Discover Financial Services (NYSE:DFS) doesn’t get no respect. That’s the message from Burr Capital LLC’s Rahul Ray, who discussed the company in the hedge fund’s recent second-quarter letter to investors.
Mr. Ray cited Discover Financial as being one of the fund’s few underperforming stocks during the second-quarter, calling it “the Rodney Dangerfield of the credit card industry.” As he pointed out, Discover Financial Services (NYSE:DFS) has nearly the same level of merchant acceptance in the U.S as its more acclaimed rivals Visa Inc (NYSE:V) and Mastercard Inc (NYSE:MA), as well as a strong balance sheet and a management team that is committed to buying back shares and rewarding shareholders (more on that later).
Despite Discover Financial’s 9% second-quarter decline, Burr Capital posted impressive gains of 10.6%, lifting its year-to-date performance to 23.9% gains, nearly 15 percentage points better than the S&P 500 during that time.
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In terms of rewarding shareholders, Discover Financial Services (NYSE:DFS) recently announced that it would buff its quarterly dividend by 16.7% to $0.35 per share, after releasing the results of its Stress Test (which it passed). That boost gives the stock a yield of 1.96%, nearly triple the yield of its aforementioned rivals.
Shares certainly do look attractively-priced, as was Burr Capital’s assertion, as they’re trading at a P/E ratio of just 10.47x, while Visa and Mastercard sport P/E’s of 57.59x and 32.73x respectively. Because the stock is trading so cheaply, the company has also been buying back its shares with vigor, taking 8% of them off the market in 2016 and announcing up to $2.23 billion in share buybacks alongside the dividend hike announcement.
Of course, Discover Financial Services (NYSE:DFS) has a different business model than Visa and Mastercard, which accounts for some of the discrepancy in valuations. It provides online banking services and has a large portfolio of credit card loans, which have a far higher risk of default during economic downturns than other loans. Because of that, Discover ranked worst among 34 banks in terms of projected loan losses should there be a deep economic downturn, according to the Dodd-Frank Act Stress Test 2017: Supervisory Stress Test Methodology and Results, with projected loan losses of 13%. However, Discover has traditionally done well in choosing who to loan money to, with credit card charge-offs of about 2% between 2012 and 2016, below the industry’s average.
Discover’s weakness in 2017 is likely due to fears that rising interest rates would lead to just such a surge in credit card loan charge-offs. But while the Fed recently confirmed that there has been an uptick in credit card deliquency rates this year, which contributed to Capital One Financial Corp. (NYSE:COF) stumbling its way through the Stress Tests and reducing its buyback program over the next year, Discover otherwise passed with flying colors.
Nonetheless, Discover shares can’t seem to get no R-E-S-P-E-C-T, remaining relatively stagnant since the Stress Test results and the company’s capital plans were announced, being 15% in the red this year.