I'm Buying This Stock That Made Me Look Stupid

It was arguably the 1997 book with the wild title You Can Be a Stock Market Genius that put Joel Greenblatt on the map for many investors. How could it not? We all want to be stock market geniuses after all.

Ten years later, in 2007, it was the third chapter of Greenblatt's book "Chips Off the Old Stock: Spinoffs, Partial Spinoffs, and Rights Offerings" that first led me to Discover Financial  (NYSE: DFS  ) . The chapter heading was nowhere near as sexy as the book's title, but, then again, Greenblatt's argument in the section was that it was the yawn-inducing nature of small spin-offs that could create serious opportunity for investors.

Prior to 2007, Discover had been buried in the giant conglomeration of Morgan Stanley  (NYSE: MS  ) . The investment bank wasn't the ghost of a former self that it was today, but nevertheless saw the opportunity to "enhance stockholder value" by spinning off Discover to its shareholders. The market mostly shrugged, I bought.

In the years that followed, nothing much happened. Calendar pages turned, Discover's core business produced attractive enough results, and the market still didn't care. Not only that, but as the entire financial sector was slowly dragged into crisis, Discover's stock price sagged. That combination -- solid results and a more-attractive stock price -- is typically a great time to buy. I did the opposite and sold. 

Between the time of Discover's spin-off and today, the stock has roughly doubled. The S&P 500  (SNPINDEX: ^GSPC  ) is up all of 20%.

Another bite at the apple
I won't get the price for Discover that I had back in 2007. At the close of 2007, Discover's stock traded at roughly 1.5 times tangible book value, while today it's closer to 2.8 times. 

But the picture may look even brighter for Discover today than it did in 2007. Returns on equity are notably higher. As seen in the recent round of Dodd-Frank Stress Tests, its capital ratios are particularly strong, and it's aggressively building out a direct banking business that aims to capitalize on areas that other banks are shying away from post crisis. 

It's that latter point that may be the most significant. While most consumers -- and likely many investors -- are mainly familiar with the Discover credit cards, the company is building serious steam when it comes to other direct-to-consumer loans including student loans, home equity loans, and personal loans. Discover has also been building up low-cost funding by getting more deposits -- largely through CD-type products.

This isn't an overnight win that we're talking about here though. Discover's still far-and-away a credit card-based company, and will continue to be. In 2013, Discover had an average loan balance of $62 billion and more than 80% of that was credit card loans.

But I'm a long-term thinker. While I believe there's plenty more room for growth in Discover's core card business, the much stronger brands at American Express  (NYSE: AXP  ) , Visa  (NYSE: V  ) , and MasterCard  (NYSE: MA  ) will continue to make that growth challenging. The build-out of the direct-to-consumer banking business gives Discover another outlet for growth, and an opportunity to cross-sell products -- banking products to card customers and cards to new customers on the bank side.

ING showed the opportunity to grow out an online-based, direct bank in its ING Direct business before selling that to Capital One  (NYSE: COF  ) . More recently, the romping growth of upstart BofI Holding  (NASDAQ: BOFI  ) has reaffirmed the online-only opportunity for banks. Using its established brand, Discover has a head start in building recognition among customers.

Maybe most significant of all in Discover's potential is its lack of tarnish from the financial crisis. Many consumers are still wary of major bank brands following the crisis, and though switching banks is a high hurdle for many consumers, Discover's platform may prove attractive for some.

Growth from the core
Of course I don't want to overstate the case for Discover's direct-banking arm. If the cards business doesn't pull its weight, investors will still end up disappointed.

But I don't see that as a major concern. In his 2012 letter to shareholders, Discover CEO David Nelms called the Discover it card "the most innovative new credit card to be introduced by the industry in years." While that may be overstating the case, the card does have some very attractive features. Personal finance website Nerd Wallet called out Discover it twice in its "Best Credit Cards of 2014" -- once for being the best balance transfer card and again for being the best card for college students.

Among Nerd Wallet's highlights on the card were:

  • "Fair. No annual fee. No overlimit fee. No foreign transaction fee. Pay up to midnight ET online or by phone on your due date without a fee. Plus, paying late won't raise your APR."
  • "Human. 100% U.S.-based customer service available any time."
  • "Plus, free FICO® Credit Score on your monthly statement to help you stay on top of your credit."
A primary way for a credit card company to win is to create card products that are well reviewed and that consumers want to use. Discover it seems like just that type of product.
 
Discover is also creating innovative partnerships to put it on track to follow emerging consumer preferences. Notable among these is the partnership with online payment giant PayPal.
 
The cards business is growing -- in 2013 U.S. card loans were up 4%. And though that may not sound overly impressive, it's not just the growth that's key in a lending-based business; it's also what kind of growth you're getting. For Discover, that growth is coming from a borrower base that's higher quality than key competitors. At the end of 2013, its card charge-off rate was 94 basis points below that of its peer group.

Put this all together -- a performing core business, a strong brand, and new opportunities for growth -- and I think Discover makes a compelling buy today. That's why I'm buying shares of Discover for my Motley Fool real-money portfolio.

And while I'm at it...
Those that have followed my real-money portfolio to date know that I'm not just about finding lots of new stocks to add to the mix. When I find a good idea, I like to continue adding to it over time. That's why I will build on my previous buys of specialty insurer Markel  (NYSE: MKL  ) and add more of that to my portfolio. 

For a review of all there is to love about Markel, you can visit my original write-up last August or the end-of-year write-up from fellow Fool Mike Olsen. 

If you'd like to weigh in on either of these buys, or any of the other picks in my real-money portfolio, fire off a tweet to @KoppTheFool or visit my real-money discussion board.

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  • Report this Comment On March 26, 2014, at 4:43 AM, Interventizio wrote:

    Good article. Still, I'm not confident in companies that issue credit cards. What about cellphone-based payments? This is said to be the future.

  • Report this Comment On March 26, 2014, at 2:19 PM, TMFKopp wrote:

    @Interventizio

    Thanks!

    As for the cell-based payments... the question is, who's processing those payments? A random app-maker can't just throw together a payments app and go to market -- they need the whole back end processing capability that is secure and tracks the transaction through the system.

    In addition, to the extent that users want to make a purchase on credit or earn credit-type rewards, etc, you need a lender on the other end putting up the actual cash.

    I think there is legs to the pay-with-your-cellphone idea, but what we may see is cell-payment apps linking up with existing credit/processing infrastructure.

    With that in mind, I think the online-focused payments companies (PayPal for instance, or Google Wallet) are possibly more concerning. Discover, at least, appears to be looking ahead to address this, as it's partnered with PayPal. And with Google Wallet you're still hooking up to an existing payment system -- whether your bank account or credit card.

    So I think there's a lot of innovation that could come in the payments arena, and I think it's on the lenders and credit card companies to keep up, but I also think that there's plenty of room for the credit card co's to continue to exist (and thrive) even as technology evolves.

    Matt

  • Report this Comment On March 28, 2014, at 1:42 PM, KingOfPizza wrote:

    About a year and a half ago, Discover bought two of the three student loans I had with Citibank. No problems so far. I wish they had bought all three because Citibank is awful at servicing loans.

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