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Stock Strategist

Capital One Deserves More Respect

We see an opportunity to invest in the exceedingly cheap shares.

We believe Capital One (COF) is one of the best-run banks and does not receive the respect it deserves. Under founder Richard Fairbank’s leadership, the bank has grown from offering only credit cards into a diversified lender specializing in three businesses: credit cards (42% of loans), consumer lending (31% of loans), and commercial banking (28% of loans). Although credit cards are not as important as before, this segment still accounts for approximately 59% of income.

While much of its success can be attributed to an unrelenting focus on technology, operations, and organic growth, Capital One has periodically created significant value by acquiring businesses opportunistically and, most important, at attractive prices. We believe the acquisitions of HSBC’s cobranded card business and ING Direct exemplify the company’s aim to acquire good strategic assets cheaply. Some of the company’s acquisitions before 2008 were mistakes, in our view. But overall, using its patient acquisition philosophy, Capital One has become a stronger, diversified consumer lender.

We believe the bank understands that returns arise not only from acquisitions and share repurchases but also from internal investment in operations and IT systems, and investors are missing this. We believe the bank’s focus on IT and data has enabled it to be a leader in measuring and forecasting consumer credit quality and customer behavior, resulting in better credit performance and lower customer acquisition costs and therefore significant operating leverage. During the crisis, the company remained profitable and charge-offs peaked at 5.9% of loans, significantly outperforming rivals whose charge-offs exceeded 8%. In addition, Capital One was early to warn about the dangers of subprime auto lending, where it has partly limited its exposure.

We believe investors focusing on near-term expenses are missing the value of these investments. Marketing expenses frequently aren’t commercials or advertising but rather variable expenses tied to successful account openings and customer acquisitions. Investors should be awarding Capital One for winning customers and building out its national banking franchise.

Scale Adds to Moat
We believe Capital One has developed a narrow economic moat from cost advantages through years of steady internal investment in information technology, rewards programs, advertising platforms, and well-timed acquisitions, resulting in a captive cardholder base. In addition, we believe that Capital One benefits from switching costs as cardholders do display mild loyalty after being issued a card. We think this results in a loan portfolio that is highly balanced and would take years to replicate.

Nationwide scale is important for a consumer lender specializing in credit cards. It enables Capital One to have a diversified cardholder base across multiple geographies and FICO scores, which results in incremental earnings from sales growth as a large portion of the company’s costs are fixed. In addition, it gives the company the ability and expertise to expand into adjacent loan categories and modify its existing offerings. Capital One’s size and highly advanced IT infrastructure and data capabilities enable the firm to experiment with its offerings. A smaller, less diversified consumer lender would probably not have the resources and flexibility to do this. We point to the example of the 84-month auto loan. This is a type of loan many auto lenders have never even attempted, but recently, it has been heralded by some of Capital One’s competitors as the future of auto lending. Capital One was able to quickly run trials of 84-month loans using a small sample size and, in our view, correctly determined it was a losing proposition.

Increasingly, we view consumer lending as data driven. To compete, incumbents must develop the necessary proprietary data sets and intellectual property that Capital One has spent many years assembling over a large population. While capital expenditure gets overlooked in financials, we believe its importance is paramount as consumer lenders seek to compete in a world where the winners may be determined by which companies can best analyze and interpret large sets of data. We believe Capital One’s commitment to capital expenditures, internal investment, and the time required to build these assets enables the company to broaden its moat while raising the bar for competitors.

We also believe that Capital One’s moat results from the stickiness of its high-quality, seasoned back book of cardholders. In an ideal situation, Capital One would gather as many high-spender/low-balance cardholders as possible. Most of these cardholders would pay off their entire balance each month, resulting in significant interchange revenue for Capital One but little interest income. However, a small percentage of these high-quality cardholders would maintain a balance despite having the financial resources to pay off the balance. It is here where Capital One excels. The balances of this small collection of cardholders initially compound slowly each year but gradually result in significant interest income and minimal charge-offs. To get these high-quality cardholders, issuers must issue cards to an even larger sample and gradually weed out the weaker cardholders through charge-offs and attrition over two to three years. It takes a long time to assemble this high-quality back book, and many companies simply do not have the patience to do this.

In addition, scale affords Capital One with advantages in national advertising. We believe Capital One’s size and volume give the company some clout with advertisers when purchasing television commercials or digital display ads in bulk. We’re also encouraged by the company’s large investment in digital marketing and advertising. While most of these expenditures are expensed today, we believe these outlays represent a long-term investment in Capital One’s brand and put pressure on rivals. Capital One has been able to succeed in this arena through years of patient and expensive investments in marketing. Also, the company still invests in low-tech mass mailings across the country. While postage is a variable expense, we believe staying committed to national mass marketing campaigns is a fixed investment. Finally, we suspect Capital One’s magnitude enables it to negotiate better terms with rewards vendors such as airlines for greater benefits for cardholders. This bolsters our argument that size matters when it comes to consumer lending.

We still believe Capital One has a way to go in building a reliable, low-cost source of deposits that results in a moat. In 2018, the bank derived nearly 80% of its funding from deposits, up from 61% before the crisis--a significant improvement. However, it still securitizes a significant portion of cardholder receivables that have been a growing source of funds for Capital One the past few years. In 2018, the bank’s cost of interest-bearing deposits was 1.17%. Larger financial institutions enjoy much cheaper sources of funding. For example, Wells Fargo had deposit costs of roughly 50 basis lower than Capital One. Capital One’s deposits aren’t as sticky and will probably require the company to pay up when interest rates rise. Currently, the company is investing heavily to build out its national deposit base by offering up-front bonuses to people to invest in money market funds. The hope is that Capital One will be able to engage these customers through its digital offerings and turn them into long-term customers. Capital One’s investment in branch cafes is a part of this strategy. These investment may weigh on the income statement in the short term, but we think they will ultimately bear fruit. We have been impressed by the company’s habit of investing in long-term flexibility over short-term profitability.

Capital One operates in the U.S. banking system, which we assess as fair from a stability perspective. Though regulation has become considerably stronger in the past several years, the country still uses a complex and somewhat archaic system of regulation. Furthermore, the company’s banking market is quite fragmented; Capital One must compete with a variety of regional and community banks as well as large money-center institutions. Over the past 50 years, the banking system has achieved returns in line with its cost of capital, which supports our view of the environment as intensely competitive. Our outlook is more positive from a macroeconomic and political standpoint. The U.S. is still the world’s leading democracy, has increased GDP at a steady pace for years, and maintains the world’s reserve currency, all of which contribute to banking stability.

Change in Culture the Biggest Risk
The greatest risk we see at Capital One would be a gradual change in its culture over time that might cause the company to offer loans and credit products that generate great short-term profits but aren’t resilient over an entire economic cycle. Thus far, Capital One has avoided this, and we believe it’s partly related to the company’s long-term focus and culture. Richard Fairbank is 69 years old and the only CEO the company has ever known. Eventually, he will be succeeded, and the bank’s culture and mission could come under threat. All the structural advantages in the world won’t prevent a good company from making bad loans. In banking, it is our conviction that a company’s culture and values are the greatest deterrents in taking on excess financial risk.

In addition, a change in culture could change the company’s acquisition philosophy and result in some bad deals. Despite a strong culture, it doesn’t ensure that Capital One won’t make bad acquisitions. As the bank gets larger, it’ll be harder to find acquisition candidates that move the needle. We believe Capital One’s size is one of its biggest threats.

We believe the company is in a strong financial position. At the end of 2018, Capital One was leveraged at 7.2 times equity. We don’t believe the company is taking on too much financial risk. We do think that bank stress testing is overly punitive to large banks with loan portfolios weighted toward credit cards. Per Dodd-Frank stress test results, in a severely adverse scenario Capital One would see losses on its credit card portfolio of more than 21%. It is hard for us to see that happening.

Subprime credit cards have become a larger portion of Capital One’s total credit card portfolio. At the end of 2018, credits with a FICO score below 660 were 33% of the entire domestic portfolio, down from 36% a few years ago. While this gives us some comfort, we’ll point out we’re more than 10 years removed from the last recession and the credit histories of many consumers are untested by any significant economic headwinds.

Stewardship Is Exemplary
Rarely do we see a company stress the importance of rewarding the interests of all stakeholders--which goes beyond just investors and includes the employees, partners, and borrowers that Capital One needs in order to create long-term value.

We are highly impressed by management’s acquisition and investment philosophy. It takes advantage of bear markets and motivated sellers to acquire valuable assets, though CEO Fairbank did have some misfires before 2008. In part, it’s why we’re not extremely concerned about a consumer-led recession. If this were to happen, we are confident that management would use it as an opportunity to acquire assets on the cheap. We’re also pleased that Capital One has not chased new retail credit card portfolios that we view to be expensive.

In addition, we think management should be commended for its investments in technology, which we believe have put Capital One ahead of rival banks and will result in lower costs and greater agility in building new products.

We credit Fairbank with cultivating Capital One’s culture. In an era where short-termism and cutting corners are the norm, Capital One has prioritized creating a long-term sustainable competitive advantage over maximizing short-term returns on equity. Where many companies might cut marketing and IT expenses, we believe Capital One views brand-building and having the most sophisticated IT and data systems as essential investments that it needs to survive. Few of Capital One’s rivals could stomach these investments and volatile expense lines, despite their vital importance.

Colin Plunkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.