Discover Financial Services (DFS), Wells Fargo & Co (WFC): Why This Financial Company Offers Good Upside

Textbooks will tell you that economies work in concert with some kind of ideal and consistent. Unfortunately, it never quite works out like that. In the financial sector in particular we have seen some unusual developments in recent years.

On a historical basis the sector looks cheap, with many of the leading companies trading at below book value; however, we are living in uncertain times and the credit cycle is not the same as it once was. So do the financial companies present good value right now?

It’s different this time

These are some of the most famous last words in investing. They induce investors into making assumptions that they build into stocks, which then promptly disappoint them. In the case of the financials we are seeing ongoing weak consumer demand for loans; however, I think it would be a mistake to assume that it really is different this time. At some point–as long as the economy keeps improving–consumer demand for loans will increase. History suggests that when employment and incomes increases then loan growth will follow.

With this said it is worth reflecting on how slow the recovery has been. Employment gains have been on a par with previous recoveries, but nothing near enough to recompense for jobs lost in the recession. Moreover, we have come through a few years of consumers deleveraging, and such behavior can become habitual. Meanwhile, the Federal Reserve is doing anything it can to throw liquidity into the economy. Interest rates are low and financials are facing declining net interest margins as they struggle to replace higher rate loans that are maturing. A veritable mix of pluses and minuses.

How this plays out in the Industry

We can see these issues playing out in the metrics of the lenders. For example, here is Discover Financial Services (NYSE:DFS)’ net charge off rate and delinquency rates for its US credit loans.

Clearly asset quality has improved in a rather dramatic way since the last recession, and it is notably lower than before.

While asset quality has improved across the board, low interest rates have created net interest margin (NIM) difficulties. For example, here is a look at Wells Fargo & Co (NYSE:WFC)’s NIM numbers.

In the case of Wells Fargo & Co (NYSE:WFC) It has seen significant increases in deposits, which created pressure on its NIM while new mortgage origination hasn’t been as strong as many might have hoped.

In a sense the whole industry is positioned in a similar manner. Asset quality is improving, but consumer demand remains weak and many loans are maturing, leading to significant amounts of runoff and capital appreciation.

Enter Capital One Financial Corp. (NYSE:COF)

Within financials the stocks that I like are Wells Fargo & Co (NYSE:WFC) (on the basis of its exposure to the US housing market and conservative approach), Goldman Sachs Group, Inc. (NYSE:GS) because it still trades below book value and offers significant upside from exposure to more M&A activity this year, and Capital One Financial Corp. (NYSE:COF).

Here are the price to book numbers for the stocks discussed in this post.


GS Price / Book Value data by YCharts

Discover Financial Services (NYSE:DFS)’s evaluation reflects its more aggressive approach to lending, while Goldman Sachs Group, Inc. (NYSE:GS) remains subject to regulatory risk. Nonetheless I think Goldman is good value. I’m not the biggest fan of this company and the way that successive administrations have catered to its interests, but I’m willing to bet that these trends will continue and regulatory fears will ease. As for Discover Financial Services (NYSE:DFS), investors have to ask themselves if it is chasing too much business.

Good Value?

Evaluations are attractive, but these stocks will not have such good value if lending doesn’t come back. My point is that if the economy continues to improve then at some point loan demand will surely return. However if it doesn’t (or if the same weak environment ensues) then I would rather be invested in a financial with a traditionally conservative approach to lending. In this regard I think Capital One is a good option.

Drilling down into the details of Capital One’s latest numbers it’s clear that it expects run-off to continue this year and the next. It plans for $12bn in 2013 and then a further $8.5 billion in 2014. So while its credit performance is good, consumer demand is still weak. It would be understandable if its management then decided to chase growth in areas like auto loans (which grew $800 million); however its auto loan originations declined by $500 million in the quarter as they refused to chase low quality loans.

In essence Capital One is a more conservative lender that still gives exposure to the upside of an improving economy. The fact that areas like auto loans have offered growth to lenders hasn’t caused Capital One to create potential areas of weakness in its loan book which could then threaten the company’s ability to lend in future.

Moreover, it is planning to use its capital appreciation to reward investors with buybacks and is already in talks with regulators about this.

The bottom line

Capital One offers a solid way to get exposure to the financial sector without too much risk. I think investors should take this into consideration rather than just looking for broad-based financial exposure.

Its evaluation is not expensive on a price to book basis, and a dividend yield north of 2% plus the prospects of further capital returns to shareholders offers upside prospects if the economy continues to grow.

The article Why This Financial Company Offers Good Upside originally appeared on Fool.com and is written by Lee Samaha.

Lee is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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