Capital One: How I Beat the Best With a 37% Stock Rocket

(Adds Wednesday's market close information, updated returns and stock ratios.)

NEW YORK ( TheStreet) -- On some occasions, the obstructionists can be your friends.

When I was asked to pick a bank stock for 2012 as part of the 10 Best Stocks for 2012 series at InvestorPlace, I looked beyond the obvious choices of Bank of America ( BAC) and Citigroup ( C), both of which had fallen significantly, in order to select a much more profitable bank that had suffered because of delays by regulators in approving two key acquisitions.

Through Wednesday's close at $57.79, Capital One was in first place among the 10 Best Stocks for 2012 at InvestorPlace, trailed by Turkcell ( TKC), which was selected by Charles Sizemore, a registered investment advisor who is also the founder and editor of the Sizemore Investment Letter. Capital One's shares are up 37% this year, while Turkcell is up 33%, closing at $15.66.

I chose Capital One on Dec. 16, 2011. The shares had outperformed most of the largest U.S. banks, returning 7% from the start of January 2011 to close at $43.05 on Dec. 15, 2011, while the KBW Bank Index ( I:BKX) declined 27%, Bank of America plummeted 60% and Citigroup sank 45%.

Capital One's shares had pulled back 20% (on a total return basis, including reinvested dividends) from their closing 2011 high May 19.

At that time, Bank of America was trading for just 0.4 times tangible book value, while Citigroup was trading for half its tangible book value. Capital One was much more expensive in a stressed environment for bank stocks, at 1.4 times tangible book value, according to SNL Financial, and also was solidly profitable, with returns on average assets (ROA) ranging from 1.42% and 2.08% over the preceding five quarters.

So why pick Capital One, when Bank of America and Citigroup had so much potential for recovery, since they had already fallen so far? After all, going with "last year's losers" has been a fantastic strategy for 2012, with Bank of America's shares returning 109% through Wednesday's close at $11.55, while Citigroup was up 50%, closing at $39.55.

In December 2011, my inclination was to make a conservative pick of a company with a strong earnings track record, limited downside risk (because of strong earnings) and some sort of "edge," which for Capital One was the softness in the shares from the delayed acquisition approvals.

With all the negativity surrounding Bank of America as its mortgage putback demands mounted, and Citigroup, with investors mistrusting management's ability to turn the company around, these two stocks didn't appear to be solid long-term picks.

Capital One announced its $9 billion deal to purchase ING Direct from ING Groep ( ING) on June 16, 2011. Then on Aug. 10, the company said it would buy HSBC's U.S. credit card portfolio, consisting of $30 billion in loans, for a premium of $2.6 billion, including a planned capital increase of $1.25 billion, which put some dilutive pressure on Capital One's shares.

The two acquisitions fit together beautifully, because ING Direct had over $80 billion in cheap deposits and about $41 billion in loans, leaving plenty of liquidity to fund the HSBC credit card loans.

The acquisitions promised to make Capital One the fifth-largest U.S. bank by deposits, raising an outcry among those concerned with the formation of another "too big to fail" bank, along with consumer advocacy groups who said it was a terrible thing for Capital One to pursue growth in its core competency: credit cards.

U.S. Rep. Barney Frank (D., Mass.), who was then the senior democrat of the House Financial Services Committee, requested in August 2011 that the Federal Reserve extend the public comment period before approving the ING deal, saying that "care should be taken to thoroughly examine the impact of this purchase with respect to the consolidation of banking assets, the provision of credit by the resulting bank and compliance with the Community Reinvestment Act."

The National Community Reinvestment Coalition was among the organizations pushing for the Fed to extend the comment period, and group CEO John Taylor said Capital One was aiming "to fund a larger credit card business and not to provide the safe, sound mortgages and small-business products that consumers need."

The Fed had three public hearings on Capital One's ING deal, and the Office of the Comptroller of the Currency also took plenty of time to analyze the HSBC credit card deal. The ING acquisition was completed in February, the $1.25 billion common equity increase was completed in March, and the HSBC card purchase was finished in May.

With gains on the purchase of ING Direct, a temporary liquidity bump in advance of the HBCB card deal, and special loan loss reserve provisions during the second quarter for the acquired credit card loans, Capital One's "first clean quarter" for 2012 was the third quarter, when the company reported earnings available to common shareholders of $1.17 billion, or $2.01 a share, excluding income from discontinued operations.

Capital One's third-quarter return on average assets was 1.6% and its return on average tangible equity was 21.5%, compared with ROA of 11.8% and ROTCE of 22.6% a year earlier.

The company's net interest margin -- the average yield on loans and investments minus the average cost for deposits and borrowings -- was 6.97% in the third quarter, increasing from 6.04% the previous quarter (when the company's margin shrank because of the ING acquisition, without yet realizing a full quarter's benefit from the HSBC cards), but narrowing from 7.4% a year earlier. The year-over-year narrowing of the margin is in line with the industry, in the prolonged low-rate environment.

So Capital One is ready to continue outperforming most of other big banks, simply because the credit card business is more profitable than other lending operations.

Shares of Bank of America and Citigroup are still cheaper to book value, but more expensive to forward earnings.

Bank of America trades for 0.9 times tangible book value, according to Thomson Reuters Bank Insight, and for 12 times the consensus 2013 earnings estimate of 96 cents, among analysts polled by Thomson Reuters. The consensus 2014 EPS estimate is $1.25.

Citigroup trades for 0.7 times tangible book value and for 8.5 times the 2013 consensus EPS estimate of $4.65. The consensus 2014 EPS estimate is $5.13.

Capital One trades for 1.5 times tangible book value, but for only 8.2 times the consensus 2013 EPs estimate of $7.03. The consensus 2014 EPS estimate is $7.39

So there you have it. On a forward P/E basis, Capital One's shares are still cheaper than the shares of Bank of America and Citigroup, and Capital One has unbeatable earnings power.

Interested in more on Capital One? See TheStreet Ratings' report card for this stock.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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