A Cheap Stock That 2 Great Money Managers Like

Capital One Financial COF is a favorite stock for at least two smart money managers. Warren Buffett’s Berkshire Hathaway added shares to its position during the second quarter; in fact, we included Capital One in our three Buffett stocks to buy this quarter. The stock is also the second-largest holding in Gold-rated Oakmark Fund; manager Bill Nygren talked about it in a recent episode of The Long View. Plus, Morningstar chief U.S. market strategist Dave Sekera recommends Capital One as one of five financial stocks to buy after earnings.

Capital One maintains a more limited branch network than its traditional banking peers; it uses its online and mobile channels to acquire customers and service its accounts. The focus on online bank accounts has allowed the company to establish a national presence that is broader than its narrow branch network would traditionally allow. This dynamic allows Capital One to enjoy the benefits of being a large bank without the expense of operating the branch system of a large bank. Capital One’s largest driver is credit cards, which make up around 44% of its total loans. The remaining business mostly consists of commercial loans and auto loans through the consumer banking segment. This narrow product offering focuses assets, giving Capital One the benefit of scale in its chosen business lines, but it does have the consequence of leaving the bank reliant on credit cards and auto lending.

Key Morningstar Metrics for Capital One

• Fair Value Estimate: $146
• Star Rating: 4 Stars
• Economic Moat Rating: Narrow
• Uncertainty Rating: High

Economic Moat Rating

We believe Capital One has durable competitive advantages that will allow it to continue to earn returns on tangible equity that are above its cost of capital. The company’s heavy investment in technology and marketing has enabled it to use online bank accounts to build an asset and deposit base that is national in scope while maintaining a limited branch network. This has given Capital One the scale necessary to compete effectively in its business lines while keeping operational costs under control. In turn, this has allowed Capital One to enjoy returns on tangible equity that have been comfortably above its cost of capital. Banks typically create cost advantages by controlling operating expenses, building low-cost deposit bases, and utilizing effective underwriting to keep credit costs below their peers. Capital One has been particularly successful in keeping its operating structure lean.

Read more about Capital One’s moat rating.

Fair Value Estimate for Capital One Stock

Our $146 fair value estimate translates to a 2023 price/earnings ratio of 12.9 based on our current estimates. Our valuation is sensitive to expectations for net interest margins, credit card receivables growth, and how well the company manages its noninterest expenses. Projected net charge-offs are a key driver, particularly for the bank’s lucrative credit card loans. We assume that the companywide net charge-off rate rises to 2.80% in 2023 and 3.68% in 2024, returning to 2.91% by 2026. Despite higher loan losses, we expect Capital One to be more than adequately provisioned, with its current reserve for loan losses at just under 4.70% and a common equity Tier 1 capital ratio around 12.7%. We see the efficiency ratio ending 2027 at 54.6%, roughly in line with historical levels.

Read more about Capital One’s fair value estimate.

Risk and Uncertainty

The bank is exposed to the economic cycle as its profitability is affected by changes in credit quality, interest rates, and consumer spending. Capital One is more exposed to the credit cycle than most of its peers because of the large amount of subprime consumer lending it does. Around 31% of its credit card receivables and 47% of its auto loans are from borrowers with a FICO score lower than 660. There is the risk that a negative economic climate could lead to higher charge-offs from weaker borrowers. The company’s economic exposure is increased by its volume of auto lending. Auto lending relies on the ability to resell repossessed vehicles at a reasonable price in order to keep net charge-offs low. If the value of this collateral falls due to economic pressure, then the credit risk of Capital One’s auto loans increases. However, we see limited risk that Capital One’s financial position will be materially affected in the near future.

Read more about Capital One’s risk and uncertainty.

Capital One Bulls Say

• Capital One’s credit card portfolio is enjoying rapid growth, providing a boost to net interest margins and revenue growth.
• Technology investments, the transition away from legacy data centers, and a reduction in the branch count should help the company reduce costs.
• Capital One has expanded its card product offerings as it leans into the commercial and luxury travel card markets.

Capital One Bears Say

• Credit card reward spending continues to rise industrywide, and competition for cardholders remains intense. This will likely lead to higher spending for Capital One and could threaten returns on its credit cards.
• Capital One is exposed to a significant amount of subprime lending through its credit card and auto loan segments, while credit costs are set to rise.
• Capital One competes with online banks for deposits. This pushes its interest costs up as the bank must offer competitive rates.