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Stock Investing Tread Softly… and Carry a Big Risk-Management Calculator

Companies / Sector Analysis Apr 15, 2015 - 11:02 AM GMT

By: Money_Morning


Shah Gilani writes: We’ve been talking here for the past two weeks about peer-to-peer lending – or P2P lending, as it is known – and have given you several ways to cash in on these new Lending Disruptors.

And if you’ve acted on our recommendations, you’re already making money.

In my April 6 report on the New Lenders, I recommendedGoldman Sachs BDC Inc. (NYSE: GSBD) and Apollo Management Corp. (Nasdaq: AINV).

GSBD, which yields more than 8%, popped at the open of trading Monday. At its high price Monday morning, you were up almost 10% from where I recommended it only six trading days ago (an annualized gain of nearly 2,600%). And just two days after we told you about it, the widely read Investor’s Business Daily highlighted the Goldman business-development entity as one of two recent initial-public-offering (IPO) stocks “notable for their eye-catching earnings and sales growth in recent quarters.”

Triple-digit sales and profit gains is part of what caught my eye.

As for Apollo Management – it’s roughly flat from where I recommended it. But the stock has a juicy yield approaching 11%, which means you’re ahead of the game even before it delivers the gains I’m predicting.

The bottom line: Stick with these two investments. They’ll rise nicely in due course. In the meantime, you’re getting a better risk-adjusted yield than you’ll find in most other places.

That brings me to the market intelligence I want to share with you today.

Most of our talks here focus on opportunities – places and ways to make money.

But successful investing also involves managing risk – minimizing the losses you incur… or avoiding them altogether.

Thanks to Disruptors like Goldmanand Apollo, the new lending market is one of the sexiest profit opportunities in the finance arena.

But what you don’t know can hurt you.

So today I’m going to show you how to avoid losing money in the shifting lending market…

Don’t Follow the Herd

Investors are heading into the new lending arena for a lot of reasons.

They’re heading there to pick up yield.

They’re increasingly “investing” on (that’s “on,” not “in“) P2P lending sites like the one operated by LendingClub Corp. (NYSE: LC), a publicly traded firm, and Prosper, a privately owned Disruptor site.

On both the LendingClub and Prosper sites, investors fund borrowers looking for loans. You can see on the sites what borrowers want money for. They are all personal loans, mostly for such things as consolidating high-interest-rate credit-card debt.

The interest rates that the “lenders” (investors) earn are based on each borrower’s creditworthiness, as measured by new Disruptor credit calculation metrics and algorithms meant to be predictive of a borrower’s likelihood to repay their debts, as well as on the term (length) of the loan. Terms vary, but most are three-year (36-month) and five-year (60-month) loans.

If you’re considering funding a stranger’s loan request – because the interest rate being dangled is attractive to you – here’s what you need to know…

About Those Enticing “Interest Rates”

I said earlier that what you don’t know can hurt you.

Here’s where that warning comes home to roost.

You see, the posted rates aren’t really what you get.

And you’re funding someone’s personal loan – someone who can default and not pay you back.

About those rates.

First of all, you’ve got to pay a “service fee” to the site operator. Typically platform operators charge lenders 1% of every payment they collect from the borrower and pass the money through to the lending investor. So right away, knock off one percentage point from the posted rate the borrower is paying and that you think you’re getting.

Second – and more important – the borrower can default, meaning he or she stops making payments.

Because you’ve made a loan to that person, you’re screwed – as in, you’re not netting the interest you expected to earn on your money. And because these loans are unsecured, you may not get back the money you lent – as in never.

Here’s a good way to look at defaults and how to figure your real risk.

LendingClub and Prosper have to declare all their transactions in U.S. Securities and Exchange Commission (SEC) filings. So the data is there.

Sites like LendingMemo and Nickel Streamroller track P2P lending statistics. The data I’m going to consolidate for you comes from them.

LendingClub’s 2007-2014 average interest rate paid by borrowers was 12.533%. The average default rate per year for the same period was 6.9%. Default rates plummeted from 14.81% in 2007 to 2.38% in 2014. And although the return on investment (ROI) was (3.44%) – a loss – in 2007 and rose handsomely to 9.61% in 2014, the average ROI over the period was just 4.587%.

The average interest rate borrowers paid on Prosper from 2009 through 2014 was a whopping 17.945%. The default rate over the same period averaged 7.18%. And the average ROI for the period was 9.68%.

But there’s more to numbers than digits on a page. For one thing, both platforms changed their borrower credit requirements – mostly easing them as the economic cycle moved away from the Great Recession and as unemployment, a key factor in their repayment metrics, dropped.

Interest charges over the respective periods changed, too.

To better understand the available numbers, or the ones you calculate yourself (as I did), you have to further “look through” them to better understand what they’re telling you.

There’s a lot more to the statistics.

And, on some levels, there’s also less.

These stats are for three-year term loans over the period we’re talking about.

That means the 2007 vintage loans were closed out by 2010. Most of the 2012 loans are winding down (depending on the month they began). That means some of the 2012 loans – and their successors from 2013 and 2014 – are technically not “completed.”

The takeaway: The final default rate tally isn’t available and won’t be for years to come on some of the loans.

And that changes the real numbers.

If you use the data of completed loans for three-year and five-year loans (for which there is a lot less data), the average default rate for three-year loans might be about 5% and for five-year loans about 10%.

Matt Burton, CEO of Orchard Platform, a New York firm that works with mostly institutional lenders on P2P sites, says that “performance can vary significantly, though returns have typically ranged from 6% to 7.5% over the past three years across all LendingClub and Prosper loans, net of fees and defaults.”

Burton’s right. And that’s just what I’m talking about.

The returns sound good, but because the more recent loans are largely not completed, the whole game has yet to be played. A downturn in the economy and a jump in unemployment could cause the default rates to balloon, blowing the results apart.

This is the definition of real risk. Unless you’re going to be really, really diversified -meaning you fund lots of loans in equal increments – or devise your own diversification modeling program, you’re more exposed to risk than you realize.

It only takes one default on the one loan you fund to wipe out your entire investment, net of any interest you may have received.

So be careful – very careful. If you like the nice fat yields you see on the lending sites, remember you need to engage in some risk-adjusting calculations to see if the return you hope to get is worth the risk of not getting your whole investment returned or “Not Completed.”

That’s why I recommended you invest in some of the players – instead of becoming one yourself.

[Editor's Note: Shah appreciates the big response he's received for his recent reports on "Disruptor" investments and will be addressing some of your questions. Keep the comments and queries coming. Just post them in the comment box below.]

Source :

Money Morning/The Money Map Report

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