An overlooked stock may be this sector's best bargain

Capital One isn't exactly flying under the radar, but investors might be surprised to learn about its profitable recent moves.

By StreetAuthority Jul 29, 2013 4:55PM
Image: Pile of credit cards © Image Source, Getty ImagesBy Chad Tracy

It's a story that hasn't gotten a whole lot of press recently, but U.S. banks are doing well.

Very well.

Wells Fargo (WFC) shares hit an all-time high on July 8. The other three large U.S. banks are also on the rise: Citigroup (C) is up 25%, Bank of America (BAC) is up 14% and JPMorgan Chase (JPM) is up 24%.

The reason? Put simply, banks make money by borrowing at a low rate and lending at a high rate. The rates being offered for the average savings account are next to nothing these days. Yet banks are able to turn around and issue loans to businesses and individual customers for rates of 4% to 5%. This difference is called the interest rate spread. On top of that, banks are able to loan many times the amount of money they are required to keep in reserve. This use of leverage maximizes profits even further.

Ever since the financial crisis, lending has been on the rise. And when the money flows, banks get rich.

As you can see in this chart, showing the total loans and leases of U.S. commercial banks over the past five years, lending levels are now surpassing the same $7.3 trillion mark reached just before the financial crisis.

StreetAuthority expert Michael Vodicka pointed out in a recent article that Warren Buffett has been stocking up on financial stocks:

"Buffett was busy loading up on shares of Wells Fargo between January and March, closing this year's first quarter with 460 million shares, up 4% from last year and his biggest holding with a 20% allocation."

"But while Buffett has been accumulating shares of Wells Fargo for years, he initiated a new position in another bank stock during the first quarter. Berkshire Hathaway (BRK/A) disclosed ownership of 50 million shares of U.S. Bancorp (USB), Berkshire's seventh-largest holding with a 2.6% allocation."

While all the aforementioned companies deserve a closer look, today I'd like to tell you about another financial stock that is selling for what I think is a bargain price and just announced a $1 billion share buyback program.

Although it doesn't often get the same kind of press as the "big four" banks mentioned above, Capital One Financial (COF) is actually the seventh-largest bank in the U.S. by deposits.

On July 2, Capital One received Federal Reserve approval to repurchase up to $1 billion of its own shares. The bank plans to start buying the shares later this year and complete the buyback by the end of next year's first quarter.
Capital One currently has 561 million shares outstanding, which at today's prices bring the total value to roughly $36.9 billion. So $1 billion worth of share repurchases won't have a huge impact on the current value of shares.

But what is more important here is that Capital One is making an effort to increase shareholder value. It's also worth noting that companies often repurchase shares of their own stock when management believes those shares are undervalued.

Earlier this year, there was more good news for Capital One shareholders.
On May 2, Capital One raised its dividend to 30 cents a share from 5 cents. This marked its first dividend increase since the financial crisis. The current yield stands at 0.7 %, but analysts at Morningstar forecast a projected yield of 1.8% in the near future.
With a price-to-book ratio of 0.9, Capital One's shares are currently trading below book value; compare that with the industry standard of close to three times book value. Capital One's trailing 12-month price-to-earnings (P/E) ratio of 11 is almost half of its competitor's average of 21, and its forward P/E is even cheaper at 9.4.

As for the future, Capital One looks to be in a very strong position. To keep things simple, it may be best to look at the three main business segments -- credit cards, consumer banking and commercial banking -- separately. Credit cards represent 40% of revenue, consumer banking 40% and commercial banking the remaining 20%.

The company's credit card segment was bolstered in 2012 when Capital One acquired HSBC's $30 billion credit card portfolio. This transaction made Capital One one of the top five credit card issuers in the world.

In 2012 Capital One's banking division acquired ING Direct's (ING) entire U.S. operations. The deal added 7 million customers and $83 billion in additional deposits to the banks' portfolio. The deal also jump-started Capital One's automobile lending -- up an astonishing 24% in 2012 alone.

Finally, the commercial and industrial lending segment is also showing growth -- up 13% in 2012.

In spite of its recent acquisitions, Capital One carries virtually no debt and is gushing free cash flow. In this year's first quarter, Capital One reported free cash flow of $2.5 billion, nearly double its $1.3 billion in the same period last year.

Risks to consider: Financial stocks have been surging in part due to the recovery in housing. Although housing prices continue to rise, weakness in the sector would be a drag for banks.

Action to take:
Capital One is a solid, growing business selling at a bargain price. I think Capital One's fortress balance sheet and recent success indicate that this company's best days are still ahead. I rate it a buy for long-term investors at today's prices.

Chad Tracy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

More from StreetAuthority
Jul 30, 2013 6:49AM
If we trashed the major banks and started down the road to regulatory control and supervision of bank activities... Capital One would change very little and could/would even survive divestiture. There is a lot to be said about balancing growth with portfolio integrity. There's a lot more to be said about the type of education certain executives get in their early years... more- overly scrutinized finco than sleazy bank.
Jul 30, 2013 12:12PM
Good point, Monkey. Thanks.....Maybe some profit taking, eh?
Jul 30, 2013 9:00AM
He says they have no debt but the debt to equity ration is .89.  Everything else looks great just like he says, and on the surface the forward looking prospects appear favorable to own this company long term, not to mention it's solid reputation in the consumer markets.  Only one thing that would keep me from buying ...  Insiders are selling.  If the prospects are so great (as they appear to be) then why are insiders selling?
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