Why Value Investors Should Flock to Credit Card Stocks

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The consumer financial segment is on the rebound. After the worst correction in recent memory during the 2009 financial crisis, consumers are back to paying their bills and using their credit cards. In recent months, credit card delinquencies have ticked higher, but only after striking lows not seen since the early 1990s.

As charge-offs dwindle and customers begin to pay on time, why are credit card stocks trading as if they're dead money? 

Top credit card stocks with low valuations

The credit card industry as a whole has certainly entered the value category. Capital One (NYSE: COF), one of the biggest players in consumer loans and credit cards, trades for a paltry .78 times book value and at a price only seven times higher than forward earnings estimates.

The company swallowed up whole HSBC's credit card business as well as ING Direct's savings and banking operations in 2012, giving it valuable assets to exploit in future years. Capital One has the potential to squeeze more money from each customer as its share of wallet grows. The company sports a robust credit card arm, growing auto finance business, and a recently acquired leading online bank, ING Direct.  

Meanwhile, companies like Discover Financial Services (NYSE: DFS), which issues its own credit cards and runs a processing network, trades at only 2.1 times book value and 7.3 times forward earnings estimates. Most impressively, the company manages double-digit return on equity for investors thanks to higher leverage levels.

Investors enjoyed return on equity of 30% in 2010 and 26% in 2011, a trend which will continue to play out as the company levers up for outsized returns. Discover looks especially cheap when compared to the forward earnings multiple for comparable American Express (NYSE: AXP), which trades at nearly 12 times forward estimates.

American Express makes for the most direct Discover comparable because it operates its own payment network. While the company does have growth potential in a new lineup of prepaid cards - the Bluebird card just launched in partnership with Wal-Mart - analysts expect near-equal earnings growth from both Discover and Amex. On a relative basis, Discover's forward earnings are cheaper than American Express' at the current multiple.

Neither Capital One nor Discover Financial Services are priced for growth – and no one expects impressive growth rates – but investors do not need growth to make money. Let's get to why these slow-growing financial firms would make a great fit for any void in your portfolio.

Bank on better capital allocation

Discover and Capital One plan to shift their capital allocation priorities. In 2012, Discover engaged in an aggressive share repurchase plan that sent diluted shares outstanding falling from 533 million shares to 506 million shares in just one year. Discover also increased its quarterly dividend to $.14 per share, giving it a yield of 1.45% with plenty of room for dividend growth. Goldman Sachs analysts believe the company will continue this policy in 2013, paying out more than 100% of its earnings in buybacks and dividends. That's good news for long-term investors.

Capital One is also in position to return capital to shareholders after digesting major acquisitions. In the latest conference call, CEO Richard D. Fairbank fielded analyst questions about a higher dividend and robust share repurchases. Fairbank implied that the company would ask the Federal Reserve for permission first to pay a “meaningful dividend” to shareholders before increasing repurchases once a higher dividend is in place. The chief executive told investors to plan for a simple ask at the next comprehensive capital analysis and review with the Federal Reserve for 2013, which will set the pace for a larger dividend in 2014.

Better capital allocation is a boon for shareholders. Single-digit forward earnings multiples and stock prices less than book value are generally reserved for dying businesses rather than growing and safe consumer finance companies. Look for improved capital allocation to drive these value stocks as dividends and repurchases act as built-in catalysts to drive shareholder value. You can't go wrong buying leading brands at double-digit earnings yields.


valuemagnet has no position in any stocks mentioned. The Motley Fool recommends American Express. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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