Capital One Financial(NYSE: COF) is not your typical bank. When deciding whether or not to buy it, this is probably the most important thing to keep in mind. But what exactly is Capital One Financial? It's a mixture of a credit card issuer and a car loan maker. These both tend to be higher-risk areas of the banking industry. Here's a deeper look at the issues that you'll face if you buy Capital One Financial.
Owning Capital One Financial has been rewarding
Taking prudent risks on Wall Street can lead to very strong returns. For example, Capital One Financial's stock price has risen around 60% over the past five years, versus a 20% advance for the broader banking sector. Very clearly, whatever Capital One's management team is doing has worked well over the last five years.
The nuance here is that while Capital One is a bank, it has a very focused business. The biggest division is the company's credit card operation, which accounts for roughly 48% of its loan book. That's a gigantic number for a bank. The next biggest piece of the loan pie is auto loans, which account for about 23% of the total. These are both riskier types of loans. Capital One also has a penchant for issuing cards and car loans to lower-credit-quality customers.
Overall, higher-risk businesses make up just over 70% of Capital One's loan book. More traditional loans that banks make, such as mortgage loans, account for the rest of the loan portfolio. The benefit of focusing on higher-risk loans is fairly simple: Capital One gets to charge higher interest rates. Thus, these loans are more profitable than loans that are usually seen as less risky.
Capital One has managed risk well, but be prepared for downdrafts
On the whole, Capital One has done a very good job of building its business and rewarding investors. But you have to keep the inherently riskier nature of this bank in mind before buying it. History suggests that it will likely be a rewarding investment over the long term. But the business can be a little scary over shorter periods.
The reason for this is simple. When the economy faces financial difficulty, the worst pain often falls on the weakest consumers and riskiest loans, which is basically what Capital One focuses on. Right now, the economy appears relatively strong, despite the Federal Reserve having jacked interest rates higher over the past couple of years. It has, notably, just reversed course and begun to lower interest rates.
That could be a signal for investors to worry a bit more about Capital One's business. For example, charge-offs in the company's credit card business have been heading higher for a year. They are now 36% higher than they were a year ago. To be fair, that represents a rise from 4.41% to 6%, so armageddon hasn't descended on the bank's credit card portfolio. However, the trend suggests increasing stress on Capital One's customers. Charge-offs in the auto loan business rose from 1.4% to 1.81% over the past year, for reference.
There is a notable change coming to Capital One's business model, assuming its planned acquisition of Discover Financial(NYSE: DFS) goes through as contemplated. This move will add a payment processor to its business model, perhaps allowing for more consistent revenues. However, Discover does not have the scale of its larger competitors, Visa and Mastercard, so the impact on Capital One is likely to be positive but perhaps not material enough to offset the inherent risks of lending to some of the highest-risk customer bases. Until this deal is done and there's some history behind the combined entity, it is probably best not to get overly excited about the impact it will have on Capital One's business.
Should you buy Capital One Financial?
Historically speaking, and from a big-picture perspective, Capital One has managed its business well, taking on extra risk but doing so in a way that has rewarded investors. So it does appear like a worthwhile investment to consider, but it is probably best suited to investors with a more aggressive bent. When the economy falls into a recession, Capital One's business will probably be performing worse than other, more conservative banks, and Wall Street will react accordingly. That's just normal for this credit card lender. If you want to buy it, make sure you can handle the drawdowns, or you'll likely sell out at the worst possible time.
From a near-term perspective, Capital One's price-to-book value ratio is above its five-year average, suggesting it is a little expensive today. And, as noted, it looks like its customers are facing increasing financial strain. It might be best for investors to hold off for a while, until the economic environment becomes a bit clearer.
That said, if there's a recession, aggressive investors who understand the company's approach and long-term success might want to jump in, while others on Wall Street will likely be running for the exits.
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Discover Financial Services is an advertising partner of The Ascent, a Motley Fool company. Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Mastercard and Visa. The Motley Fool recommends Discover Financial Services and recommends the following options: long January 2025 $370 calls on Mastercard and short January 2025 $380 calls on Mastercard. The Motley Fool has a disclosure policy.
