Stocks have been on a tear in recent months. High interest rates weighed on markets for all of 2022, but falling inflation has investors optimistic the worst may be over. The last several consumer price index readings show slowing inflation.
That has led to a growing expectation that the Federal Reserve will curb its aggressive rate hikes. One stock that has gained almost 30% over the last month is Capital One Financial (COF 0.16%). Despite its recent run-up, the stock trades at a cheap valuation relative to its recent history. In this article, we'll explore aspects of this value stock and assess if it is a solid addition to your investment portfolio today.
Capital One is one of the largest credit card issuers in the U.S.
Capital One provides financial services to consumers, small business, and commercial clients. It owns a bank where it collects deposits and makes loans, and at the end of the first quarter, its $469 billion in assets had it ranked as the ninth-largest bank in the U.S.
However, its bread-and-butter business is providing consumers with Visa or MasterCard credit cards. According to the Nilson Report, a news outlet that analyzes the global card and payment industry, Capital One's $535 billion in transaction volume makes it the fourth-largest credit card issuer in the U.S., trailing only JPMorgan Chase, American Express, and Citigroup.
Capital One's stock and others in the financial sector faced some pressure earlier this year when SVB Financial's Silicon Valley Bank and Signature Bank both faced deposit outflows that required federal regulators to seize the bank. There were concerns about contagion and how it could affect other banks.
The Fed stemmed some concerns when it introduced the Bank Term Funding Program to help out banks facing liquidity pressures. Besides that, 78% of Capital One's deposits are insured by the Federal Deposit Insurance Corp. (FDIC). In comparison, only 15% of Silicon Valley Bank's deposits were FDIC insured.
Investors may be concerned about its subprime borrowers
One concern investors share is that Capital One's consumer base includes many subprime borrowers -- a group that tends to undergo greater financial stress than more prosperous borrowers during an economic downturn. At the end of the first quarter, 48% of Capital One's auto loan borrowers and 32% of its credit card customers had a credit score below 660, which is roughly the cutoff for prime classification. Its higher concentration of subprime borrowers makes it more sensitive to economic conditions than its peers.
These concerns are a big reason Capital One trades at a discount to its historical value. Despite its share run-up in the past month, the company's price-to-earnings ratio is 7.8, while its price to tangible book value is 1.1 -- both of which are below its 10-year average of 11.5 and 1.2, respectively.
Data source: YCharts
Capital One must answer this question
Some forecasters predict that the U.S. will enter a recession within the next 12 months. The biggest question Capital One must answer is, Can it manage its credit through a recession? During the company's conference call in April, Chief Executive Officer Richard Fairbank said:
We've tended to see that periods of abnormally good credit are followed by periods of worse credit and vice versa. And the credit performance we saw over the past three years was unprecedented. So there's what maybe we could call a catching-up effect that happens on the other side of that for consumers who might otherwise have charged off over the past three years.
In the first quarter, Capital One built up its reserves for credit losses on its credit card portfolio, bringing its allowance for credit losses to $10.4 billion or about 7.6% of its total portfolio. Its net charge-off rate on its credit card loans was 4%, up from 2.2% in the same quarter last year. Its allowance for credit losses gives it some room to cover any further losses on its credit card loan portfolio. However, if economic conditions worsen and lead to an uptick in unemployment rates beyond 5%, the bank could face potentially higher losses.
Image source: Getty Images.
Should you buy it?
Capital One has made its way onto many investors' radars in the past month because Warren Buffett's Berkshire Hathaway purchased 9.92 million shares in the first quarter. It may be a sign that Buffett believes we won't enter an economic downturn or that it won't be so bad if we do. Or it could be that Buffett and his team at Berkshire like the management team and believe the first quarter sell-off went too far. Or maybe Berkshire is beginning to build a position that it will add to as the year goes on if the valuation continues to drop.
The recent run-up in Capital One stock would make me hesitant to buy right now, especially given the uncertainty about the economy and the potential uptick in unemployment. However, if we enter a recession and Capital One stock sells off further from here, its dirt-cheap valuation could make it appealing to buy and build on for a subsequent economic recovery.
