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Continued from here (& here). In this post, we’ll turn our attention to the distressed consumer.

You may just consider this exploitation of the great unwashed – but in reality, they’re often the most expensive customers (pro rata) to acquire & service. (Illegal) immigrants also fall into this category – a fairly unavoidable cost of freight they pay in light of their status. [As US-listed Hispanic plays become increasingly touted & expensive, distressed consumer businesses are a cheap back door play on a sub-set of that population]. Also, the amounts involved with these customers is (inevitably) small. Actually, businesses are really targeting a much bigger & more lucrative opportunity – the democratic exploitation of an enduring human frailty:

Financial stupidity…

The obvious place to start here is with the usual vices – drinking, smoking, gambling, luxury goods… 😉 But these sectors are huge & everybody’s doing ’em – I’m going to skip anything so mainstream (but I’m fascinated how highly rated they are!). I probably should consider drugs too, with marijuana access now increasingly legal & convenient across the US – but the real stupidity here might actually be investing in marijuana stocks!?

While I’m at it, we could make a case for including healthcare – people who make poor financial decisions surely make even worse decisions about their long-term health? [Especially with the communist approach to healthcare in the US & most other developed nations: All good deeds go unrewarded, and the worst 20% consume 80% of the resources… Which simply encourages everybody to race to the bottom (of the ice-cream tub). Look, I’m all for providing a safety net, but not when it’s stuffed with cheese burgers!] Let’s skip healthcare as a whole other mess… In similar vein, a trillion dollars of US student debt could have mutated into the biggest distressed consumer play around – since everybody seems to have now decided they can’t/won’t pay any longer – but that’s underwritten by a suckered population also.

Right, let’s move on – picture you’re an average distressed consumer:

Your most valuable possession is the roof over your head. But to say it’s your possession is probably a little misleading… You have God-awful credit, so your only choice is a sub-prime mortgage. Except I must object, as an investor! A sub-prime mortgage is a completely illogical construct – something only government largesse & corporate greed could dream up. It’s a well-known fact foreclosed properties are sold for at least 30% less than comparable (non-distressed) properties. Which obviously implies a max. 70% LTV, but what distressed consumer’s ever saved that kind of down-payment?! Prudence inevitably gets thrown out the window, and ticking time-bomb mortgages are written.

Sure, the lender earns a higher spread – but so what, their cost of capital, admin & servicing costs, etc. are all higher too. And how sensible can it be to lend to somebody who’s proved incapable of honouring a liability/financial contract, or is clearly buying a house that’s unaffordable? Most of this sector was wiped out post-credit crisis, anyway – though some companies are jumping back in over the past year. It’s a shame, slum landlords used to  exist for good reason… Now politicians have co-opted the taxpayer as the ultimate evil landlord! I’m avoiding this sector (as I always have).

OK, so we need to re-think that roof over our head. Mobile homes/trailers, RVs & manufactured homes are the solution – Warren Buffett didn’t miss a trick when he bought Clayton Homes. In Europe these are genuinely used for leisure, while in the US that’s often just a marketing fantasy – people actually live in these shit-boxes. Cavco Industries (CVCO:US), Deer Valley Corp (DVLY:US), Fleetwood Corp (FWD:AU), Nobility Homes (NOBH:US) & Skyline Corp (SKY:US) might have what you need. Speaking of housing, I was astonished to discover this business:  EnerCare (ECI:CN). They’ve built a huge business renting water heaters to people who haven’t figured out owning might be better than renting such a long-lived piece of essential kit!

[Actually, mobile homes or trailers are a great source of amusement & class warfare. In Ireland or the UK, the most likely inhabitants of a trailer would actually be farm animals… Also, in more innocent times, mobile home parks – technically, trailer parks – were (most ironically) quite posh get-aways by the sea, while the hoi polloi were confined to teeming caravan parks. And if you were too poor even for the caravan park, you could try camping – except nobody in Ireland would be caught dead in a tent in those days, unless you were some bloody stoodent. So the poor headed to Mosney instead. For non-Irish/UK readers: Just imagine something like a refugee camp, complete with nightly entertainment. I’m not kidding – seriously, Mosney has now (seamlessly) transformed itself into an actual refugee/asylum-seeker camp!]

Your second most precious possession is, of course, your car or truck. Again, your shitty credit history stands in the way of making a brand new purchase. Buying second-hand might be the answer:  America’s Car-Mart (CRMT:US), CarMax (KMX:US) & QC Holdings (QCCO:US) can help. There are plenty of Japanese companies in the business too, but strict local regulations dictate an export-oriented model – companies like Gulliver Int. (7599:JP), Trust Co (3347:JP), USS Co (4732:JP) & Bike O & Co (3377:JP) (motorbikes) are worth a look.

Occasionally, dealers will finance your purchase themselves, but it’s more likely they’ll steer you to a sub-prime auto-lender:  Consumer Portfolio Services (CPSS:US), Credit Acceptance Corp (CACC:US), Nicholas Financial (NICK:US), Regional Management Corp (RM:US), Rifco (RFC:CN) & Carfinco Financial Group (CFN:CN). With the remarkable aging of America’s car fleet, I believe this sector has amazing potential – but most companies don’t appear particularly cheap. I’d also like to see a little less leverage – I’d prefer a 50% Debt:Equity ratio, but 100%+ Debt:Equity ratios are far more likely. While we’re at it, distressed consumers seem remarkably adept at crashing/wrecking said cars – Copart (CPRT:US) & KAR Auction Services (KAR:US) benefit.

Now they’re taken care of, you’re ready to fill your palace with stuff – starting with the biggest goddamned TV that actually fits in your living-room. Rent-to-own/hire purchase seems like a marvelous way to skip saving, which takes far too bloody long… Rent-A-Center (RCII:US), Aaron’s (AAN:US) & easyhome (EH:CN) showrooms are bursting at the seams with stuff you really need. Simply renting is an even cheaper & stupider option from Thorn Group (TGA:AU). If you’re a little more flush, Cash Converters Int. (CCV:AU) might offer some great second-hand bargains.

But hang on, before you buy stuff on tick or start rummaging through the used knickers bin, maybe your credit isn’t thaaat bad… And surely borrowing at exorbitant rates – so you can actually buy rather than rent all that stuff – would save you money in the end?! Fortunately, there’s plenty of friendly lenders: In the UK, Provident Financial (PFG:LN), S&U (SUS:LN) & Secure Trust Bank (STB:LN) would be happy to lend you a few bob. Regional Management Corp (RM:US) & World Acceptance (WRLD:US) lend in the US – WRLD also lends in Mexico. Japan has Acom Co (8572:JP) & Aiful Corp (8515:JP). International Personal Finance (IPF:LN) lends in E Europe (& Mexico), MCB Finance Group (MCRB:LN) lends in the Baltics & Australia, and Money3 Corp (MNY:AU) also lends in Australia.

Once again, there’s an appalling dearth of investing opportunities in W Europe – doubly frustrating considering the day-to-day trickle-down impact of the sovereign-debt crisis. Conafi Prestito (CNP:IM) looks like a potential candidate, but it only hosts an Italian website. [NB: I’ve generally omitted companies with foreign language-only websites, or sub-10 mio market caps, in this entire post]. [Actually, I’ve come across one other company I have (rather unexpectedly) discovered is becoming one of the biggest pawnshop & consumer lenders in Europe. Unfortunately, it’s got far too much debt right now – but it’s still intriguing, so I’ll save it for a possible future write-up…]

Again, these loan companies tend to have too much leverage – sometimes debt’s even a multiple of equity. Which is absurd – if that’s the only way you can turn a decent profit on sub-prime lending, clearly your expense structure is too high and/or your lending rates are too low. These companies are often high growth, but also quite unpredictable – you have little idea how prudent, or imprudent, they’re being in their lending. In fact, they’ve a rather nasty habit of going ex-growth without warning, while simultaneously shitting all over you with a bunch of loan write-offs. A limited amount of leverage is the only way I get comfortable in this sector.

OK, you’re really rolling in the golden clover now – and your loan repayments are pretty reasonable (erm, even though your loan term’s far longer than you expected). Perhaps some more shopping’s in order – why interrupt the celebrations, when you can just shop at home? HSN (HSNI:US) & Valuevision Media (VVTV:US) are right there selling tat on your TV. Maybe you should spread some of the joy to your family. Why rely on a bank, when you can go out & find a Western Union (WU:US) or a Moneygram (MGI:US) office instead. [Though if you’re in the US & trying to send money overseas via a bank, you’re probably screwed – the bank will charge an inordinate fee for such an extraordinary transaction, and they’ll probably presume you’re a terrorist too… WU & MGI may actually be the better bet!] If you’re a little more ambitious, maybe saving for Xmas would be a good idea with Park Group (PKG:LN).

Perhaps catching up on some bills might also be in order – Tio Networks Corp (TNC:CN) or Paypoint (PAY:LN) offer a more convenient & expensive way to pay. And loading some funds onto a pre-paid card may be a great way to pay for the next shopping spree. Green Dot Corp (GDOT:US), Netspend (NTSP:US), DirectCash Payments (DCI:CN) or SpendSmart Payments Co (SSPCD:US) (which is still, rather hilariously, called BillMyParents on their website) have so much more cachet than cash, or a zero-fee bank a/c. You can also pretend you’ve finally gotten your hands on a credit card again. And if you grow bored with shopping, not to worry – the cards will spend your money regardless…on outrageous monthly fees. You’ll also need some of the folding stuff for walking-around money – where better than your local convenience store ATM machine, as provided by Ezeatm (EZA:AU), Cardtronics (CATM:US) & DirectCash Payments (DCI:CN) (again). Sure they charge a $2-3 withdrawal fee, but if you take out a bare minimum each time, you’ll probably spend less cash in the end – smart, eh..?! Oh btw, while you’re there, you may as well buy some ciggies & who could resist a quick scratch card from Pollard Banknote (PBL:CN).

You know, you obviously love to buy new products & technology, but unfortunately it’s also quite clear you have sod all interest in harnessing them for your own financial benefit. However, there’s one technology you’re on top of – on-line credit checks with Experian (EXPN:LN) or Equifax (EFX:US), because only somebody with shit credit regularly checks their credit history… And you’ve gotta admit, you’re a sucker for ID theft/fraud companies like LifeLock (LOCK:US) & Intersections (INTX:US) – because there’s surely somebody worse off who’d love to steal your glowing credit history… [Actually, there is…in Africa! Maybe if you stopped responding to their emails you wouldn’t be so worried about ID theft].

Right, that’s about as good as it gets…it’s all pretty much downhill from here. First, you notice your budget’s getting squeezed, so you begin shopping in discount stores to stretch the pennies. Now, I’m not talking about stores everybody shops in for fun – like the big Dollar stores, TJX Cos (TJX:US) or Wal-Mart Stores (WMT:US), for example. [I must admit, even I’ve shopped in a Wal-Mart – well, I didn’t shop, but I definitely had fun! Lord Jesus, cousins really can produce some remarkably ugly kids…] I’m talking about the kind of stores where consumer dreams go to die, and the flickering track lighting illuminates the corpses. And the clothing selection is a strange mix of ghetto & ’90s white boy fashion…

This, of course, isn’t something you’ll discern from a website, and I’m certainly no discount store connoisseur. But if you’ve been to NYC, I’m sure you’ve visited Macys (M:US)? Directly across the street, there’s a store called Daffy’s, which I had the misfortune of visiting once – anybody know it? That’s exactly the kind of store I’m talking about! [Now see it’s bankrupt…as are most of the other discount stores in NYC – surely means the city’s doing well!?] At a guess, these might be a little similar:  ALCO Stores (ALCS:US), Big Lots (BIG:US) & Fred’s (FRED:US). The Reject Shop (TRS:AU), Gordmans Stores (GMAN:US) & Citi Trends (CTRN:US) deserve special mention, respectively, for their name, ticker & totally offensive idea of fashion. There’s also a whole slew of listed Japanese discount stores, but most only have Japanese language websites & I suspect they’re mainly the fun dollar store type anyway.

Things then quickly go from bad to worse… Soon you’re hocking everything that isn’t nailed down to the pawn shops:  Albemarle & Bond Holdings (ABM:LN), H&T Group (HAT:LN), Cash Converters Int. (CCV:AU), Cash America (CSH:US) (also operating in the UK & Sweden) & First Cash Financial Services (FCFS:US). Most US companies have now moved into Mexico also. Ezcorp (EZPW:US) deserves to be highlighted as it actually owns substantial stakes in Albemarle & Cash Convertors, and is also rapidly expanding in Mexico. And these pawn stores will be only too delighted to offer you payday loans next…as will QC Holdings (QCCO:US) & Cash Store Financial Services (CSF:CN).

With the rally in the gold price in the past few years, pawn shops have relied far more heavily on gold buying & gold pawn loans. And investors have been generally fearful of what might prove a temporary trend – witness Albemarle’s recent profit warning & reaction, for example. This is patently absurd – sure, a decline in the gold price might cause a little hiccup, but what’s the impact on the medium/long-term outlook? Zilch! Don’t forget, we’re talking about distressed consumers here – if they stop selling gold, for whatever reason, how exactly do they plug the hole in their finances? They’ll be back, they can’t afford not to…

Your options are becoming extremely limited now. If you’re the more genteel sort, perhaps you’re still hanging on to a decent life policy you could cash in with Imperial Holdings (IFT:US) or Life Partners Holdings (LPHI:US). If not, you may want to encourage your children to start playing in heavy traffic, or with heavy machinery – for many distressed consumers, the loss of a limb might be their only winning lottery ticket in life. Foris (FRS:GR) or Frenkel Topping Group (FEN:LN) can help with the litigation, and here’s Imperial Holdings (IFT:US) again to offer up-front cash on your settlement – for a fraction of its total value, of course.

At this point, you could try one last ditch effort at trying to re-organize your debts with the assistance of Fairpoint Group (FRP:LN) or FSA Group (FSA:AU). Or maybe you should just give up the ghost & abandon your debts at this point… Unfortunately, your creditors won’t – eventually they’ll sell them to the debt collectors, and you’ll face the final painful stage of the entire debt cycle. If you’re in the US, expect a call from one of the 4 Horsemen:  Asta Funding (ASFI:US) (I have a 3.3% portfolio holding), Encore Capital Group (ECPG:US), Portfolio Recovery Associates (PRAA:US) or Asset Acceptance Capital Corp (AACC:US). In Australia, you can expect to hear from Collection House (CLH:AU) or Credit Corp Group (CCP:AU). All of these companies buy aged consumer receivables, priced at pennies on the dollar, and assumptions on price paid vs. the time, cost & size of their ultimate recovery are crucial. This is a pretty opaque business for investors, so (again) I believe a low level of leverage is needed as an appropriate margin of safety.

Of course, once all these collection efforts are satisfied (or exhausted), you can eventually look forward to the day (how long depends on the country) when you can do this all over again..!

Now, as an investor, I’ll leave you with a final observation: This is something I’m still pondering, but I suspect distressed consumer plays don’t actually offer negative correlation within your portfolio. If the economy deteriorates sufficiently, demand probably increases overall, in terms of the number of distressed consumers – but this is likely overwhelmed by the decline in confidence (to borrow) & the ability to repay (which will prompt write-downs on the current book of business).

However, there is good news – I do believe the distressed consumer generally offers a cheap & interesting low/zero correlation investment for your portfolio. This reflects the fact that most of these consumers remain permanently distressed, regardless of economic circumstance (or climate) – simply because it’s a state of mind, not an economic condition.

The sad fact is – picture one of these poor lucky sods winning the lottery:  In due course, almost inevitably, he will end up a distressed consumer again…

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