Lynch & Buffett: What's In Your Wallets?

Lynch & Buffett: What's In Your Wallets?
John P. Reese, Validea Hot List 08.11.06, 6:00 AM ET

Capital One Financial has some funny advertisements (at least some people think they're funny), such as those with comedian David Spade. But there's no joking about how this financial institution is growing and making money.

Recently, I wrote in this column about the strategies I use based on Warren Buffett's and Peter Lynch's approaches to investing. These are both great strategies, and they both think that Capital One is laughing all the way to the bank.

What is Capital One (nyse: COF - news - people )? It was a major issuer of credit cards and still is. It used to focus on sub-prime borrowers, but refocused a few years back and now attracts better-quality customers. Yet again, however, it is redirecting itself by entering the banking business. Just last year, it purchased Louisiana's Hibernia National Bank and is currently completing the purchase of New York's North Fork Bancorp. (nyse: NFB - news - people ). The advantages of owning banks are that they bring in relatively cheap deposits and diversify the company's revenue base.

Upon completion of the North Fork acquisition, Capital One should be among the ten largest banking companies in the country. Also, it recently posted earnings that disappointed Wall Street and knocked more than 10% off the stock's market value.

This setup means that in Capital One we have a strong company and a stock that seems unjustly discounted--its price-to-earnings ratio is only ten. For these reasons alone, Capital One is worthy of your consideration. And, of course, two proven guru strategies conclude that Capital One is worth buying.

Warren Buffett Strategy

The Buffett strategy likes companies with a competitive advantage, such as being among the largest or best known in their industry. Capital One is about to become one of the ten largest banking companies in the country, and it already has strong brand recognition; it has a Buffett-type franchise.

Another plus is that its earnings have been predictable, rising every year for the last ten years. Return on equity should be north of 15%, and Capital One's return on equity is 19.7%. Another plus is its return on assets, which needs to be at least 1%; in Capital One's case, ROA has averaged 2.5% over the past ten years.

A measure of management's ability to perform for the benefit of shareholders is how well management invested the company's retained earnings. Over the past ten years, retained earnings at Capital One have totaled $30.62, while earnings per share have jumped $5.96, which earned for shareholders a 19.5% return on the earnings kept.

This is during a period in which an index ETF such as the S&P Depositary Receipts (amex: SPY - news - people ) has struggled to produce low single-digit percentage gains on an annualized basis. Nice work, Capital One.

All of this analysis suggests that Capital One is performing well from a financial point of view. But the Buffett strategy wants the stock also to be well priced. The Buffett strategy uses two methods to analyze price, and they agree that at current prices Capital One shareholders can expect a rate of return somewhere between 13.8% and 19%, or 16.4% on average. This is very strong.

Bottom line: The company is performing well financially, and its stock is nicely priced. It's a Buffett-style buy.

Peter Lynch Strategy

The screen based on Peter Lynch's strategy also thinks Capital One is a born moneymaker. One very compelling criterion is its price-to-earnings-growth ratio, or PEG (P/E relative to growth). This should be 1.0 or less, and anything south of 0.5 is very strong. Capital One's PEG is a very strong 0.46. Note, its P/E is a weak 10.41, while its growth rate (based on the average of the three-, four- and five-year historical EPS growth rates) is 22.5%.

Also noteworthy is its equity-to-assets ratio. The Lynch strategy wants this to be at least 5%, while Capital One's is a robust 18%. Plus, its return on assets is a compelling 3% (1% is the minimum). If you loved Lynch at Fidelity Magellan (FMAGX), you could buy some Capital One to emulate the investing style of this master.

Capital One has a track record of success. It is diversifying into banking, which has its pluses. The stock is now trading at friendly levels. And the guru strategies are banking on it

John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best . Click here for more of Reese's insights and analysis, and to learn about subscribing to the Validea Hot List. At the time of publication, John Reese and his clients owned shares of Capital One Financial.

in http://www.forbes.com/2006/08/10/capitalone-buffett-lynch-in_jr_0810guruscreen_inl.html?partner=yahootix