Investors can now invest indirectly in peer loans through stock in the world’s largest marketplace lender. What are the risks to investing in Lending Club stock and should you buy in?
Lending Club (NYSE: LC) issued stock on the New York Stock Exchange last Thursday and raised $865 million on its offer of 57.7 million shares. The stock surged 56% in the first day of trading and closed Friday at $24.69 per share. At that price, the company is valued at $9.7 billion and an enterprise value 60 times expected sales of $165 million this year.
Even on the potential for growth to continue well into the future, investors need to ask if the shares are too expensive and if they would be better off investing directly in peer loans.
Risk and Return on Peer Loans
The table below presents Lending Club statistics for loans issued from 2007 through the first quarter of 2013. It is important to look at loans that are more than a year old because the default rate stabilizes after about a year and returns are more certain.
The table shows the average interest rate for peer loans, the annualized return realized by investors and an implied loss rate for the portfolio of peer loans within each risk category.
Risk in peer lending is very low for the safest categories of peer loans and still manageable even in the riskier categories. As with any investment, you need to understand your own tolerance for risk. If a few defaults are going to make you skittish, then stick with the top-rated categories. If you can ride out a few defaults, understanding that the total default rate will average out over a large portfolio of 200 loans, then you can realize higher returns in the riskier categories.
Defaults on general consumer credit have come down a lot since the end of the recession. The S&P Experian Consumer Credit Default Index reports a default rate of just 1.06% across auto, mortgages and bank card loans it tracks. That is well under the 4.75% default rate it reported in 2010.
By comparison, the S&P 500 index of stocks has seen volatility of 11% over the last two years and 20% over the last ten years. That means that the stock market is likely to swing up to 20% higher or lower in a given year.
Of course, as the disclaimer goes, past results are not a guarantee of future returns. We don’t yet know how rising rates in 2015 will affect direct investment in peer loans. Generally, lower-quality bonds are more correlated with the economy than they are with interest rates. This is intuitive because companies or people are better able to pay their debts in a strengthening economy. Most peer loans are held to maturity so you don’t see as much interest rate risk as you see in the fixed-income market. While the average returns on peer loans are very good on a risk-adjusted basis, you can realize even better returns by picking loans on important loan criteria, featured in a recent interview with a Prosper peer lending investor.
Rising rates could be a good thing for peer lending investors. Higher interest rates should also increase the rates on peer loans and defaults may decrease if the economy stays on track. This would increase the net return for investors. I provide a detailed comparison of the risks and potential for peer loans on both Prosper and Lending Club in my peer lending sites review.
Risk and Return on Lending Club Stock
Anyone with money in the stock market since 2000 can tell you that investing can be a roller coaster ride and I doubt it will be any different for shares of Lending Club. As a partial owner in the company, shares entitle you to a piece of the massive growth in the industry.
Lending Club’s platform originated $3.2 billion in loans over the seven years through 2013 and almost doubled that amount in the first three quarters of this year. The company is just starting to tip its toes into small business loans and a new two-year super-prime loan. Revenue grew by 190% to $98 million in 2013 and I estimated sales could reach $1.1 billion by 2017 in a stock valuation infographic I posted before the IPO.
The peer lending market at about $7.5 billion is still just a fraction of the $3.3 trillion consumer credit market and there are likely years of double- or triple-digit growth ahead for Lending Club. The company has nearly a billion dollars after the IPO to pay for growth projects and profitability should improve as the business matures.
Still, the huge increase in the stock price over the first two days of trading may be a bit much. For the risk inherent in stocks over that seen in fixed-income investments like peer loans, investors should require a higher return.
If we assume a required annual return of 9% for shares of Lending Club, the price would need to rise to $32 per share by the end of 2017.
This increase of about 30% doesn’t seem too far fetched considering the shares’ meteoric first day but would still lead to a relatively expensive enterprise value of about 11 times expected sales in 2017.
Which is the Better Investment?
Asking which is the better investment between Lending Club stock and direct investment in loans is something of a trick question. They are two different asset classes and you should probably have a little of both in your diversified investment portfolio. Stocks generally offer higher returns if you can ride out higher risk over the short-term while fixed-income investments like peer loans are more stable and offer near-term cash returns.
Using the S&P Experian Consumer Credit Default Index as a proxy for peer loans, we find almost no correlation (0.014) with stocks over the last five years and a very low (0.28) correlation with bonds. This means that not only can you realize high returns on peer loans but, combined with a portfolio of stocks and bonds, you will reduce your risk significantly.
The better question is should you invest in Lending Club stock following the IPO? While a decent return over the next three years is well within reason, history shows that investing immediately following an IPO is not always the best idea. In a study of IPOs from 1980 through 2009, companies saw their stock higher by 18% on the first day but then produced a total return of only 21% over the next three years. Note that the 21% return is including the 18% from the first day and not an additional return.
Initial offerings of stock tend to get bid up in investor exuberance, especially when the industry is seeing as much growth as that of peer lending. It looks like this is what happened in the case of Lending Club and I would hesitate to buy shares at this price.
While the long-term potential for the company is still higher, I think you could wait for a couple of months and watch for a better price on the shares. Enter separate buy orders at $22 and $20 per share for your total investment. In the meantime, look to direct investment in peer loans to diversify your portfolio and provide a strong risk-adjusted return.
Hi, My name is Joseph Hogue. Born and raised in Iowa, I graduated from Iowa State University after serving in the Marine Corps. I started out in corporate finance but quickly realized that I had a passion for investments and helping people understand their money. That led me to open my own firm, Efficient Alpha, providing research and analysis for financial advisors and institutional investment firms. I have appeared on Bloomberg and led a team of equity analysts for a Canadian private equity firm. I also hold the Chartered Financial Analyst (CFA) designation, the gold standard for ethical and professional conduct in investment management.