Bullish On Financials Despite Macro Uncertainty

| About: Capital One (COF)

Given the uncertainty in the macroeconomy, investors are justifiably weary about cyclical stocks. In my view, however, the global economy is stronger than what the market recognizes when it comes to consumer expenditures. Job figures may be disappointing, but they are heading in the right direction. Towards capitalizing on my bullish outlook, I recommend broadly investing in Amex (NYSE:AXP), Discover Financial (NYSE:DFS), Capital One (NYSE:COF), and Visa (NYSE:V) over time. These consumer financials are the "infrastructure" behind consumer spending and thus well positioned to outperform in the event of a quicker-than-expected recovery.

Like investing in the S&P 500, I encourage investors to slowly increase any long position in the four stocks listed above. Don't put your eggs in one basket, since any signs of worsening debt crises abroad will limit the principal that allows for compounding. The idea is to not have your investment be disrupted by negative short-term events / news. Top value investors search for long-term growth, and card businesses have a strong brand image to warrant higher multiples.

While the S&P 500 trades at 15.7x past earnings, Amex trades at only 13.9x past earnings. With a beta of 1.8, the firm is likely to recover lost shareholder value from the financial collapse quicker than the market overall. Discover is even cheaper at 8x past earnings; Capital One is cheaper still at 7.1x past earnings. The odd ball out in card business is Visa , which trades at a respective 28.9x and 17.5x past earnings. Part of the reason why Visa trades so high is due to the company's strong brand name and sustainability. Based on data from FINVIZ.com, all 4 of these consumer financials are rated a "buy" or better.

Capital One is nevertheless preferred given how cheap it is. Assuming no growth, the firm raises more free cash flow than its market capitalization. Based on consensus 9.1% EPS growth expectations over the next 5 years, 2016 EPS will be around $9.74. At a 12x multiple, the future value of the company is worth $116.88 per share. Discounting backwards by an aggressive 12% discount rate yields a $66.32 price target, which is at a more than 20% premium to the current market value. With the firm trading 14% book value, I find that margin of safety is large enough to justify making an investment in a brand name firm that could more than double in value.

Amex has stronger growth expectations going into its valuation with consensus forecasting 11.5% per annum EPS growth over the next 5 years. That means 2016 EPS of around $7.39. At a 12x multiple, the future value of the stock is $88.69. A discount rate of 12% would imply that the firm is roughly 15% overvalued. The Street's price target is nominally higher than the current market. Despite limited upside, I recommend backing the company since multiples nevertheless have room to expand. My 12x multiple is, after all, conservative in light of the current 13.9x multiple.

Discover Financial has a PEG of 0.87, which implies that the market has failed to properly consider growth prospects in assigning a valuation. It also offers an industry-leading 1.2% dividend yield. By contrast, Visa has a PEG of 1.5 and a dividend yield of 0.7%. Brand name is critical in the consumer financial / card business, but the premium appears somewhat risky. Moreover, Visa has a low beta of 0.8, which indicates that it won't outperform broader indices from a macro recovery. The fundamentals are nevertheless solid against peers and reinforced by the absence of meaningful debt and 2.9 current ratio. For safety, go with Visa; for high reward, go with Capital One, Discover, and Amex.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.

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