Friday, 25 January 2019

The capacity to suffer, LCV/CAC, and Capital One Financial

Earlier this week, Capital One Financial (COF US) - a stock I own - announced a 4Q18 result which, while above expectations at the EPS line on a reported basis, was below expectations after excluding various 'one-off' items. Markets sent the stock down 6.2%.

COF is a US bank focused mostly on the credit card segment. The reason for the miss was that the company had seen an opportunity in the marketplace in 4Q to add a lot of new accounts, and so had boosted marketing spending by 80% QoQ. The campaign was a success. They added a lot of new accounts, at an attractive cost of acquisition. However, new accounts don't immediately generate a lot of revenue. Indeed, often they involve an upfront hit to earnings, because not only do new customers cost money to acquire, but they also take time to ramp up their balances; upfront provisions need to be taken against new account balances for expected credit losses over the lifetime of the loans (whereas the interest is only accrued and recognised month-to-month); and it also takes time to sift through which are the good customers and which are the bad, and adjust credit lines accordingly, so as to emerge with a robust back-book of business several years hence.

Furthermore, the pace of credit card loan balance growth was only 2% YoY, despite a 11% YoY increase in customer credit card spending, undershooting expectations. COF emphasised that this was due to a deliberate decision to curtail credit limits, given where they currently see the credit cycle. Indeed, they have been scaling back high credit limit customers for several years now. They could very easily boost earnings at this stage of the cycle by expanding credit limits, but they don't see that as prudent. That's exactly how you want a CEO running a financial you own to think.

On the conference call, analysts nevertheless asked a lot of questions that manifested anxiety about the outlook for EPS growth next year, including whether the current marketing spend run-rate would continue; why loan growth was disappointing; and why the company wasn't trying to find investment opportunities that better matched near term costs with near term revenues.

The reaction to the EPS miss, as well as many of these analyst questions, though perfectly understandable, completely miss the point. The object of a company is not to maximise accounting earnings per se - which are mere book entries - but rather to find opportunities to invest $1, where they will get back much more than $1 over time, and at a healthy risk-adjusted rate of return.

Accrual accounting policies attempt to match the recognition of revenues with their associated costs, but the process is imperfect, and in practice there are many cases where costs need to be expensed upfront, but the revenues only recognised much later over time. If a company invests in a new factory, that expenditure gets capitalised, and so does not impact near terms earnings, even though it entails an upfront cash outflow. That is because the cost of the plant is 'matched' with revenues, and written off gradually over time against those revenues via the depreciation line. If a high-ROIC factory expansion that promises to boost revenues and earnings is undertaken, markets and analysts would applaud it, because it will boost the medium term outlook for EPS growth.

However, if the exact same economics of 'cash out upfront for more cash in later, at a high ROIC' are at play, but instead involve expensing rather than capitalising the upfront costs, suddenly this becomes a bad idea and people sell down the stock. An example is a marketing campaign that allows you to acquire a large number of new customers. But the economics of the cash flows are exactly the same, and so this reaction makes absolutely no sense. The goal of a company is to maximise value, not to maximise short term book-entry earnings.

Funnily enough, tech investors get this. They don't focus on accounting earnings so much as 'unit economics', and focus on the key LCV/CAC equation - lifetime customer value as a multiple of customer acquisition costs. If customer acquisition costs are being expensed upfront, but the lifetime value of acquired customers are many multiples of these acquisition costs, tech companies are encouraged and rewarded for undertaking these investments, as they add value to the company. Such investments may penalise earnings upfront, but over time, the company will earn more by aggressively investing in customer acquisition. Investors here focus on user growth over current earnings.

Amazon has understood this for years, and taken advantage of many companies' lack of 'capacity to suffer' earnings hits in the near term. This aversion creates exploitable business opportunities for companies that are willing to take a longer term view. And the market has tended to applaud tech companies when they do this, and award them with higher rather than lower share prices.

However, when an 'old world' credit card company like COF does the exact same thing, the market reaction is entirely the opposite. They ignore the LCV part of the equation, and focus only on the CAC part of the equation. They penalise the company for incurring more upfront costs, while giving them no credit for the new customers they have added. And they do this even if the LCV/CAC calculus is actually likely to be favourable over time, given the company's history (excellent management and high returns on capital). This creates an opportunity for longer term investors.

The below is the response from COF's CEO Richard Fairbank to analyst questions on why the company hasn't been trying to better match the costs of expansion/growth with short term revenues (i.e., so they won't entail such a significant near term headwind to EPS), and also why loan growth has been below expectations. Fairbank's response pretty much demonstrates everything you would want to hear from a bank CEO:

"Yeah. So, let me go back to start with Moshe's very heartfelt lament. It would be nice to see more matching of spending and return. Boy, isn't that the – that would be my wish for this business. And in fact, over the years, the matching has become even more not aligned as with FAS 166/167, the massive allowance builds, growth math, a lot of things in this business get pretty disaligned. Now, a lot of it is inherent in the actual mechanics of how accounting and the business works. This particular alignment we're talking about here is – now, some of it is inherent in the sense that whenever one spends a lot of money on marketing to generate accounts, accounts don't make any money. So, the only things that bring instant revenue are going to create that alignment and things like big balance transfers. It's really basically things that bring a lot of balances in that's what creates that alignment.

One of the things we've done over time – it's funny, I haven't dusted off this phrase for a couple of years now. But you will remember, Chris, for years we were saying we were running down high balance revolvers. And we have continued to – now, we're more in equilibrium with respect to that. But there are a lot of things that in the good times make a lot of money. And I put high balance revolvers at the top, number one on that list. The issue is the resilience of that particular segment. So, we – just as – because of who we are at Capital One, we have focused tremendously on resilience and we, over the years, have really driven down the proportion of our book that's high balance revolvers.

Now, the – and to the specific issue today, it's a pretty much one sentence answer as to why the account growth and the loan growth are not connected, and that is our choice on credit line. And the – while the CARD Act makes probably the stakes – well, not probably – the CARD Act makes the stakes even higher to make sure that one's underwriting decisions are right the first time. We believe – we spend a lot of our energy looking at the competitive marketplace, looking at the credit cycle, and then trying to make our choices accordingly. And a lot of times, we zig while others zag, and it's not an accident. It's actually a causal relationship because a lot of where opportunity lies and where risk exists is the flipside of what competitors are doing.

So, in this particular case, and I really want to stress, we're capitalizing on the opportunities the marketplace presents and the success that we are seeing in our individual programs in the card business. We will lean into that and capitalize on the growth opportunity. While our credit numbers are great and you can see the same numbers that we see, we are deep into the credit cycle, and nobody knows when this thing is going to turn. But we believe that the prudent thing to do is have our foot on the gas of account originations and our foot a little bit on the brake with respect to credit line extension. But it just turns out that that method of driving, if you will, creates some really asymmetrical timing in numbers and causes a bunch of people to scratch their heads and wonder what we're doing. All I can say is that's probably a manifestation of the way that we think and way we have thought over all these years. This particular disconnect of brake and accelerator is among the highest examples of that that I can remember in our history."

So what are the very positive things this comment has to say about Fairbank's stewardship of COF, that you would look for in a financial you own? The following:

*Firstly, from an investment standpoint, there is a 'capacity to suffer' a short term hit to EPS if it makes economic sense for the business long term. He is not focused on maximising EPS, but on maximising value, and doesn't care if there is a short term upfront impact to earnings if it makes sense for the business. While there is a preference for matching, if the best business opportunities are in areas where the booking of expenses and revenues are misaligned, then so be it.

*Secondly, there is also a willingness to penalise short term earnings in order to mitigate risk. He notes they could easily boost earnings by expanding credit lines, but don't believe it is prudent to do so at this point in the cycle. The fact that credit card loan growth was only 1-2% in 2018 was their own choice - a deliberate curtailment in supply, not a lack of demand. They have been proactively reducing high-balance revolvers for years. That means the quality of COF's earnings is high, because they are much higher on a 'risk adjusted' basis than companies showing less caution, and are therefore likely to prove far more resilient in a downturn. This was exactly COF's experience during the GFC, where it's charge off rates were well below peers, and the company did not need any government assistance/bailout.

*Thirdly, an understanding of the importance of investing counter-cyclically. Fairbank notes that the best opportunities are often doing the exact opposite of what most of your competitors are doing (much as it is in the stock market). That's exactly what you want in a manager.

*Lastly, the approach taken to internal investment decisions/initiatives is opportunistic rather than deterministic/bureaucratic. A high level 'strategic decision' isn't made and then adhered to automatically over several years, irrespective of feedback from the marketplace. They adapt their marketing spend, for instance, to what their competitors are doing, and when and where they see actual opportunities in the market. That's why they wouldn't commit to guidance on marketing spend for this year - how much it is will depend on the marketplace, not pre-existing budgets. This entrepreneurial approach is vastly preferable to more bureaucratic means of running companies.

I for one thought COF deserved better than a 6.2% sell-off (albeit the stock recouped some of that sell off yesterday). I bought more at US$78.30. The reaction was particularly silly in light of the fact that the company actually earned more during the quarter than expected, but the market excluded 'one time gains' that more than offset the increase in marketing spend, but did not also excluded the elevated marketing spend that drove real long term value for the company. So when all was said and done, the company (1) earned more in 4Q than expected; and (2) added more accounts than expected. So the sell-off makes no rational sense. So much for market efficiency. Investor short-termism, and obsession over short term optical EPS growth and P/Es, is a fantastic opportunity for longer term investors.


DISCLAIMER: The above is for informational/entertainment purposes only, and should not be construed as a recommendation to trade in the securities mentioned in this article. While provided in good faith, the author provides no warranty as to the accuracy of the above analysis. The author owns shares in Capital One Financial and may sell this position or buy more shares at any time without notice.


  1. Appreciate the insights, as always, LT.

    Just curious, how much of the relatively cheap valuations amongst many financial businesses do you think are due to (1) regulatory worries/risks, (2) recession/economic/credit worries/risks, (3) worries/risks of disruption/automation, (4) general disreputability ever since the GFC? Of course, if you break out all of the combinations of various slashed items in that list, there might actually be something like 13 factors I've asked you to consider, so probably a bit unfair of a question, but perhaps you have a strong view on one or two of them that render the others moot.

    I recently bought into several banking and finance businesses based almost entirely on valuation (sounds like I should have left some capital for COF when it fell into the low $70s), but I know that I'm taking on risk when I'm not especially confident in assessing the aforementioned considerations. Guess I'll find out what kind of "margin of safety" I really had over the next 12-24 months when we find out what comes of some of the worries and risks.

    Whether you can or want to share any thoughts or not, thanks, again.

    1. Thanks for your thoughts/comments.

      In my opinion, it’s mostly a matter of #2, with a bit of #4 thrown in as well. #1 was an issue in past years, but most post-GFC conduct penalties & redress have mostly been settled now, and heavy regulatory burdens actually act as a significant barrier to entry, aiding incumbents. I would also say there have been some concerns around growing competition in CCs, as well as the fact that COF is ‘liability sensitive’, so it will potentially experience some NIM pressures if short rates continue to rise.

      I don’t think markets are concerned about disruption, and nor should they be. Unlike many ‘tech’ businesses that are scalable, in the sense you can grow at limited marginal cost, banks are not only highly regulated, but required to hold capital against loans. So there is a more linear relationship between capital and earnings, and you can’t grow and disrupt a bank by running at a loss to grow, because you need to generate capital as you grow.

      In addition, banks have long been users of technology, rather than being disrupted by it. They have used technology to launch ATM networks, online banking, and mobile banking, as well as sophiticated payment networks. Payments are now fast, secure & reliable, and almost costless. There isn’t much value for tech companies to add. Banks are also continuing to use technology to automate processes and lower costs.

      P2P lending has also failed. You can’t fully automate risk assessment through data. That’s what rating agency MBS models did pre GFC, and it was a disaster. You also can’t regulate regulatory compliance, which requires huge economies of scale to mange. The banks will be fine.

      In my opinion, the best way to assess the risk of a financial is to consider (1) management behaviour and track record, esp during past downturns; and (2) the overall credit cycle. COF performed well during the GFC, and as noted in this article, is run by a prudent risk manager. Financial should be run by risk guys, not marketing guys. Financials run by marketing folks tend to blow up in downturns. Meanwhile, US household debt has fallen from 100% of GDP to 80% over the past decade.

      I also don’t buy into the impending US recession narrative. So I think stocks like COF are actually far lower risk than investors believe. And those are the sorts of stocks I look for - where perceived risk is much higher than actual risk, and therefore where underwriting that risk makes sense.


    2. PS third to last para, should read *you can’t automate regulatory compliance*

    3. Thanks, yes, more or less my thinking and thesis, but maybe a bit surprised at the skepticism from markets that banks will eventually be able to earn a nice full-cycle ROTCE and continue to grow roughly indexed with the economy. Just seemed to me these are ingredients of a potentially very nice, if not great, businesses (I suppose I should have included "non-disruptive competition" as a possible threat and have to concede that I'm depending on relatively rational competition, partly enforced by discipline around leverage and cap reqs). Also, please correct me if I'm wrong, but COF is not the only large financial business that seems to now have strong risk and execution oriented management teams in place (in fact, I would be curious if you had insights into a large financial company that had an obviously bad management team in place, especially a marketing-oriented one – although WFC's culture of "cross-selling" ended up proving a problem in the end). I suppose I took a little comfort, as well, after finding out that Buffett had been adding to his investments in financials as of 3Q18, at least relative to some other sectors – especially since they were even cheaper in 4Q18 – although Berkshire as a whole was also putting money into Apple (ApplePay?), Paytm, and StoneCo, which is why I still have disruption in the back of my mind and am tempted to similarly diversify, even though making some of those "disruptors" work as value investments (PYPL, SQ) feels tricky.

      Anyway, I greatly appreciate your thoughts. I also continue to assign much lower probabilities to recession than some say they do – it's amusing to hear people say they think recession is "likely" in the near-term and yet merely trim their equity exposure, which by my analysis only indicates cognitive dissonance and undercuts their authority on the subject – but I'm assuming you're also like me and ready to ramp up those probabilities if the data starts turning more sour. As for financials, they will definitely be a big chunk of my excess returns over the next 12-24 months if they work, and I thank you again for the insight into COF and their management.

  2. I call this "time frame arbitrage", and agree that it's a fertile hunting ground for investors. It manifests in various situations - not only in investing via the P&L at the expense of short-term profits (as is the case here with COF), but also via:

    - Capital expenditures: particularly for long-term and large capex programs, the market sometimes seemingly forgets (or places a ludicrously high discount rate on) the earnings that will flow upon the completion of the project. Buying companies that are making large, NPV-positive capex investments that won't return anything for 2-3 years, at valuations that ascribe zero value to those programs, is a strategy that has worked repeatedly.

    - Financing: Applies particularly to high yield stocks getting smashed because they choose to cut dividends to either solidify the balance sheet or undertake sound growth investments. This applies to large parts of the US MLP market now, for example.

    Bottom line: in the short term, the market is an ass is so many different ways.

    1. Completely agree.

      I do think there is a framing issue at play though too. People are looking for EPS growth and low P/Es, and catalysts. So they don’t necessarily think about it in terms of economic value - more in terms of, what’s going to drive the share price up. A lot of investors focus on predicting how investors will reat to future news, rather than think like owners. So the conclusion is, the stock is going to have weak earnings over the next year that will make the multiple look fullish short term so why would anyone buy it?

      It all comes back to Ben Grahams comment that investing is most intelligent when it is most businesslike. Business owners would never think about it this way.


    2. I 100% agree with this comment and virtually all of the other investing commentary and insights you provide on this blog, but I recently decided to reread Graham's book as I was buying stocks in the depths of the December sell-off РI know, what a clich̩, right? Except maybe more self-proclaimed value investors might consider doing it as well Рand for the first time I found myself reading that oft-quoted line about "investing being most intelligent when it is most businesslike" in a slightly new way. Certainly, he encouraged active investors to think like business owners, but in discussing the hurdle that an investor should be able to clear to justify being an active/aggressive investor rather than a passive/defensive one Рhe suggested consistent excess returns of ~500 bps per year Рwhat I think he might have been alluding to in his "businesslike" line is treating one's own investment program as if it were a business. In that sense, you will have to invest intelligently in order to actually make a successful business out of it Рthat is, paying attention to whether your program is really paying off and having the discipline and skill to make it so, just as a real business would have to pay off in order to continue to run Рand similarly, if you could make a successful business out investing, meaning consistently over many years, then it's virtually guaranteed that you will have had to have been investing in an intelligent way. Perhaps a tendentious interpretation, and perhaps not even what Graham had in mind, but not inconsistent with other concepts he presented in his book either, namely what should be the standard for when a serious person (businessperson?) should undertake the effort and risk of active and aggressive investing. Just thought this blog's audience might find that an amusing notion, or hope so. Thanks, as always.

    3. To elaborate, why I like this reading even for the point you were making is this – supposing some people have the skill (or edge) that let them win the short-term game, it might still make for a successful business. Graham was skeptical of this, so he more or less identified value investing (which is roughly how I perceive your investment program working, and hopefully my own) as the only path to success, and therefore would assume any successful "investment business" to be run along value investing lines. But in the face of a truly efficient market or perhaps better to say one offering little to nothing in the way of excess returns from active investing, I think his slogan about intelligent investing being businesslike would militate against active investing altogether, even if one went in thinking of owning stock as owning shares in a business – what would be businesslike in that case would be acknowledging that it's not a good business to be in. But I might only be digging myself in deeper with my tendentious interpretation.

      As a final broader point, I think Graham is an example of why I am somewhat pessimistic about the transmission of knowledge, which is to say that if you read him (or an author of similar calibre and expertise in another domain) without the requisite knowledge, you will either miss the idea or, worse, get the wrong idea altogether. But if you have the requisite knowledge, then reading him adds less than he might have hoped – although it is always a beautiful experience to see how one's knowledge might be systematized or seen as a more coherent whole. Of course, perhaps I am merely revealing my own intellectual deficiency. Perhaps I thought I was intelligent, but the first two times I read Graham, I didn't get him, which might prove something more about my intelligence than about the ability for knowledge to be conveyed. Meanwhile, 10-year-old Buffett may or may not have thought too much about his intelligence, yet I suppose it is possible he read Graham and understood it clearly the first time, which would prove either that he (and perhaps even a relatively large number of people like him) are the actual class of intelligent people or else that he had a certain kind of intelligence that made Graham intelligible, whereas to an intelligent person of a different sort, a genius even, Graham would be unintelligible. If this is too discursive, at least it should have relevance for why so few people seem to be able to successful businesslike investors, especially at the excess returns of 500 bps/yr hurdle.

  3. There are various financials that, at today's price, seem to be fully expecting a recession - and a recession that is as painful to the lender as the last one was. In answer to an anonymous comment above, I tend to agree that most of this is the commenters points 2 and 4, fighting the last war kind of thinking. If the future turns out somewhat less bad, these business ought to continue to do well. Even if the future is a repeat of the past, most of these businesses are in a more conservative posture going in.

    Lyall, have you looked at Alliance Data? I'd like your opinion on it if you're willing to have one.