Capital One: Book Value Down 3% in 2008, Stock Down 60%

When I construct an equity portfolio, I focus on individual companies rather than sector allocations. My thought process is that if I can pick the winners and avoid the losers in any given sector, I don’t have to predict which sector will do well and which won’t.

Now, I could go out on a limb and avoid all energy stocks, for instance, if I thought demand for oil (and therefore prices) would decline. But what if I was wrong? Energy stocks could soar and I would have no exposure whatsoever. Personally, I find it far easier to identify strong energy companies than to predict where energy prices will go.

If the energy stocks I choose to invest in are better than average, then the energy portion of the portfolio will outperform the S&P 500. If I can replicate that in more sectors than not over the long term, then I can outperform the benchmark index. In a nutshell, that is how I try to beat the market over the long term.

It sounds simple enough, but in unique times (such as today) rationality completely goes out the window, and that makes my job as a long term investment manager very difficult. I will use Capital One (COF) as an example. If you believe in efficient markets, this will serve as some evidence against that hypothesis.

I have followed Capital One for a long time and have written about it extensively on this blog over the years. In my view, it is one of the best managed and financially strong banking companies around. As a result, when faced with a choice of paying 10 times earnings for Citigroup (C) or the same price for COF, I chose COF.

My analysis has been mostly correct. Capital One has avoided huge losses on packaged securities of sub-prime loans and purchased various deposit banks before the credit crisis hit, which allowed it to maintain appropriate capital levels without begging the government for cash. As a result, the company’s tangible book value per share in 2008 dropped from $29.00 to $28.24, a loss of 2.6% in a year when many banks went out of business or were bailed out by the government and larger competitors.

As you can see from the chart below, however, Capital One’s stock price has fared far worse than their book value deterioration would suggest. It has dropped 60%, from over $50 to under $20 as of this morning. Fundamental analysis has gone completely out the window lately.

Sellers of Capital One will tell you that as the unemployment rate rises, Capital One’s loan losses will increase throughout 2009 and their earnings will decline, if not turn negative. I completely agree! Everybody knows this, including the company (management is forecasting $8.6 billion of loan losses in 2009, a dramatic increase from 2008).

Still, that does not justify a 60% drop in share price coinciding with a 2.6% drop in tangible book value. Let’s say book value falls 10% in 2009 (nearly four times the 2008 rate), reflecting an even worse year. At the same rate (20% decline in stock price for each 1% loss in book value), COF shares would drop 200% in 2009. Fortunately, a stock can’t go down more than 100%!

The market is behaving as if larger loan losses and a temporary disappearance of earnings threatens the survival of Capital One, although the company has a very strong balance sheet and can withstand these recession-related shocks, unlike many of their weaker competitors. Because such an assumption is off base, it makes very little sense for a long term investor to shun strong bank stocks in the current market environment.

Capital One may trade at two-thirds of book value today (how that figure is justified, I don’t know), but when the recession ends and the unemployment rate begins to drop, the odds are very good that the stock trades at two times tangible book value or more, which means the stock could triple in value, even ignoring any increases in book value which would certainly result as time went on.

Until then, the market will continue to only focus on the short term and conclude that a bad 2009 means companies like Capital One somehow have bad business models or are broken in some way. In actuality, they are simply riding the economic cycle. Finance companies make good money when times are good and do poorly when they aren’t. Fortunately, the good times far outlast the bad times.

Full Disclosure: Peridot Capital was long shares of Capital One at the time of writing, but positions may change at any time

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11 Thoughts on “Capital One: Book Value Down 3% in 2008, Stock Down 60%

  1. Chad,

    I like your blog because I believe your value-oriented thinking and approach is similar to mine. But I’d like to hear more of your rationale (beyond simply book value) for liking COF. If you consider their atrocious cash flow and their likely ongoing deterioration in their credit card business, I think you might reconsider your long position.


  2. I agree, I think now is the time to buy strong bank stocks. I would also like to add the fact that there is fear that the government will have to take over one of the banks. I think this is what has caused most of the fear in the banking sector, sending share prices plummeting. But it seems that the new treasury secretary Geithner does not want to nationalize any banks. Banks like Bank of America and Wells Fargo are at a bargain because of this fear.

  3. I also think media is overplaying the risk of government taking over BAC.

    In my opinion, BAC was well aware that by taking over Morgan Stanley it was doing the government a big favor.

    It only makes sense for the government to return that favor, which is what is happening now when money are being given left and right.

    However, I can’t think of a reason why would the government want to nationalize a reasonably well run and well capitalized bank that came up to save it from the trouble of having to deal with Morgan Stanley.

    Yes, BAC will be down for some more time and yes, there is a risk that they may choke over Countrywide and Morgan Stanley…but that’s still quite far from having to be nationalized.

  4. Chad,

    You’ve completely missed the point of why ALL financial stocks are down. While the differentials are due to their various loan losses, the point is clear: we’re entering an era of poor credit, low cash flow, increased capital requirements and regulation. In short, it ain’t 2005 anymore.

  5. Also wanted to mention to Bobby that it was Merril Lynch not Morgan Stanley that got taken over.

  6. Chad Brand on January 26, 2009 at 8:47 AM said:

    I think everybody knows that is why financial stocks are down. Just because we are in recession, though, it does not mean all financial companies become nearly worthless. The strong companies being valued as if they won’t survive are mispriced in the short term, and that is where the opportunity in the sector lies. Fear that nobody is safe is driving down the entire group, but there will be survivors and those stocks are undervalued based on earnings power in a normal credit environment (neither 2005, nor 2009)

  7. Chad Brand on January 26, 2009 at 2:59 PM said:


    The deep recession we are currently experiencing has clearly put every consumer finance company in a poor fundamental operating environment, and that is going to continue throughout 2009. The ongoing credit deterioration is exactly why the stock is trading at 0.67 times tangible book value. As a contrarian value-oriented investor, buying strong franchises when the short-term fundamentals are poor is a consistently powerful investment strategy.

    You asked about other reasons to like the company, aside from valuation. Well, in addition to a good price, traditional investment criteria apply like in any case. Examples would be a strong brand franchise, good management, healthy business model, etc.

    The fact that COF avoided the sub-prime market, didn’t get tempted by risky asset-backed securities, and hasn’t been stung by CDO and SIV exposure, etc all point to good management. Despite being primarily a credit card company and doing a lot of direct to consumer advertising, they did not get carried away with loose lending standards during the boom, which is impressive.

    As for their business model, they moved early to move toward a deposit-funded model as opposed to many other lenders who only in recent months have scrambled to transform into banks. American Express is a good example. Another strong credit card franchise without sub-prime exposure, but they do not have a large bank to fund their operations when credit markets dry up. AmEx recently applied to become a bank holding company. AmEx has also traded at a much higher multiple than COF, hence I preferred the latter company as an investment.

    I guess I look at the banking industry right now and if I only considered the fundamental outlook for the next 12 months, I would not want to get anywhere near COF or any other bank for that matter. However, a stock’s value is not determined by its earnings power during a terrible economic climate. The long term earnings power of COF (over an entire economic cycle, not just a recession) looks impressive to me.

    To expand on that point, let’s look at cash flow, which you characterized as “atrocious.” Capital One’s pre-provision earnings for 2008 was $5.7 billion. For those who aren’t familiar with “bank speak” the term “pre-provision earnings” simply means pre-tax profit before accounting for loan defaults. It essentially tells you how much cash a company generates before writing off bad debts.

    I think $5.7 billion in annual pre-provision earnings is pretty darn strong. Combined with the $4.5 billion COF has already set aside for future losses, and the $8.6 billion in credit losses they expect for 2009 (based on a peak unemployment rate of 8.7% by December 31st) seems quite manageable. Even at 2008 loss levels ($5.1 billion), COF would earn pre-tax net income of about $600 million. I doubt the economy never recovers from last year.

    From my perch, the bearish case for the financial stocks that appear strong enough to survive, like Capital One, is simply a short term fundamental argument. I don’t know too many investors who value stocks based on earnings booked during deep recessions. Most equity valuations are based on “normalized” earnings and I think if you look at stocks like COF in that light, it is hard to argue that the stock is overvalued and does not warrant a long position. Of course, this is based on a long term value-oriented perspective. I completely agree with your assessment if you are a short-term trader rather than a long-term investor.

  8. credit card business is gonna or is having huge problems. they have no collateral for the loans. they are seeing spiking bankruptcie. they are in the cycle of coming down from peak credit. for proof, we only need to look at MA and V going IPO. I have short COF since Aug 2008. I know they overextended and have bad borrowers. the only thing suprisng to me in the business is that AXP stock prrice has fared worse than COF.
    value is one thing, but with no way to grow out of the credit bust, i dont see why anyone should hold COF.

  9. Chad,

    Why are you so positive on COF? You have been pumping this stock ever since I started reading your blog. I don’t get it.

  10. Chad,

    Thanks for your reply with additional explanation of your rationale re COF. My use of the word ‘atrocious’ as related to their cash flow was intentional. I’m not an accountant, but I was looking at their 4th quarter cash flow statement where they showed negative $1.4 billion in cash flow compared with positive $327.6 million in the same quarter the prior year. With this trend and their relatively high long-term debt-to-equity ratio of 46.6%, their ongoing ability to continue servicing their debt considering their negative debt-to-cash-flow and miniscule current return on equity is unfortunately now a real possibility. Senior management is likely now be in deep prayer for a bad assets bailout from the Federal Government — we should hear the Fed’s plans in this regard sometime later this week.


  11. Chad Brand on February 1, 2009 at 1:07 PM said:


    I am just trying to identify the banks that I believe are going to survive this mess because they are all cheap stocks. That is why I have highlighted COF, PNC, USB, etc. I liked COF when the economy was doing well, so that is why it has been written about longer. I’ll try and add some new ideas too though in the future.


    Bank cash flow will be poor this year because of how banks account for loan losses. Since they have to set aside cash for future losses before those losses are incurred, whenever you have unemployment rising, loan losses will be projected to increase in the future so the reserves go up. Every bank is facing this so it is a just a matter of finding the banks that will have access to liquidity to cover the losses. COF is well positioned in that regard, even though obviously they will have a bad year like everyone else.

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