Today’s Panic in COF Represents a Buying Opportunity
COF was the worst performer in my portfolio today, with news and rumors swirling wildly. I thought it would be helpful to step back and look at the facts in a broader context.
What Happened Today
A number of factors conspired today to bring down the stock price of Capital One Financial (COF) to the tune of 6.6%. By my approximation those factors are, in order of importance:
- Synchrony Financial (SYF), a private label credit card issuer, warned today that they anticipate incremental charge-offs in the amount of 20-30bps of total loan balances over the coming 12 months. In reaction to this news SYF stock lost more than 13%, today.
- Analysts at Evercore ISI connected the Synchrony news to COF, speculating that what SYF is seeing might be a sign of broader weakness in subprime lending. This comes less than one week after another research firm, Sterne Agee, downgraded COF to “Underperform” and assigned the stock a price target of $67.50.
- Tomorrow, the FOMC will conclude their June meeting and provide forward guidance on interest rates. This is especially highly anticipated in the context of globally flattening yield curves, which are depressing the profitability of lenders, such as Capital One. To wit, during last night’s trading session the interest rate on 10 year German Treasury Notes (“Bunds”) dropped below zero for the first time in history.
- Also tomorrow, Capital One management will address the Morgan Stanley Financials Conference 2016, possibly providing updated credit loss forecasts, pushing “weak holders” to sell ahead of potential bad news.
- Next week, Britain will elect whether to exit the EU (“Brexit”). Should this happen, it could theoretically (though not likely) lead to British financial institutions losing access to the European common market, at least on a temporary basis. This would by extension also affect all those American banks that have made London their European domicile. While British financials have suffered more than their US counterparts, the XLF financial sector ETF lost just under 1.5%, today, underperforming the market by a wide margin.
The Valuation Context
While all of the above issues clearly affected the stock price of Capital One today, none of them are really news. The fact that credit metrics have deteriorated in the past quarter and are expected to deteriorate some more in the coming quarters, has been disclosed by COF in the context of their most recent quarterly earnings call, back in April. The upcoming FOMC meeting and Brexit vote have occupied Wall Street for weeks and months.
So, the real question to ask is: Have these risks been priced in already, or is COF maybe still overvalued in light of these issues?
The following represents a back-of-the-envelope calculation that tries to sketch out an answer to this question. The entire spreadsheet is available for download, here; the following is a screenshot:
It is common practice to evaluate the market price of bank stocks in relation to their book value. When looked at it this way, COF stock looks astonishingly cheap. As the screenshot shows, while the median price to book value (P/BV) over the past 17 years has been 1.09, and the average of that ratio is still higher at 2.16, COF trades now at a paltry 0.69 times BV (see cell B8).
Here’s how I would like to address the valuation question I posed, above: Considering the valuation reserve that is embedded in the current P/BV ratio, relative to its historic value, is that reserve enough to compensate for the potential of elevated near-term losses?
To be extra conservative, I view the valuation reserve as the distance between the BV and market capitalization, meaning that the stock would be fully valued at a P/BV of 1, instead of 1.09 (historic median) or 2.16 (histoirc average). The book value of equity for COF is $47.7 billion. The market value of equity for COF is $33.1 billion. So, for the sake of this argument, the valuation reserve is $14.6 billion (cell B11). If there were a recession coming, and this recession would last, say, 6 quarters, by what amount could quarterly charge-offs rise without P/BV exceeding 1, assuming stock price and loan balances stay where they are now? Cell B13 shows the answer to be $2.4 billion.
So, how much is $2.4 billion in incremental quarterly charge-offs, in the context of Capital One’s portfolio? Well, as of 3/31/2016 Capital One had total loans outstanding in the amount of $227.6 billion, and during the most recently reported quarter, the company took net charge-offs of $1.18 billion, representing about 52bp of charge-offs. Therefore, in our scenario, COF could sustain a tripling (!) of quarterly charge-offs to $3.6 billion a quarter (1.58%, cell B20) for 6 consecutive quarters (9.5% aggregate charge-offs over 6 quarters, cell B23), without the book value of the company dropping below the current market value.
Finally we need to ask ourselves, how likely is this to happen? To at least hint at an answer, take a look at the following excerpt of the company’s Dodd-Frank-Act mandated company-run stress-test scenario:
If you look at the number highlighted with the red ellipse (added by me) you see that in a hypothetical “Severe Adverse Scenario” Capital One estimates to have to charge off about 9.1% of average balances over the course of 8 quarters. Based on our previous calculations, this “severe adverse scenario” is actually less severe than the what the stock market has already discounted in the stock price. I also want to point out that in our analysis we are assuming BV to be static. In reality, BV is actually increasing by hundreds of millions of dollars per quarter, especially excluding the loan loss reserve requirements, which we have looked at separately in this back-of-the-envelope calculation.
To summarize, I find that the current discount to normal valuation levels is so large, that the market has already anticipated a “severe adverse scenario” as envisioned by a Dodd-Frank mandated stress test.
- Even if such a scenario would come to pass, and
- even if those losses would accrue faster than in the company-run stress test (6 quarters instead of 8), giving the company less opportunity to absorb these charges through ongoing earnings, and
- even if the company were not building book value from its normal, pre-allocation business, and
- even if the stock would not drop one cent during this (hypothetical) severe recessionary period
…even then, the stock would still be valued below its historical median price/book ratio, and at roughly half of its hitorical median price/book ratio.
Taking one final look at the spreadsheet, I’d note that the scenario we discussed sees annual charge-offs increase by more than 400bp (4x1.07%, see cell B22). Now, recall that Synchrony Financial antipicates their incremental charge-offs to increase by a mere 20-30bps for the year. If that were to happen to COF, the losses will easily be fully funded by ongoing cash flow, and the stock would be undervalued by roughly 50% relative to its historical benchmark.
Obviously, I have no crystal ball (else I would have waited until today to buy COF), but it is my opinion that unless we revisit a recession of epic proportions, Capital One’s stock is a screaming bargain.
Note: The preceding is obviously just my opinion, and it should not be construed as investment advice. You should make your investment decisions solely based on your own research.