Lending Club IPO- Transforming Lending

I submitted this article to seekingalpha.com

Summary: Lending club has had consistent growth in number of loans issued since 2009, and holds a competitive advantage over traditional lending institutions. While I don't generally recommend Initial Public Offerings, this company doesn't seem to be going public because they need money. 

Background:  What do Borders and Blockbuster have in common? They are both information based businesses that have been largely displaced by the internet. Looking back at the story of the US economy during the turn of the century I think we'll agree the dominant trend will be the internet disrupting large, information based products like these.

As Lending Club CEO states: "There have been many examples of this happening before, whether it was when Borders could not react fast enough to Amazon or when Blockbuster could not react fast enough to Netflix and eventually went bankrupt. There have also been many attempts at companies trying to survive by spinning out low-cost operations... Despite their best efforts they keep the same culture."
Renaud Leplanche 1 

The financial industry could very well be the next one up for a ride.  Every interaction of the financial industry is currently being re-evaluated from transactions with Paypal, to fundraising using Kickstarter public funding with Neighborly and even currency itself using Bit-coin. While I'm not totally convinced that all these "innovations" will turn out to be real improvements, one in particular has caught my attention. Partly because Lending Club is going public, I've been thinking about Peer to Peer Lending. Peer to Peer Lending first emerged in the UK with Zopa followed by companies like Funding Circle and Assetz Capital.2 The essence of these peer to peer lending is that the companies are not issuing the loans but simply use the internet to facilitate loans being made from one person to their peer.

Peer to Peer Lending
https://www.prosper.com/welcome/how_it_works.aspx

Peer to peer lending is the natural development of applying the internet to finance. This is the emergence of an entire industry not limited to one or two companies. Along with peer to peer lending, micro-finance organizations for charity like Zidisha have popped up using the internet to give individuals access to funding otherwise un-available in  developing world. Out of this developing field two major players in the U.S. that have shown staying power are Prosper and Lending Club. In 2008 during the financial crisis, the SEC required these companies to register their loans as traded securities, and offer re-sale on a secondary market which ended up suspending new loans from being issued and forced Zopa out of the US market.2 After adjusting to the new regulations, both companies were able to resume issuing loans near the end of the financial crisis of 2008-2009 with Lending Club taking the lead as the largest, best run Peer to Peer Lender in the US.  Lending Club had originally been formed by Renaud Laplanche in 2007 partly "after he became irked by the massive disparity between the 18% interest rate on his credit card bill, and the 1% savings rate at his bank."Laplanche collaborated with Oracle co-worker Soulaiman  Htite in 2006 and initially tried to issue loans through Facebook but later realized they would have to build their own platform. Video summary: http://youtu.be/GWsVTu1rgUo

Potential- Since then Lending Club has continued to facilitate more loans, gain financial strength as well as recruit prominent financial industry leaders to their team. John Mack former CEO of Morgan Stanley and Lawrence Summers former chief economist at the World Bank, Simon Williams former Citigroup head of Global Consumer Risk are the more notable recruits.4

https://www.lendingclub.com/info/statistics.action

Probably the strongest indicator of their success though, is the continued increase in number of loans facilitated which more than doubled from $600 million in 2013 to $2 billion in 2014. In addition to this consistent upward trend as LePlanche states: "I feel that our competitive advantage compared to traditional banks is really long lasting because, again, it is grounded in technology and cost, not something they can react to. The amount of debt that American families are carrying is really huge, so the opportunity to make an impact and help people is really tremendous."1

2013 SEC Report http://tinyurl.com/n93dj9u  p.58

Risks- while Lending Club has enormous promise and is growing at an surprisingly consistent pace, it should still be remembered that this is a high risk start-up that has only 1 year of actual functioning with positive income. This is an industry that 10 years ago wasn't even an idea and it has never paid a dividend and is untried in its long term performance. With revenue of about $100 million and net income for the first time becoming positive around $7 million in 2013 this company has a long way to go before living up to the $1.55 billion dollar valuation heaped on it via the loans from $125 million investment by Google, $15 million from Kleiner Perkins and others. 7 For the long term investor it will likely take years and overcoming some large setbacks for Lending Club make money for  its investors. It is by no means a sure bet during the bull market in an economy artificially propped up by a federal stimulus.

Along with its profitability, Initial Public Offerings in general are not a great way to find value, as Warren Buffet has stated in different ways on multiple occasions: "It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors)."8 His own history speaks even louder as he grew his wealth without ever having to purchase an IPO.  Or as Seth Klarman explains: "Gone are the days when a new issue was a collaborative effort in which a business that was long on prospects but short on capital could meet investors with capital in hand but few good outlets. Today the IPO is where hopes and dreams are capitalized at high multiples." 9  Or as Ben Graham, quips IPO really stands for Insiders Play Only, so for the true value investor IPO's are out of the question.

http://www.lendingmemo.com/lending-club-for-investors/

Despite the IPO drawbacks, I think that for every 100 or so overvalued new issues there may a few good ones hidden in the mix if you have the time, acumen and patience to identify them. And if we can take LePlanche at his word, Lending Club isn't actually going public because they need the cash but primarily " to use it as an opportunity to raise awareness for the company."1

Recap: Because Lending Club is run using the internet to its advantage, I believe it will continue to take market share away from banks, credit card companies and other traditional lenders by offering better rates to individual borrowers and lenders. Although Lending Club is a company organized around the internet and has a culture that will give them a competitive advantage, it is still an untried business model in an emerging industry. My personal interest in this company is not purely about making more money so much as participating in the greater cause of reducing people's personal debt and losing less money in unnecessary administrative and bureaucratic costs that have built up in older financial systems. I have used Lending Club's service as an investor for about 6 months and I think it holds the potential for a genuine improvement because it should enable  people to more quickly reduce personal debt and get above a 1% return on their savings.

Disclosure: I am an investor in loans using the Lending Club website. I will most likely invest a small amount of money in the IPO depending on the price.

1. http://www.lendingmemo.com/lending-club-renaud-laplanche-interview/
2. http://www.bizjournals.com/sanfrancisco/stories/2008/10/13/daily55.html
http://en.wikipedia.org/wiki/Peer-to-peer_lending.
3. http://www.forbes.com/sites/parmyolson/2013/05/02/google-buys-stake-in-lending-club-valuing-peer-to-peer-lender-at-1-6-billion/
4. https://www.lendingclub.com/public/board-of-directors.action
7. http://www.forbes.com/sites/parmyolson/2013/05/02/google-buys-stake-in-lending-club-valuing-peer-to-peer-lender-at-1-6-billion/
8 Margin of Safety Risk Averse Value Investing Strategies for the Thoughtful Investor Seth Klarman
9 http://www.cbsnews.com/news/buffett-ipos-are-almost-always-bad-investments/

"Neither do men put new wine into old bottles: else the bottles break, and the wine runneth out, and the bottles perish: but they put new wine into new bottles, and both are preserved." Mathew 9:17

The Intelligent Investor

     Warren Buffet, largely regarded as the greatest investor of all time, said of Ben Graham "I attended Colombia University’s business school in 1950-51 not because I cared about the degree, but because I wanted to study under Ben Graham." 

     Ben Graham's family immigrated from London in 1894. Graham grew up poor because of the death of his father, and an economic crisis in 1907.  He displayed brilliance in academia and was offered a teaching position at Columbia University. He probably would have preferred studying and teaching there but due to the lingering pain of the economic need to support his mother and family, he instead applied his brilliant mind to investing. He was almost wiped out by the crash of 1929 but survived and brought with him the lesson he learned from those experiences. His writing combines a serious sober perspective with mental agility. The work that he did in business has benefited countless investors and added soberness and stability to the financial world ever since

       According to Buffet there are three important lessons that were established reading Graham's most popular and fundamental work  The Intelligent Investor. Basic number one: Stocks are tiny pieces of businesses. This may seem obvious but people often don't look at the underlying business when they are investing in stocks. They aren't just ticker symbols! They are real live companies that have people have put their blood, sweat and tears into building and maintaining. If they are truly growing, it's because smart, dedicated, hard working people are going in day after day and making things happen. To understand stocks you must understand the people and numbers behind them. There are other ways to invest, you can invest in real estate or land, but when you are buying stocks you are buying businesses. If you wouldn't buy a business maybe you should think twice about buying stocks.

      Two: Mr Market.  Ben Graham came up with the metaphor Mr. Market. He's this crazy bipolar guy who generally feels optimistic and occasionally gets very depressed. You can't predict what he'll do next and you DO NOT want to get sucked into his mania!  What this means is in the stock market it's impossible to predict short term changes because the people buying and selling them are un-predictable. Predictions are difficult and timing things perfectly might as well be impossible. Instead of trying to  time your purchases, you should look at the price you are paying. As with anything you buy, look for bargains and keep your own costs down. To determine price Graham suggested looking at Price to Earnings Ratio and Book Value which are still a decent place to start. He said not pay more than 15 Price to Earnings Ratio but look for between 5 and 10, for book value don't pay more than 1.5 times book value but look for less than 1. The companies should also be large, about 1.5 billion and have paid a consistent dividend for 10+ years.  

     Three:Only purchase if you have a large safety cushion. Graham called this cushion a margin of safety. I think many people (myself previously included)  have the false notion that to make more money investing  you have to take more risks, which is completely the opposite with value investing. As with many things, to do better at it you have to put more time and effort into it and know your limitations, not take more risk. This cushion also includes reducing your risk in other ways, like not using money you will need any time soon. Graham also recommends holding 10 to 30 companies, essentially not putting all your eggs in one basket. He also recommends having bonds be make up 25-50 percent of your stocks partly for the emotional stability that it will add to your investments.

      Warren Buffet, who I'll talk about him more in later posts, has since refined much of Graham's thinking, but I think we still owe a lot to this guy.

                                  

some financial sites I have found useful:
http://seekingalpha.com/
http://www.multpl.com/shiller-pe/table
http://www.libertyinvesting.com/blog/
http://www.shillerfeeds.com/
berkshirehathaway.com/letters/letters.html
http://warrenbuffettresource.wordpress.com/

Some other quotes I thought were important from the book: 

“One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium sized companies with a long market history.” P. 143

“An enterprising investor is not one who takes more risks than average or who buys ‘aggressive growth’ stocks; an enterprising investor is simply one who is willing to put in extra time and effort in researching their portfolio.” p.159

“Concentrate on the larger companies that are going through a period of unpopularity…First they have resources in capital and brain power to carry them through. Second, the market is likely to respond with reasonable speed to any improvement shown.” p.163 

“The aggressive investor must have a considerable knowledge of security values, enough to warrant viewing his security operations as equivalent to a business enterprise. There is no room for middle ground between passive and aggressive status… The majority of investors should be defensive.” p. 176

The longer the bull market lasts the more severely investors will be affected with amnesia; after five years or so, many people no longer believe that bear markets are possible. p.190

“The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stock had no market quotations at all for he would then be spared the mental anguish caused him by other persons mistakes of judgment.” p 203

Price fluctuations have only one signal to the true investor: they provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. “The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.” p 205

Would you allow a lunatic come by at least 5 times a week to tell you that you should feel exactly the way he feels? Yet millions of people let Mr. Market tell them how to feel and what to do despite the fact that from time to time he gets nuttier than a fruitcake. The cheaper stocks got, the less eager people become to buy them because they are imitating Mr. Market instead of thinking for themselves. By refusing to let Mr. Market be your master, you transform him into your servant. After all when he seems to be destroying value, he is creating them elsewhere.   p 215

4      “For anyone who will be investing for years to come, falling stock prices are good news, not bad since they enable you to buy more for less money. The longer and further stocks fall, and the more steadily you keep buying as they drop, the more money you will make in the end-if you remain steadfast until the end. Instead of fearing the bear market you should embrace it. You should be perfectly comfortable if the market stopped supplying prices for 10 years. ”

“You will be much more in control, if you realize how much you are not in control.” p 223

"Buying funds based purely on their past performance is one of the stupidest things an investor can do.” 

Fund Drawbacks Conclusions p. 243

1.       The average fund does not pick stocks well enough to overcome the costs of researching and picking them

2.       The higher a funds expenses, the lower its returns

3.       The more frequently a fund trades its stocks, the less it tends to earn

4.       Volatile funds stay volatile

5.       Funds with high past returns are unlikely to remain winners for long

“Sector funds are the investor’s nemesis.”

The higher the growth rate you project and the longer the future period over which you project it, the more sensitive your forecast becomes to the slightest error. P 282

“It is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable, rather than dilute your results to a mediocre figure, merely for diversification's sake. But this is not done because it cannot be done dependably.” P 290

“Corporate accounting is often tricky; security analysis can be complicated; stock valuations are really dependable only in exceptional cases.” P 318

“Today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with serious temporary and perhaps even permanent loss.” P 345

“Surely, then, by the exercise of even a moderate degree of skill- derived from study, experience and native ability- it should be possible to obtain substantially better results than the DIJA.” P 376

“It is true that a fairly large segment of the stock market is often discriminated against or entirely neglected in the standard, than the intelligent investor may be in a position to profit from the resultant under-valuations.”   P 380

The vast majority of people who try to pick stocks learn that they are not as good at it as they thought; the luckiest ones discover this early on, while the less fortunate take years to learn it.” p 396

“The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some ‘action’ in progress. It will fall for any company identified with ‘franchising,’ computers, electronics, science, technology when the particular fashion is raging. Sensible investors are above such foolishness.” P 437

“Just as the Surgeon General’s warning on the side of a cigarette pack does not stop everyone from smoking; no regulatory reform will ever prevent investors from overdosing on their own greed. The circle can only be broken one investor and one financial advisor at a time. Mastering Graham’s principles is the best way to start.” P 437

Just as a coin does not become more likely to turn up heads after landing on tails nine times in a row, so an overvalued stock (or market) can stay overvalued for a surprisingly long time. p. 466

“It is well established that people often assign a mental value to stocks based largely on the emotional imagery that companies evoke. The intelligent investor always digs deeper.” P 474

“The market scoffs at Graham’s principles in the short run, but they are always revalidated in the end. If you buy a stock purely because its price has been going up –instead of asking whether the underlying company value is increasing-then sooner or later you will be extremely sorry.” P. 486

"Never dig so deep into the numbers that you check your common sense at the door..." p.508

"..chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions…the margins of safety is always dependent on the price paid.” P 516

“A sufficiently low price can turn a security of mediocre quality into a sound investment opportunity.” P 521

Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it- even though others may hesitate or differ…In the world of securities, courage becomes the supreme virtue after adequate knowledge and tested judgment are at hand.”

“Limit your ambition to your capacity and confine you activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”  P 524

“Simply keeping your holdings permanently diversified, and refusing to fling money at Mr. Market’s latest, craziest fashions, you can ensure that the consequences of your mistakes will never be catastrophic.” P 531

“One lucky break, or one shrewd decision-can count for more than a lifetime of journeyman efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity. Interesting possibilities abound on the financial scene, and the intelligent and enterprising investor should be able to find both enjoyment and profit in this three ring circus. Excitement is guaranteed.” P534

“Without a saving faith in the future, no one would ever invest at all.” P 535