1 Bank Investment for the Next Decade

1 Bank Investment for the Next Decade

Relative to its peers among the top 10 U.S. banks, Capital One looks very attractive. On average, it's more profitable than those other banks, with a nearly 11% return on equity, and it's better capitalized, with a 13% Tier 1 capital ratio. So what's holding down the valuation of Capital One shares? It's 20% cheaper than comparable banks based on price-to-book and price-to-earnings ratios.

My near-term concerns: credit cards and auto loans
Capital One doesn't trade at a discount for no reason. It faces major near-term credit cycle risk in two of its key businesses. Compared to peers, Capital One generates a significantly larger percent of profits from consumer credit cards and auto loans. Both of those areas are expected to experience headwinds in the next few years. After years of taking on debt, consumers are reducing credit card balances. It's a trend generally expected to continue. Auto loan spreads are at an unsustainable level, with some calling the situation a major bubble. These trends could spell big trouble for Capital One in the short term, and Wall Street isn't comfortable with all of the uncertainty in the company's near-term earnings. Thus the cheap multiples, relative to other banks.

Why I'm ignoring my own concerns
I don't dispute that credit card balances are falling or that auto loan spreads are likely to contract. There's significant evidence these things will happen -- the direction of the credit cycle is clear. And the level of decline in those markets will probably be the biggest determinant of Capital One's earnings and stock over the next few years. So, why do I choose to ignore the biggest near-term driver of the business and stock?

First, credit cycles are highly unpredictable, and the length and magnitude of contraction is totally uncertain. Even the experts -- professional economists and Wall Street strategists -- haven't proven able to make accurate forecasts on these types of cycles.

Second, the danger to Capital One is well known among investors. A reasonable estimate of its effect is probably already reflected in the stock price. I could spend days or weeks studying the issues, but I probably wouldn't be "wiser than the crowd," particularly as an admitted nonexpert in credit cycles.

Third, I'm a long-term investor, aiming to hold for a decade or more. This gives me an edge on most professional investors, who are more focused on quarter-to-quarter results. I have time to wait out the credit cycle. Even if things get rough over the next few years, eventually, the cycle will turn. Credit cards and car loans aren't going away. Things will eventually get better, and I'm able to hold through the storm.

So instead of wasting my time trying to be an amateur credit forecaster, my thinking about the company is focused on the quality of the business and its management. The credit cycle will likely drive near-term performance, but long-term results depend on the industry, business model, strategy, and people. Those are things I understand, so that's where I focused my analysis.

My focus: the business and the people
Capital One is a high-quality business. It operates in a favorable market in which long-term trends in online banking and electronic payments should provide a tailwind for decades. It is well positioned relative to competitors. It benefits from strong brand, scale, and customer switching costs across its business segments. It generates good profits, which I believe are sustainable over the long term. Banking as an industry isn't going to become obsolete -- as long as there is money and capitalism in this country, we'll need banks. As a leader, I'm confident that Capital One will continue as a viable business for decades. Even if it experiences a few rough years, I fully expect it to be generating higher profits in a decade than it does now.

Of course, as a levered business, Capital One will always be at risk of insolvency. But it's one of the best-capitalized large banks in the country, it's got a stable deposit base, it's well managed, and the possibility of getting sunk by a financial panic seems unlikely.

Capital One has a strong team of managers. CEO Richard Fairbank is a savvy operator with a proven record of success. He founded the company in 1988, and over the course of a few decades built a small spinoff of First Union into one of the nation's top 10 banks, including navigating the company successfully through the financial crisis. I like management's focus on innovation, pioneering the use of analytics, technology, and testing in banking. And it's a low-cost operation. The only large bank with a better efficiency ratio is U.S. Bancorp , which is generally considered the best-run bank in the country, along with Wells Fargo .

And, importantly, the company scores well among its employees. According to Glassdoor.com, 89% of employees approve of Fairbank as CEO, and 71% would recommend the company to a friend. Ultimately, as investors, we rely on management and employees to deliver results, and I like to see a successful, engaged, and motivated workforce.

My back-of-the-envelope valuation: 10%-12% annual returns
A business is worth its future stream of free cash. Ultimately, the price you pay for a stock will be a major determinant on your returns. Even a great company can generate mediocre returns if you overpay for the stock. So it's extremely important to estimate the value of the company. Most investors come up with their valuations based on a discounted cash flow, or DCF, model, or they use a relative method, measuring the company's key valuation metrics, like price to earnings or price to book, to similar companies. Personally, I don't find either of those methods particularly reliable. There's a lot of false precision, but not much accuracy. And because of the uncertainty in the credit cycle, those methods both seem particularly troublesome for Capital One.

I prefer to just do a rough, back-of-the-envelope estimate with the fewest, simplest assumptions possible. In this case, I attempted to very roughly approximate future dividends based on the yield and growth in dividends. Today, Capital One pays a pretty small dividend (around 1.7%), which represents only 10% of profits. However, I'd expect that on average, the company will pay out a larger share of profits in the future. Let's assume the company's average payout ratio is 40% over the next 10 years. That equates to an average yield of about 4% over that decade. Let's also assume the remaining 60% of profits are reinvested to fuel growth at the company's current cost of equity (11%). That would result in 6%-7% growth in profits and dividends. In total, the expected return would be 10%-12% annually (again, just a rough estimate).

It's not exactly a screaming bargain, but Capital One is a solid candidate to beat the market over the next decade.

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The article 1 Bank Investment for the Next Decade originally appeared on Fool.com.

Brendan Mathews owns Capital One warrants. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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