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."
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.
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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Matt Koppenheffer owns shares of Markel and Morgan Stanley. The Motley Fool recommends American Express, BofI Holding, Markel, MasterCard, and Visa. The Motley Fool owns shares of BofI Holding, Capital One Financial., Markel, MasterCard, and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.