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