Credit Services Companies Set For Long Term Growth
Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Once upon a time, credit services companies were seen as defensive stocks. The thesis used to be that loans expanded when the economy was doing well, which led to increased profits. Then when it faltered, the policy response of interest rate cuts, tended to increase net interest income as rate differentials got wider. Of course, when the economy did slow, worsening credit quality leads to increased loan loss provisions which would then eat into profits. But a well managed firm would seek to manage the downside through prudent lending in the upswing.
How quaint that idea seems now!
However, despite the negativity around the sector following the trauma of the financial crisis, there is a case to be made for a long cycle of profit growth. The three major plays in this area are Discover Financial Services (NYSE: DFS), Capital One Financial (NYSE: COF) and American Express (NYSE: AXP). All three have performed very well this year and have improved credit quality. A brief summary of their current credit conditions.
Of the three, I like Discover for its growth potential and exposure to the US.
The Financial Crisis was not caused by the Credit Card Companies
There is a sort of moral admonishment against credit issuance because the roots of the financial crisis lay in over leverage by the banks and willfully negligent issuance of mortgage capital. However, let’s not be too quick to blame consumer credit. The facts state otherwise.
Here is data from the Federal Reserve. The debt service ratio (DSR) is the ratio of debt payments to income. FOR is the financial obligations ratio.
Ok, this is a busy chart but bear with me. Note how the rise in the DSR occurred in the period after Greenspan cut rates in response to the ‘dot-com’ bust. However, in that time, Renter FOR was below long term averages. Moreover, Consumer FOR for Homeowners did not rise by much.
Consumer credit was not the problem. It was the massive expansion in mortgage leverage and the hopelessly inadequate risk management regimen of the investment banks.
Of course, this does not mean that credit card companies are immune. Far from it. A worsening economy means higher net charge offs (a declaration that a creditor will not be paid) which leads to losses from loan loss provisions. We can see how Discover Financials metrics played out here
Note how the current charge off rate is actually lower than it has been for ten years.
So, putting these two charts together (at least for Discover Financial) creates an understanding of an environment of low charge offs compounded with a relatively low DSR and consumer FOR. Given increasing employment gains, I think the conditions are ripe for a continued expansion in credit.
What about the Housing Market?
Housing is still a substantive portion of US net household wealth (NHW), and the argument that consumers have been using their house as an ATM is well known. However, the share of NHW made up by housing has been falling in recent years and, there is evidence that the market is at least bottoming.
Moreover, I’m a great believer in behavioral finance. Economic agents do change behavior when they are emotionally affected by an event. We can see that with corporations, who are stuffed with cash and run historically conservative balance sheets. They were affected by the aftermath of the over-investment boom in the late 90’s. As such, ‘cost-cutting’ became the new ‘dot-com’.
Similarly, consumers have been affected by the housing bust. They are busy deleveraging and refinancing as austerity becomes the new norm.
However, whilst I don’t expect a boom in housing, that doesn’t mean that consumer credit can’t expand as the economy recovers. On the contrary, if the US is set for a slow sustainable housing recovery with the Federal Reserve being accommodative, then the environment is ripe for consumer credit do to well. If you get a job, your credit quality improves and you start spending money.
What about Financial Services Regulation?
I would argue that this is good for the credit card companies. If it stops the banks from self imploding (or rather their employees blowing shareholders cash) then it could lead to a sustainable long term recovery.
Moreover, if you force everyone to increase capital-asset ratios then when a downturn comes, even if one bank is in trouble, the others can step in because their financial position will start from a stronger base. The regulatory focus is on ending ‘Too Big To Fail’ and, reigning in the excesses of the investment banking sector.
Whilst the investment banks maybe muzzled from racking up risk (no doubt in order to shuffle it off to the taxpayer in the future) and this will reduce their potential profitability, this should be of benefit to the consumer credit card companies. The political aim is to increase the velocity of money and to get credit flowing in the economy. This is what Discover, Captal and Amex do!
Given the prognosis of a slow but stable economic recovery, I think the combination of low charge off-rates, low interest rates and a historically favorable DSR suggests a bright outlook for the credit card companies.
Clouds on the Horizon?
Analysts believe that charge offs may increase next year and the possibility of markets pricing in an interest rate hike is also a threat. Indeed, we have been hearing these dangers for over a year now. Here is how analysts have been forced to change their views.
The real question is what is the ‘new norm’ for charge off rates? For DFS, management is talking about the 4-5% rate and it is safe to assume it will go up in teh future. But, I’m arguing that this reversion (if it occurs to that level) may take a while due to the factors discussed above.
Turning to the payment processors Visa (NYSE: V) and MasterCard (NYSE: MA), they have also been sterling performers this year. Not only are they seen as a safe place to ‘hide’ within the financial sector but they appear to have successfully negotiated the threat imposed by the Durbin amendment. The purpose of which was to break their duopoly in processing small merchant’s debit card transactions. Visa responded by announcing a network participation fee (NPF) and, MasterCard is believed to have raised fees for small retailers. Throw in the recovery in credit issuance and the environment is set for these stocks to continue to do well. More credit equals more transactions which turn translates into increased revenues for Visa and MasterCard.
In summary, whilst any global slowdown will hurt US growth and, consequently, the prospects for the credit card companies. The current outlook seems favorable and the potential for upside remains.
SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of MasterCard. Motley Fool newsletter services recommend American Express Company and Visa. 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. If you have questions about this post or the Fool’s blog network, click here for information.