With unemployment claims skyrocketing and Fed chairs forecasting unemployment rates of 30%, it’s pretty clear to many investors that a recession is coming.

At this point, most of the alpha has been chased out of the companies you’d expect to boom with social distancing – Zoom, Slack, Blue Apron and the like. So the next question is, what stocks might outperform in a recession where there’s still value?

The short term loan industry: a quick overview

A payday loan is a short-term, high-interest loan that’s due on the borrower’s next payday. In theory, it’s designed to help bridge the gap between one paycheck and another. In practice, many people end up using payday loans far more regularly than they should. There’s been a lot of controversy over these, but we’re just focusing on the investment thesis here.

IBIS loops in payday lending with check cashing and puts the entire industry revenue at $11.4 billion in the US and $1.3 billion in profit. They claim that, according to data from Microcredit Summit, there are 12 million borrowers in the US annually, and the average borrower pays $500 in fees for an average loan of $375.

The industry is countercyclical, with the main economic driver being the poverty rate. These loans are used by those who have very little access to traditional banking or credit products. The average income of a borrower is $30,000 annually.

A delayed onset presents a buying opportunity

Payday lending will undoubtedly surge in a recession, but there is likely to be a lag effect during this cycle for a few reasons. First of all, payday lending sees the least revenue in the first quarter due to tax refunds, so we’re already in the low of things. And as long as people are sheltered in place, it’s less likely to spend money on discretionary goods, and thus borrowers are less likely to lend. Finally, nearly every potential payday loan borrower will likely get their $1200 stimulus check, and not need a payday loan for a few months. Perhaps these factors are why Google search volume for the term ‘payday loans’ is at an all-time low.

So, while payday lending is countercyclical, it’s likely that the effects will be delayed for a quarter or two, making it a perfect buying opportunity.

Picking the Stock

While much of the payday loan revenue is by private companies, there are three publicly traded companies in the space. The main one to focus on is Curo Holdings.

Curo Holdings (CURO)

Market Cap: $269m

PE (TTM): 2.73

Dividend: 3.51%

Curo is the name of the company behind Speedy Cash, one of the most recognized storefront lenders in the space. The company also does online payday lending as well, and is probably the most mature of the bunch.

The stock price has been hammered with the rest of the market, and currently trades at only 2.73x trailing twelve months earnings with a 3.51% yield. The price is currently $6.11, with $1.85 cash per share. As you’d expect, the company is highly levered with an ROE of over 1,000%, but with a quick ratio of 5, the company should have no issues weathering short term fluctuations in the market.

The company has seen revenue CAGR of 8.9% from 2014-2019, which is impressive given that the payday industry has declined in overall revenue. In February the company announced plans to buy back shares.

The stock is cheap compared to EZ Corp’s (EZPW) and World Acceptance Corp (WRLD), which have PE ratios of 39 and 11 respectively. Neither of these alternatives pays a dividend.

Key risks

Other than the economy recovering, the key risk in the payday lending industry is regulation. For the most part, short term loans are regulated at the state level, with 13 states having outlawed this type of lending. There are likely more to follow.

The argument for outlawing these types of loans is quite simple: nothing seems right about paying $500 in fees for a $375 loan. And nothing these lenders do is transparent.

However, the counterargument is pretty simple. Anybody who understands lending knows that the interest rate prices the risk. If lenders have a capped interest rate, these lenders can’t afford to lend and borrowers have no better options.

Federal legislation has severely dampened the profits of the payday lending industry, and the CFPB has made it clear that they intend to continue down that path. In November 2017, the CFPB announced new rules that limit lenders’ ability to auto-draft borrower accounts, and that also requires lenders to assess a borrower’s ability to pay. That law goes into effect November 2020 but has likely already been priced in.