How to get a 24% return in this economy

Credit card companies look really good right now, perhaps too good.  A friend of mine recently noticed that Discover is holding more than $11 billion in cash and other earning assets, while the market cap is well under $3 billion.  Although there is some debt on Discover’s balance sheet, the asset spread relative to total capitalization is much better than the industry average.  So are credit card companies your ticket to the big time?

Well, yes, but not in the way you’re thinking of investing in them.  The problem with Discover and all those other “undervalued” financial stocks is that they might not be undervalued.

While excess cash is king in this economy, Discover’s excess cash is tied up in working capital (which means it can’t be liquidated without bankrupting the company).  That cash may also eventually be needed to pay off long-term liabilities, so that even a company with excess working capital can see all their cash dwindle slowly over time.  That’s where the balance sheet comes in.

The balance sheet is a snap-shot of the company’s financial position that was taken in the past.  Not only that, but that snapshot represents the accountant’s best guess of what the assets and liabilities are worth.  As we’ve seen in the past few months since Discover last reported its financial position, assets can evaporate over night.  Worse still, liabilities can balloon.  Discover’s biggest asset is in the form of consumer debt.  When Frank, your college buddy with the bad credit, finally decides to walk away from his mounting credit card bills, Discover has to write down its assets by whatever he still owes.  But unlike many companies where assets and liabilities act as hedges against each other (when Circuit City goes bankrupt, Sony, at least, doesn’t have to deliver any more TVs), Discover’s liabilities stay the same, even when its assets decline.

So the key question you have to ask before investing in a credit card company is: will Frank come through on his debt?  If he does, Discover will win in a big way.  If he doesn’t, Discover will have to liquidate.  When that happens, shareholders will lose everything.

But wait, surely a big company like Discover can’t be worth nothing!  In a liquidation, it won’t be worth the plastic in your wallet.  Even though there will be ample assets in a liquidation (maybe even excess assets), the claimants on those assets will form a line a mile long.  First in line will be Macy’s, next in line will be Warren Buffet (who has bought senior notes, not equity, in his recent forays into the financial sector), and then, after a million other retailers and lenders, you, the shareholder, will get your opportunity to haul off what’s left.

If you are a shareholder in a major credit card company, there is some good news: Frank appears to be trying to pay off his debt.  NPR reported this morning that the percentage of owed credit that is more than 30 days overdue has fallen by 11% since last year.  As consumer debt shrinks, hope grows that the credit card companies may survive the credit crunch.  If they survive, the shareholder returns will be huge.

But not guaranteed.  Unless you’re big enough to issue senior debt, the only way you can get a guaranteed 24% return in this economy, is if you pay off your own credit card debt.