This credit card paper offers a good risk-reward proposition

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After reaching historic highs in 2021, Capital One Financial (COF -1.80%) has seen its shares fall about 22% this year as high inflation, aggressive Federal Reserve rate hikes and concerns about a severe economic downturn spooked investors.

Although there are headwinds – including a potential deterioration in the macroeconomic outlook which could lead to higher loan losses – the company is doing well at the moment and management seems acutely aware of the risks it faces. All of this sets up a good risk-reward proposition when you look at Capital One’s valuation. Here’s why.

Imminent risks

Although Capital One’s return on equity has declined since its peak in late 2021, it is still generating returns well above pre-pandemic levels. In the second quarter, Capital One achieved a return on equity of approximately 15.8%. Before the pandemic, the best return generated by Capital One was around 12%. Loan growth remained strong in the second quarter, with ending loan balances increasing 6%. Margins also continued to rise and Capital One repurchased shares.

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But investors have rightly been worried because Capital One serves a less affluent clientele with lower FICO scores. At the end of the second quarter, about 70% of Capital One’s credit card customers had FICO scores above 660, while 30% were below, meaning Capital One has high subprime exposure.

In the company’s automotive portfolio, it’s even worse. While more than half of auto loans in Q2 went to borrowers with a FICO score above 660, 20% of loans went to borrowers with FICO scores between 621 and 660, and 28% to borrowers with FICO scores below 621.

While consumers at all levels come from a strong place, credit card loans can see higher default rates than other loan categories. Investors are also very concerned about auto loans, as car prices have been so high due to a shortage of inventory caused by pandemic-induced supply chain problems. But everyone expects those prices to come down eventually.

Capital One takes all of this into account. By the end of the second quarter, it had set aside enough money to cover losses on 6.76% of its total credit card portfolio and 2.5% of its total consumer bank loan portfolio, which are primarily car loans. At the end of the second quarter, current write-offs, which are debt unlikely to be collected and a good indicator of actual loan losses, were 2.34% in the company’s credit card portfolio and 0.67% in the retail banking portfolio. Management also said it is currently reducing auto loans significantly as financing costs rise and the space remains competitive.

Additionally, Capital One has huge excess capital that it could draw on if losses and defaults turn out to be worse than expected. The Federal Reserve requires Capital One to maintain a Tier 1 (CET1) core capital ratio, which measures a bank’s capital base as a percentage of risk-weighted assets such as loans, of 7.6 %. Capital One ended the second quarter with a CET1 ratio of 12.1% and management has an internal long-term CET1 target of 11%.

Attractive valuation

Capital One has long traded at the bottom of its peer group and is currently trading at 132% of its tangible book value or net worth. While I understand the concerns given the macro outlook, this is an experienced, disciplined management team that appears to be cautiously booking. The company also has a lot of excess capital. If it can successfully navigate the potentially tough economic conditions ahead, the stock has an edge.

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