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Capital One Is a Bargain Among Bank Stocks

The financial sector had a wonderful three months. The
SP 500 Financial Sector
index returned 11.6% including reinvested dividends during that period, easily outpacing the 6.3% rise of the
SP 500
index. That gain has been powered, however, by the sector’s banking stocks—including
JPMorgan Chase
(ticker: JPM)—which have returned 18.7%. Diversified financials have gained just 9%.

The broader diversified financials space is home to Capital One (COF), a company primarily known for its credit cards. But Capital One is closer to a diversified bank than it is to a specialty finance company. And if the market comes around to that way of thinking, the stock, which has gained 34% in 2019 to $99.57, could have even more upside ahead. After all, it trades for around 8.3 times estimated 2020 earnings of $11.93, a 25% discount to its larger banking peers. Capital One declined to comment for this article.

Among banks, the largest tend to command the highest valuation multiples because they have diverse businesses not dependent on any one source of funding. More important, they have the most stable, lowest-cost source of financing: deposits. JPMorgan and
Bank of America
(BAC), along with
Citigroup
(C) and
Wells Fargo
(WFC), have more than $5 trillion in customer deposits among them.

On the other end of the spectrum are specialty finance firms, which tend to be more dependent on one line of business and have less stable sources of funding, such as asset-backed securitization. The heightened risk shows up in valuation. The group trades at about 8.5 times earnings. Capital One started as a specialty finance company. It was in the business of card lending and relied on securitizing card loans—or selling a package of loans to outside investors to raise cash—to fund the business.

Credit cards are still a big part of Capital One’s business, as anyone who has seen one of its ubiquitous ads knows. The company has almost $250 billion in loans, including ones to tens of millions of cardholders, making the bank a top 10 U.S. lender.

What has changed over time is the funding. The liability side of Capital One’s balance sheet doesn’t look like a consumer-finance company. CEO Richard Fairbanks realized a long time ago that being reliant on one source of funding—like securitization—was a risky way of doing business for a lending institution. Now, Capital One has more than 520 bank branches, primarily on the East Coast, and almost $250 billion in customer deposits.

JPMorgan CEO Jamie Dimon is credited with coining the term “fortress balance sheet”—one that can withstand just about any crisis. JPMorgan’s balance sheet is the gold standard for banking analysts. From a midsize bank perspective, Capital One deserves the sobriquet “fort.” It finances it business from deposits while maintaining access to credit lines and asset-backed markets. The company also has $80 billion in liquid securities on its balance sheet, another cushion against a liquidity squeeze.

And it has survived a crisis. Capital One navigated the 2007-08 financial crisis with flying colors. It lost money in only one year, 2008. And it lost only 21 cents a share, in part due to an accounting change. Citigroup lost a cumulative $64 a share over 2007 and 2008 and required federal assistance.

Part of the reason the financial crisis was a blip for Capital One is because of credit cards. That may sound strange, but it turns out that cards aren’t as risky as other loans. It’s true that more credit-card loans get written off than, say, mortgages. But credit-cards loans are higher-yielding assets. Capital One’s total revenue yield—total revenue including fees divided by total assets—is about 8%. JPMorgan’s revenue yield is about 4%. Credit cards are priced to absorb higher losses.

There is another reason that card lending isn’t as risky as other forms of bank lending. In a downturn like the financial crisis, credit-card write-offs can double. That’s bad. But mortgage write-offs went up fivefold during the financial crisis. Mortgage lending is, in effect, more competitive and less rational than credit-card lending.

Earnings at Capital One have grown at an average annual rate of about 8% for the past five years, in line with its banking peers and two percentage points better than the SP 500. And earnings growth is expected to exceed its larger banking peers for the next two years, though it trades for about 1.2 times tangible book value—a metric used to value financial stocks. That’s a 13% discount to its history and a 31% discount to other banks.

Oakmark Fund manager Bill Nygren counts Capital One among his top holdings, along with banking giants Citigroup and Bank of America. “I think the story is that the big banks today are just much less risky than they were a decade ago,” he says.

Capital One may soon get some fresh attention on Wall Street. That’s because a deal the bank struck with
Walmart
(WMT) in 2018, to issue store-branded cards, should start paying off as hefty start-up costs subside. It all could make Capital One’s stock as much of a bargain as anything on the shelves of Walmart.

Write to Al Root at allen.root@dowjones.com

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