Capital One: One of the "Last Remaining Cheap Banks"

Capital One is a compelling investment because (i) it has attractive financial metrics, (ii) they are beginning to return capital to shareholders, (iii) it has a quality credit card and auto lending business, which is primarily driven by a strongly quantitative culture, and (iv) they are growing conservatively and diligently,.

COF was traditionally funded by credit card securitizations, which was a volatile source of funding, but the company reduced its dependency on such funds by becoming a full fledged bank. COF acquired a series of regional banks starting in 2004, and currently securitized debt is only 1/10 the amount of deposits. As a bank, COF is subject to Dodd Frank regulations and must undergo the usual stress tests, etc. It is extremely well capitalized relative to peers, with a Tier 1 leverage ratio of approximately 12% (minimum is 6%). It is also extremely cheap, at 9X normalized 2013 earnings, and 1x tangible book value.

This is a pretty good bargain relative to most other banks, which have recently become more fully valued. Assuming 4-5% annual net loan growth, and the return to a more bank-like multiple of 13x, you can see this stock returning a solid 14% IRR over a five year time horizon.

Capital One has been trading at a discount relative to peers because Capital One historically has not returned much capital to investors, instead using that money to grow the business further. This is changing. The company has already boosted the dividend to 30 cents a quarter (~1.6% a year), and repurchased $1bn of stock in the second half of 2013. Their proposed stock repurchase plan for 2014, if approved would increase the payout ratio to well above the industry norm.

Quality of Lending Business
The COF team prides themselves on being highly methodical in every decision they make, and have even taken steps to ensure that the marketing effort is well aligned with the credit risk team as they are mixed in the same division (Marketing and Analysis). The claim is that the highly quantitative effort enables them to more finely segment the customers and give them offers that are better suited to their "true" financial strength.

The quality of the credit card and auto lending businesses can be exemplified if you chart historical charge-off rates and historical yield over the last decade. You can see that Capital has clearly and consistently outperformed its Visa merchant peers on both credit and yield. It even rivals the asset and earnings quality of American Express, which is known to be targeted toward wealthier individuals. This is by no means a small feat and indicates that there is truly something unique about the Capital One underwriting team.

Credit Card Economics
The company has made a decision to shift some focus from targeting high balance customers (aka people who have a credit card and max it out, and pay it back over time) to high "transactioners", which are customers who spend frequently but pay back the money before the 30 days grace period is up. This seems counterintuitive for a card company, because this reduces loan growth, but I think that it is a prudent move and further demonstrates COF's conservative and deliberate approach to growth. High transactioners are less volatile and have less chargeoffs (presumably because they don't maintain a balance), and they have increased purchase volume which pumps up the alternative form of income for COF, the interchange fee.

Summary
Capital One is one of the last remaining "cheap" public banks, and offers one of the best loan metrics in the industry. I believe that Capital One has long been discounted by investors due to perceived risk in the credit card business as well as the perception of shareholder unfriendly management, but these concerns will prove to be unwarranted thanks to the COF's prudent diversification in and around its credit card lending business, its improved investor communication, and demonstrated willingness to return capital to shareholders.