Banks are vital financial institutions that facilitate commerce, but not all banks are created equally. Capital One Financial(NYSE: COF), for example, has a unique operating model that can result in material swings in its performance. Here's why some investors will appreciate this large bank and others will want to avoid it.
What does a bank do?
From a simplistic perspective, banks take in deposits (bank and checking accounts) and then use that cash to make loans (mortgages). Banks make the difference between the interest they charge on loans and the interest they pay on deposits. Although large banks have expanded well beyond this simple model today, it is still the core of many of the biggest names in the industry. Capital One does this, too, and regular banking is generally a fairly consistent, and perhaps even boring, business.
Image source: Getty Images.
What does Capital One do?
The thing is, Capital One's consumer business only accounted for about a quarter of the net interest income it generated in the second quarter of 2024. A far larger 70% came from the bank's credit card business. Credit cards are an important business for most banks, but it is really "the" business for Capital One Financial.
To be fair, credit cards can be very profitable. And Capital One has a fairly large exposure to lesser-quality borrowers, which generally have to pay higher borrowing rates on their cards. So the bank's card business can generate fairly robust profits. Although this is a rather aggressive approach in the banking sector, it is also why more aggressive investors will like the stock.
The problem with Capital One's approach
Credit cards are a valuable payment tool for consumers. When the economy is strong, transaction fees and interest can generate strong profits. But cards are usually one of the first forms of debt to weaken when finances get tight. And trouble can show up fairly quickly, particularly when there are recessions. It should come as no surprise that Capital One's stock price tends to decline materially during economic downturns as investors try to shed riskier investments.
To be fair, other bank stocks fall as well. But with more diversified and less risky business, economic uncertainty isn't as troubling a headwind. To provide an idea of just how quickly things can change for Capital One, look no further than the second quarter of 2024. In the first quarter, the company's card business generated $961 million in income. That fell to just $91 million in the second quarter. To be fair, there were some unique one-time items during the quarter, but the big quarterly drop highlights how quickly things can change within Capital One's business. Looking back a bit further, Capital One's net income dropped 54% between 2019 and pandemic-hit 2020.
Capital One continues to grow
That said, Capital One Financial has managed to weather the rough patches and, notably, has continued to grow its business over time. Most recently it agreed to buy Discover Financial, materially expanding its business (and doubling down on credit cards). The company's growth has resulted in the stock rising over time despite sometimes heart-stopping price declines along the way -- which is why some long-term investors with strong stomachs will like the stock.
More conservative investors, however, will probably be better off sticking to a bank that is more diversified and, frankly, boring to own. The upside potential may be less exciting, but that is often the price that has to be paid if you want to get a good night's sleep.
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Discover Financial Services is an advertising partner of The Ascent, a Motley Fool company. Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends Discover Financial Services. The Motley Fool has a disclosure policy.
