experiencing a similar liquidity crisis earlier in the decade when a recession and 0% new car financing crushed both credit quality and default rates, AmeriCredit's management team was prepared with a game plan. As we wrote last year, the company "found itself in a hole and promptly stopped digging." The company dramatically slowed new loan originations in order to conserve cash, content to sit back and collect interest on its existing portfolio. The management team was further enhanced when representatives of  Fairholme (FAIRX) and  Leucadia (LUK) joined the board following their investments in the company. In addition to gaining management expertise--Leucadia's involvement in the subprime auto lending business dates back to the 1990s--AmeriCredit gained a source of funding. Fairholme also purchased interests in the company's securitizations, providing much-needed financing in the absence of other buyers. Furthermore, unlike some other specialty finance companies, AmeriCredit did not overly rely on short-term funding--credit facilities made up only 16% of liabilities in mid-2007, buying the company some time when liquidity began to dry up. The company also did not go overboard with leverage--its equity/asset ratio was more than 11% at the onset of the crisis. Though it was clearly a good idea for investors to avoid the most-leveraged companies as the recession deepened, avoiding debt altogether would have dampened returns significantly as the markets recovered.

While perhaps not obvious at the time, the value in AmeriCredit stock was certainly not unique. The "junk rally" beginning in early 2009 was driven by many similar stocks, as investors returned to other survivors in industries previously left for dead. At the same time, numerous stocks seen as safe havens were left behind as the market rose. In our opinion, the performance of AmeriCredit's stock over the past 12 months illustrates both the value of a contrarian approach and the potential error of avoiding certain types of securities regardless of price. Although entire industries occasionally fall by the wayside, there are often valuable babies discarded with the bathwater.