5 Credit Card Stocks Charging Ahead

Credit card stocks took a beating during the financial crisis and the ensuing regulatory tussle, which produced drastic changes in rules and disclosures in the financial-services industry. But some of the industry's top players came back last year like rested prizefighters, and some experts say the industry is ready to rumble. "We're pretty bullish" on the group, says Sanjay Sakhrani, an analyst at Keefe, Bruyette & Woods.

Investors who have taken a bullish stance on the group recently have been well rewarded. Shares of all of the five major credit card companies are up double-digit percentages so far this year. Two factors fueling the stocks fall into the category of "mildly good news." Worries about a new economic downturn have receded, suggesting that recession-scarred consumers may be ready and better able to spend. Meanwhile, the regulatory reforms that have made some bank investors skittish don't appear to have been as detrimental to credit card issuers as once feared.

Here's a look at the prognosis for the industry's Big Five. Despite solid advances this year, most of the stocks remain attractive, particularly for long-term investors. Share prices and related data are as of March 28.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

American Express (symbol AXP)

AmEx was one of the group's more modest performers last year, gaining 11.6% including dividends (an excellent return considering that the overall stock market returned only 2.1%). So far in 2012, the stock has returned nearly 26%. At $59.06, it yields 1.2% and sells for 14 times the $4.25 per share that analysts on average expect the company to earn in 2012. Meanwhile, analysts see earnings growth of about 11% annually over the next three to five years.

Although a price-earnings ratio above the expected growth rate suggests that the stock is hardly cheap, analyst David Darst at money management firm Guggenheim Partners just hiked his target price to $63 because the company is repurchasing shares. On March 26, AmEx announced that its board had authorized the repurchasing of 150 million shares, as well as an 11% increase in the quarterly dividend, to 20 cents a share.

David Rolfe, manager of the RiverPark/Wedgewood Fund (RWGFX), says AmEx's practice of pouring profits back into the business, largely by paying outsize rewards to premium cardholders, has held back the stock in the past. Those premium rewards may be why the company attracts some of the best customers, from a credit-risk perspective, in the industry. American Express charges off about half as many nonperforming loans as Capital One Financial. Still, AmEx could turbo-charge its results by shaving rewards and other expenses, Rolfe says. "We think reinvesting in the business has paid off, but at some point you want to tell management to let this horse run," he says. "Let's see what you can really earn."

Capital One Financial (COF)

Capital One was flat in 2011, making it the group's biggest laggard. But it's on a tear this year, with a gain of nearly 35%. At $56.98, the stock sells at just 10 times estimated 2012 earnings of $5.87 per share, but those projections anticipate that Capital One will earn less in 2012 than it did in 2011. But most earnings estimates do not factor in Capital One's purchases of ING Direct and HSBC, which were just approved.

Capital One is Sakhrani's top pick. He is convinced these deals will ultimately prove profitable for shareholders, putting the company in an enviable competitive position by making Capital One the fifth-largest bank in the U.S. The company became a bank partially by default -- it was looking for a good way to fund its credit card loans, and low-cost deposits fit the bill. Sakhrani thinks the company is in good shape and will be in a position to be an aggressive competitor when the deals close. He expects the stock to sell for more than $68 within the year.

Discover Financial Services (DFS)

Thanks in part to "buy" ratings in December from analysts at Guggenheim and Alabama-based brokerage firm Sterne Agee, Discover returned a solid 31% last year. And it's returned another 38% so far this year.

Once a pure credit card play, Discover has gotten into the business of making private student loans and residential mortgages, hoping to capitalize on changes in industry trends that have cut the competition in these areas while making the loans somewhat less risky. Private student loans, once the wild west of lending, are now made largely with employed co-signers. Mortgage lending has also become more conservative as appraisers and lenders have been forced to acknowledge that real estate prices can drop as easily as they can rise.

Discover's credit quality has improved, says Sterne Agee analyst Henry J. Coffey. Guggenheim analyst Darst also believes that shareholders will benefit from continuing stock buybacks. That said, Discover's growth prospects are the most modest in the group, so the expectations for the stock are also moderate. At $33.16, it sells for 9 times estimated earnings of $3.89 per share for the fiscal year that ends this November. Darst expects the stock to sell for $37 within a year.

MasterCard (MA)

MasterCard was one of the best-performing stocks of 2011, soaring 67%. To some extent, that was compensation for a 12% decline the previous year, as investors fretted about the impact of the Dodd-Frank financial-reform law and cuts to so-called interchange fees, which are the company's lifeblood. (Unlike Capital One, American Express and Discover, MasterCard and Visa have no credit exposure. They make their money on transaction fees, leaving the credit risk to the banks that issue their cards.) But as consumers all over the globe become increasingly accustomed to paying with plastic -- debit or credit -- what MasterCard loses in profit margin, it makes up in volume. Analysts expect earnings to jump 17% this year, to $21.95 per share, and by an average of 20% annually over the next three to five years.

MasterCard shares have returned 14.7% so far this year. At $427.52, they sell for 19 times estimated earnings, so the stock is no screaming bargain. Indeed, analysts at the Edward Jones brokerage firm recently downgraded the stock to a hold because they don't anticipate continued outperformance at today's prices.

Visa (V)

The Visa story largely mirrors that of MasterCard. The company continues to grow rapidly as it convinces an increasing number of customers -- particularly overseas consumers -- to use its credit and debit cards. Analysts expect Visa's earnings to grow at a 19% clip over the next three to five years. Meanwhile, the company is buying back $500 million of its own stock, which will help maintain double-digit-per-share earnings growth even when revenue growth moderates.

That said, Visa hasn't been able to boost profits as rapidly as MasterCard, making it a somewhat less compelling value. Plus, at $119.35, the stock, which returned 45.2% last year and has gained 18% so far this year, sells at a pricey 20 times estimated earnings of $5.96 per share for the year that ends this September. "We are trimming back a bit on our holding in Visa," says Rolfe. "At these valuations, it would be very difficult for the stock to repeat its performance of last year."

Follow Kathy on Twitter

ORDER NOW: Buy Kiplinger’s Mutual Funds 2012 special issue for in-depth guidance on the only investments you need.