These 3 Stocks Are Set for a Major Comeback

For better or for worse, many successful investments revolve around products or services that aren’t necessarily good for consumers. The best examples include products that aren’t very healthy: cigarettes, soda and junk food come to mind, as do gambling, pawn shops and credit cards.

For individuals who use the above products and services, moderation is key. Excessive consumption can be bad for your health and pocketbook.

But of all of these businesses, it’s credit cards that pique my interest the most. Why? Because for investors, right now is the perfect time to consider buying.

Making money in good times and bad
Credit-card companies primarily make money in one of two ways. One is from the interest they earn from customers who use their cards. The other way is by charging retailers a fee for the right to use their cards at a store.

In banking, the net interest margin, or “spread” a bank makes between borrowing and lending money, hovers around 4% for the strongest players in the industry. Credit-card companies — thanks to the interest rates they charge customers — report net interest margins more than double that amount. This makes them one of the most profitable businesses in the financial-service sector.

Of course, bad loans rise in a down economy and credit-card companies lose some money on card holders who can’t keep up with their bills. But given the net interest spreads are so high, they still generally make money in good and bad times. 

Overall, the vast majority of consumers uses credit cards responsibly and pays off their balance every month. Delinquency rates, the amount of customers who don’t pay their bills, rise dramatically during recessions. The current downturn saw charge-off rates, which is what is written off from delinquent accounts, climb into the double digits. But as the economy improves, charge-off rates have recently dropped below 7%, and could fall further back to more normal levels.

As such, the stocks of the leading credit-card players look particularly appealing right now. The timing is great to consider investing in these names. The kicker is that the leading providers are still being priced as if we were still in a major recession, trading at very low multiples of forward earnings.

Below are three names that look extremely appealing at current levels.   

1. Discover Financial (NYSE: DFS)
P/E: 11

Investment banking giant Morgan Stanley (NYSE: MS) spun off Discover in the middle of 2007, just as early signs of the financial crisis were beginning to emerge. The fact that Discover has survived and thrived since the spinoff speaks to its stable and appealing business model. Charge-offs during the downturn stayed below industry averages and the firm remained profitable during the downturn, though this was due in part to payouts from rivals MasterCard (NYSE: MA) and Visa (NYSE: V) to settle antitrust allegations that they used their size to muscle out competitors like Discover.

Discover reported an impressive net interest margin of 9.1% during 2010, and its charge-off rate has trended downward from nearly 9% to a recent 6.6%.  Discover also owns its own processing network, which allows it to garner transaction fees from retailers and others vendors that accept payment from Discover. With a low price-to-earnings (P/E) ratio that could eventually increase more than 36% to 15 and solid growth prospects, the company is one of the best bets in the space.

2. American Express (NYSE: AXP)
P/E: 12

American Express has one of the most valuable brand names in the world. Its cards are used by more affluent consumers across the globe than any other company. This helped keep charge-off and delinquency rates below industry averages during the downturn. It also means the company can charge retailers and vendors higher rates, because its customer base is appealing and vendors want them to kepp visiting their stores. Like Discover, AmEx has its own payment network whch allowed it to garner more than $500 million in revenue from transaction fees in 2010.

American Express reported an industry-leading 9.3% net interest margin during 2010. The stock trades at a slightly higher P/E than Discover, but posts higher net interest margins and is more than five times larger in terms of market capitalization. It bills itself as the world’s largest card issuer by purchase volume (consumers spent nearly $200 billion using its cards last year), which speaks to the spending power of its customer base.

3. Capital One Financial (NYSE: COF)
P/E: 10

Capital One differs from Discover and American Express in that it is no longer a pure-play credit card provider. Back in 2005 and 2006, it acquired Hibernia Bank and North Fork Bank to move into more traditional banking services. Capital One also doesn’t own its own credit card brands, but instead is one of the largest providers of MasterCard and Visa cards.

Despite the more diversified mix of business, Capital One is the cheapest of the major credit-card providers in terms of P/E. This is valid, given it also must deal with bad bank loans that arose during the credit crisis, But earnings are recovering rather quickly. It should return to posting double-digit shareholder returns in 2012 and could also start paying substantial dividends.

Action to Take —>
My favorite pick in the space is Discover. It has among the best abilities to gain market share now that it can better focus as an independent firm. It is also small enough that a big bank could snap it up and gain exclusive access to a large, loyal base of credit-card customers. American Express is a good bet for investors interested in stability and investing with a profitable market leader, while Capital One remains a solid potential pick for great upside, though with higher risk, given its traditional banking exposure.

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