Large Cap Stock Idea: Capital One

Last Friday I found myself astounded that shares of Capital One (COF) were hitting new 52-week lows at $69 and change. As far as large cap growth stocks go, I'm not sure there is any stock out there that looks more attractive to me at current levels than COF. Normally I might not share my best ideas on this blog, but in my mind this represents an excellent opportunity that I wanted to mention to my readers.

Of course, the stock has rebounded to $73 over the last several days, but the dichotomy between the company's outlook and the stock price remains evident. Capital One is one of the cheapest non-cyclical names in the S&P 500 index right now. With such a meager valuation (around 9 times forward 12-month earnings) one might think the growth outlook for the company was murky. However, when I look at what they are doing, and at the expansion possibilities they have over the next several years and beyond, I can't help but me completely baffled by the market's recent distaste for the stock. Whenever this happens, I just sit back and hit the "buy" button.

As most of you probably know, Capital One made a name for itself in the consumer lending business via direct mail and media advertising. For the next leg of growth, COF management has decided it could leverage its brand awareness by expanding into retail banking and owning bricks and mortar branches as a new distribution network for its products. Capital One bought Hibernia Bank last year, entering the Louisiana and Texas markets. This year they announced plans to acquire New York based North Fork Bank. The deal is expected to close prior to year-end.

Since announcing the North Fork deal, COF shares have fallen 20% from their closing high of $90 per share. There are many reasons why investors could be concerned, but none of them really warrant the kind of price cut we've seen, in my view. Let's go through the list of possible negatives for Capital One.

1) Mergers often go bad

Investors often get spooked by growth-via-acquisition strategies because so many mergers have failed to deliver the promises made by management at the time the deals were announced. Capital One has grown internally in the past, so it is true that they are new to the acquisition game. That said, combining a direct marketing plan with a branch distribution makes a lot of sense given Capital One's high brand awareness. COF management has delivered for investors over the last decade since its IPO, so I would be hesitant to write them off without any evidence that they have lost their ability to boost shareholder value.

2) Flat or inverted yield curves hurt bank margins

There is no doubt that bank net interest margins are being squeezed heavily by the current inverted yield curve. While this will impact profits short-term, long term investors looking to play the Capital One growth story over the next 305 years should be unconcerned. Yield curves signal potential for a recession, and rarely persist for an extended period of time. The yield curve will eventually revert back to a normal shape, which will serve as a boost to overall company profits.

3) Hibernia was based in New Orleans

Investors got really nervous when Hurricane Katrina came through and closed many of Hibernia's branches, just as the merger was about to be approved. Capital One renegotiated the purchase price lower and the company has not seen any negative effects from having a major presence in an area of the Gulf Coast that remains desolate in many areas. If the rebuilding of New Orleans eventually becomes a major priority, Capital One should be able to reap the benefits.

4) North Fork has a sizable mortgage business

The acquisition of North Fork has many people nervous because it gets Capital One into the mortgage business. With all of the talk of a housing bubble ready to collapse, investors are likely worried about the fallout it will have on Capital One's business. There will likely be some effect, as there will be with most banks, but as long as interest rates do not spike to above-normal levels, I would not expect an outright housing collapse. Capital One has a very diverse business, and mortgages still represent a fairly small portion of the total for the company. Much of this concern has already been priced into the stock.

Now I can't refute any of these bearish arguments outright. The only thing I can do is look at the track record of Capital One's management, look at the strategy they are undertaking, consider the expansion opportunities left even after these two bank deals are digested, and determine if the company's growth outlook for the next 3 to 5 years warrants a P/E ratio of 9 times earnings.

When the North Fork deal was first announced, COF presented a model to investors that showed an EPS target of $10 per share in 2008, the first full year after the integration, was possible. If they hit that number, we're looking at only 7 times post-merger earnings power at current prices.

Given that Capital One's expansion into retail banking will have only encompassed three states out of fifty by 2007, the growth opportunities for COF remain bright. There is no reason to doubt the company can deliver double digit earnings growth for the rest of the decade and perhaps beyond. And if they ever decide to sell COF outright, the stock trades at a price-to-book ratio of 1.4, whereas recent bank deals have been priced at 2.0 to 3.0 times book. All in all, a single digit multiple for COF, at this stage in their growth track, seems like one of the best large cap bargains around in the domestic equity market.

Capital One Earnings Miss Shouldn't Be Surprising

Capital One (COF) blew past earnings projections, reporting $2.86 versus the consensus estimate of $2.06 per share. Despite the beat, the company kept its annual guidance steady at $7.40-$7.80 for 2006. Some investors were disappointed that Q1 was so strong but the company was seemingly being conservative about the year. When asked, management expressed that they saw things being tougher and uncertain later in the year, prompting them to reiterate their guidance rather than raise it.

Fast forward to last night and investors should be not shocked that Q2 earnings came in at $1.78 per share, shy of the $2.06 estimate. Despite the company's own guidance ($7.60), analysts were at $7.91 in EPS for the year heading into the report. The stock reacted by dropping $6 to $80 per share after last night's report. Given what we saw and heard in Q1, the earnings miss should not be as surprising as some seem to think. The stock's drop appears very overdone and I would suggest long term growth oriented investors pick up Capital One shares today at a sale price of $80, or 10 times earnings. Several years from now it will prove an excellent entry point, in my view.

Customers Name Edward Jones Best Full Service Firm

From the Associated Press:

"A survey by J.D. Power and Associates found that brokerage Edward Jones was consumers' choice as the best full-service investment adviser for a second straight year.

J.D. Power, a marketing firm that's part of The McGraw-Hill Cos., asked investors to evaluate full-service brokers on seven criteria, including competitiveness of portfolio, account set-up and offerings, commissions and fees and account statements. More than 5,000 investors responded, the company said.

Edward Jones, the investment brokerage network of The Jones Financial Companies based in Des Peres, Mo., was rated No. 1 with a score of 808 out of 1,000, J.D. Power said. The other firms in the top five and their scores were Raymond James Financial Inc. of St. Petersburg, Fla., 800; A.G. Edwards & Sons Inc. of St. Louis, 778; LPL Financial Services operated by Linsco/Private Ledger Corp. based in San Diego, 775; and The Vanguard Group Inc. of Malvern, Pa., 775."

I found this study pretty interesting. Jones is headquartered right in my backyard and a closer look at the results of the survey are confusing to me. I am well aware that Edward Jones has below-average stock recommendations (their Model Portfolio has lagged the S&P 500 since it was created in 1992) and their commissions are fairly high as well, being a full-service brokerage.

Why then did they score so high? Evidently, their customers care much more about the overall experience with Jones and their personal brokers than they do about actually doing well in the market. Portfolio performance and fees associated with their investments made up only 33% of their overall rating of the company. Shouldn't those two factors be some of the most important?

Jones surely gets kudos for providing a positive client experience, but I wonder if such happiness is luring customers into thinking they are actually doing well with their investments.

Citigroup Shareholders Beware

If you own stocks, undoubtedly you want management teams to feel an obligation to work for the shareholders. This boils down to striving to maximize shareholder value. Of course, attaining customer and employee satisfaction is important too, but succeeding on those fronts will usually aid in boosting a company's public market value, so these factors go hand in hand.

If you own shares of Citigroup (Peridot does not) you might want to consider what CEO Chuck Prince said in response to a piece in Barron's over the weekend about the possibility of breaking up the financial services giant. The weekly paper suggested that if Citigroup's stock remains sluggish, there could be calls for the company to be broken up. The following is an excerpt from a Reuters story published Monday.

"In the article, however, Prince flatly rejected any discussion of splitting up the company into separate units. "Breaking up Citigroup is the dumbest idea I've ever heard of," Barron's quotes Prince as saying. "You would take a franchise that people have worked almost 200 years to build and break it up into two or three parts, only to see the parts acquired by others."

Now why should Citigroup investors be upset with this? Within the financial services sector, only insurance companies garner P/E ratios lower than the big, diversified banking giants. Citigroup, along with JPMorgan Chase and Bank of America trade at only 10 or 11 times earnings. Many investors see this as cheap, but if the multiples don't expand, share price appreciation will only come from earnings growth, which is hard to attain in any meaningful way since these firms are so huge.

The argument for breaking up a company like Citigroup is twofold; to achieve operational efficiencies, as well as a higher public market valuation. On the operations side, smaller firms are easier to manage and can move at a much faster pace in adapting to changing business environments. From the investor perspective, right now all of Citi's business units are getting the meager 10 or 11 multiple. Breaking up into several pieces, the logic goes, will allow some units to get higher valuations, and thus the entire Citigroup enterprise would be more valuable.

I have seen specific break up estimates on Citigroup that value the parts at between $60 and $70 per share, versus the current price in the high 40's. By splitting into 4 smaller companies (domestic retail banking, international retail banking, global asset management, and investment banking), Citigroup shareholders could make a hefty profit, perhaps 30% or more. Chuck Prince's blatant dismissal of the idea doesn't bode well for investors.

Was the Mastercard IPO Underpriced?

Lead underwriters Goldman Sachs (GS) and Citigroup (C) priced the Mastercard (MA) IPO Wednesday night at $39, below the expected range of $40 to $43 per share. On Thursday shares opened at $40.30 and then soared another $6 to close at $46 each. That trading action is quite baffling if you ask me.

Usually where the IPO is priced tells you how strong demand is, and subsequently, how well the stock will do upon opening for trading. The $39 pricing indicated to me that the smart money wasn't very enthusiastic about the deal. Then less than 24 hours later the stock is fetching $46. If demand was that strong, they easily could have priced it within the proposed range.

The conclusion I draw from this is that the smart institutional money wasn't sold on the price, but retail interest after the stock opened was strong. Following the retail crowd is rarely a good strategy, so I will put more weight into the $39 pricing than the $46 first day closing price. The stock's valuation also supports the cautious view. Mastercard earned about $2 per share in 2005, so the P/E is north of 20x, very high for a financial services company.

Investors Punishing Legg Mason Unfairly

Shares of Baltimore-based Legg Mason (LM), a leading asset management firm, have been crushed lately and now sit more than 20 percent below their highs. At a recent quote of $111, the stock looks expensive at first glance. The company will report its fiscal fourth quarter numbers on May 10th, with consensus estimates at $4.18 in EPS for the year. How then are LM shares attractive at 26.5 times those profit expectations?

With their recently completed asset swap with Citigroup (C), Legg is now a pure play on asset management and should be able to boost margins substantially. Looking out to calendar year 2007, after the acquisitions has been fully digested and integrated, LM should be able to earn at least $7 per share. Put a reasonable 20 P/E on those profits, based on a double-digit growth rate and within the company's historical valuation range, and you have a solid 30 points of upside.

Analyzing Gradient Analytics

Surely you've heard of Gradient Analytics by now, as it's all the Wall Street media outlets have been talking about lately. In case not though, let's recap. Gradient is a research firm based in Scottsdale, Arizona. They focus on forensic accounting analysis of public companies.

The latest issue that has been getting all the attention has to do with negative reports Gradient issued on Biovail (BVF), a poorly run Canadian drug company. Biovail is suing Gradient claiming their inaccurate and misleading reports caused a 50 percent drop in BVF stock during 2003 and 2004. News broke that Steve Cohen, hedge fund manager at SAC Capital and Gradient customer, actually requested a report from Gradient that focused on negative aspects of Biovail's business. SAC was interested in shorting Biovail shares, or perhaps they already were short at the time of request. Gradient did produce a report, and subsequently distributed it to the rest of its customers.

On the surface, this kind of thing looks very suspicious. If SAC Capital was short BVF and asked Gradient to write a negative report on it so they could profit from their short position, it certainly appears that so-called "independent" research is far from independent. Even still, a Gradient report is not responsible for a 50 percent drop in BVF stock, as the company contends. The company's financial results account for the drop.

In response to the lawsuit, Gradient has said that SAC was requesting a follow-up to a previous report it published about Biovail on its own. If that is true, and SAC was not ghost-writing these reports with false information (as some are contending), then it is hard to reach the conclusion that any law was broken. Unless Gradient and/or SAC knowingly disseminated false information in order to profit from existing short positions, this issue seems to be blowing way out of proportion.

Most are screaming for disclosure of these types of relationships. As a result, Gradient should add some fine print at the end of its reports saying that they might have been published based on a client's request, not because it was the research firm's original idea. I have no problem with such disclosures, but don't think for a second that it will change anything.

Sell side research now discloses how many buy, sell, and hold ratings they have on all of their investment banking clients, but we still see mostly buy ratings on stocks of banking clients. I recently read a report from a boutique firm specializing in healthcare stocks. They had a buy rating on the small cap biotech company I was reading about. In fact, at the end of the report they disclosed that their research analysts cover 11 companies with whom their firm has a banking relationship. All 11 stocks are rated "buy".

How much stock should investors put on Gradient's research anyway? Last week shares of Rackable Systems (RACK) dropped 6 bucks temporarily after Gradient's computer model spit out a negative red flag about increasing inventories. They postulated this was a sign of poor earnings quality.

Unfortunately for Gradient's clients, the computer program wasn't able to research Rackable's business model. Had it done that it would have learned that Rackable, much like Dell (DELL), builds product only after it is ordered. So, all of its inventory has already been sold, thereby making increasing inventory levels a signal of stength in the business, not the opposite as Gradient concluded.

Lagging Fidelity Fund Seeks to Change Benchmark

In the latest example of how mutual fund companies couldn't care less about their long suffering shareholders, consider Fidelity's recent announcement that it will be recommending its Blue Chip Growth Fund (FBGRX) change its benchmark from the S&P 500 index to the Russell 1000 Growth index.

As soon as I read about the proposal I knew a little research would yield some interesting findings. Sure enough, the Fidelity Blue Chip Growth fund has trailed the S&P 500 for six straight years.

In the real world such pitiful performance would result in the manager of the fund getting fired. But who are we kidding? The mutual fund world is nothing like the real world. Fund managers hardly ever get canned, even though 80 percent of them fail to beat their benchmark. So what does Fidelity decide is the proper course of action? Well of course, change the benchmark!

You guessed it, the Russell 1000 Growth index has lagged the S&P 500 over the last five years, so the switch will make it look like Fidelity Blue Chip Growth has done better than it actually has. Interestingly, the fund has also lagged the Russell 1000 Growth index over the last five years, just not by as wide a margin as it has the S&P 500.

Alright, so maybe you're thinking I'm being a little too cynical here. Maybe the Russell 1000 Growth index really is a better benchmark for this particular fund, based on the companies it invests in, and therefore such a change can be adequately defended. I admitted that was a possibility, so I did a little more digging. If Fidelity Blue Chip Growth is really quite different from the S&P 500 index, I'll be happy to get off their backs.

The top five largest holdings of the Fidelity fund are Microsoft, GE, Johnson & Johnson, AIG, and Intel. Sounds like the S&P 500 to me. What did I find when I peaked at the Vanguard Index 500 fund (VFINX), the largest S&P 500 index fund in the country? GE is the fund's 2nd largest holding, followed by Microsoft at #3, Johnson & Johnson at #5, AIG at #8, and Intel at #10.

Let me throw one more statistic out there that I find too amazing to ignore. In case it was just the largest holdings of Fidelity Blue Chip Growth that overlapped almost exactly with the S&P 500, I decided to look at the market cap of the fund's average holding versus the average market cap of the S&P 500 index fund. Guess what? They're exactly the same... $46.9 billion versus $47.1 billion!

And yet Fidelity is trying to get away with saying they think the S&P 500 isn't a good benchmark for the fund? Investors should not tolerate this. Unfortunately though, most of them probably have no idea it's even going on. Fortunately, that's one of the purposes of this blog.

Capital Depreciation

Shares of Capital One (COF) are continuing to fall after news of their nearly $15 billion bid for North Fork Bank (NFB). After hitting new highs at $90 per share, COF stock has dropped more than 10 percent to $80 and change. This sell-off is exactly what we saw after the company announced plans to buy Hibernia a year ago. History tends to repeat itself, and this instance should reinforce that view. Patient buyers will be well rewarded once the deal closes and investors realize how strong of a move it was. Momentum traders and merger arbs are causing longer term investors such as myself to salivate at the stock's current price.

Capital One Gobbles Up 2nd Bank in North Fork

Given that Capital One Financial (COF) recently closed its acquisition of Hibernia, I was a little surprised to see that they are buying New York based North Fork (NFB) so soon after. Also interesting was the fact that news of this deal did not leak out whatsoever ahead of time. In case you missed it (I didn't given that COF is a long-time Peridot holding), Capital One stock was up $4 on Friday to an all-time high.

Given that merger arbs will be shorting Capital One stock to play the deal out, we will likely see some of that huge gain given back this week. The stock is down $5 in pre-market trading. Nonetheless, COF management continues to execute on their strategy and shareholders will likely continue to reap the benefits. The NFB deal appears to be a good one for everyone involved. NFB holders get more than a 20 percent premium to Friday's closing price, and yet COF is only paying 1.6 times book value, which is hardly considered high in the world of bank buyouts.