Despite wide swings in interest rates over the past year, Michael R. Hughes has found a way to accurately project earnings for volatile consumer finance companies.
His trick: follow stocks for which the income streams have been insulated against volatility in rates.
Mr. Hughes ranked first among analysts covering credit card and general finance companies in American Banker's first annual Wall Street Sharp Shooter survey of earnings forecasting accuracy, which was conducted by Zacks Investment Research.
Because most consumer and commercial finance companies must finance their lending activities with money raised in the capital markets, Mr. Hughes said in an interview this week, many have become very savvy borrowers.
"Most of the consumer lenders have become prime or Libor (London Interbank Offered Rate) lenders," said the San Francisco-based Merrill Lynch & Co. analyst.
"Fannie Mae and Freddie Mac have become extremely proficient at match funding and insulating themselves from other problems. Commercial finance is the same story: they're mostly prime lenders."
Understanding the significance of this fundamental strategic shift is what has made Mr. Hughes one of the most respected specialty finance analysts around.
Over the last four quarters, his projections ranked first or tied for first among analysts who cover Advanta Corp., MBNA Corp., AT&T Capital Corp., Household International Inc., and Mercury Finance Co.
For the previous five years, his crystal ball ranked tops for earnings of both MBNA Corp. and Beneficial Corp.
"He's been following us for several years and has worked hard to understand the entire finance industry," said Janet Point, vice president of investor relations for Advanta Corp. "He knows a lot of the nuances of the industry and has a good gut feeling for what's really happening."
While many investors have profited from falling interest rates this year, accurately projecting the income for companies in these industries is a different matter. But even if rates were to turn around and start rising next year, Mr. Hughes has more confidence in his earnings projections than he has in the market.
"I would be less worried about my earnings projections than I would about stock performance," he said.
This year was easy he said, because analysts have "recommended everything" under the belief that rates would be declining. Though he issued an upgrade on several financial stocks two months before rates peaked in February, his clients were able to reap the benefit of this year's price rise.
For next year, he said he is sticking to Merrill Lynch's economic forecast, which calls for lower interest rates, low inflation, and slow economic growth into the first part of the year.
That should help companies like Fannie Mae and Freddie Mac, both of which have good earnings growth and are considered good stocks right now, he said. "As soon as rates bottom," he warned, "that psychology is going to turn.
He also likes credit card companies in this environment, despite their insensitivity to the direction of interest rates. Among his favorite picks right now are Advanta, First USA, and MBNA.
"These companies are going to continue to show good earnings growth in spite of what everyone knows is a slowdown in consumer spending," he said. Besides, "Everyone hates them so much, I have to like them."
But concerns about consumer credit quality have spooked many investors in recent months. While he too is concerned about these developments, he attributes most of the deterioration to the slowdown in the economy since December, 1994.
If Merrill's forecast of continued economic growth is correct, that would mean delinquencies will flatten out around mid-year, he said.
And should mortgage rates fall 100 basis points, as many people are projecting, that could give mortgage refinancings the biggest boost they've seen since late 1993. The improved consumer cash flow resulting from these refinancings should also help credit card companies.
"That money's going to get plowed back into the consumer spending in one way or another," he said.
But the biggest immediate benefit of falling mortgage rates will come in the stocks of title companies. Earnings of companies like First American Financial and Fidelity Financial depend heavily upon lower rates to boost mortgage volume, and therefore, title business.
As an added benefit, these companies do not have a large analyst following, making them relatively unknown among investors.
"But they don't require a lot of analysis," he said. "You've just got to know where volume is going."
For institutional investors like Ernst Schleimer, senior securities analyst with Franklin Resources in San Mateo, Calif., his ability to put company and industry events into perspective is what has won him their trust.
"He's an analyst you can learn from because he gives you extra insight into how a company works," said Mr. Schleimer. "He's either my first or second call."