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Monday, July 29, 2013 - 10:00

An Overlooked Stock May Be This 'Hated' Sector's Best Bargain

Monday, July 29, 2013 10:00 AM

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 (NYSE: WFC) shares hit an all-time high on July 8. The other three large U.S. banks are also on the rise: Citigroup (NYSE: C) is up 25%, Bank of America (NYSE: BAC) is up 14%, and JPMorgan Chase (NYSE: 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 disclosed ownership of 50 million shares of U.S. Bancorp (NYSE: 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 (NYSE: 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 3 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 (NYSE: 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.

P.S. -- Stocks like COF are similar to a special group of securities we call "Forever Stocks." These are world-dominating companies with fortress balance sheets that buy back massive amounts of stock, boosting the value of the rest of the shares. They're solid enough stocks to buy, forget about and hold "Forever." To learn more about these stocks -- including some of their names and ticker symbols -- click here.

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.