A test of management competence (Capital One? Seriously?)

July 7, 2009

Benjamin Graham wrote in Security Analysis that  there are few tests of management competence and none of them scientific. This was in the 1951 edition of his book, and in almost 60 years there have been few improvements.

One reasonable test, however, is management’s opportunism and understanding of the broad economic climate. Although “proactive” is viewed as a desirable quality to the point of being cliche, being reactive is also a good quality. Although there is a risk of confirmation bias (remembering what management did but forgetting what management didn’t do), developing a history of management actions is about the only way to assess their competence.

At this point it may seem unusual for me to hold up Capital One, a credit card company that is writing off its accounts at an annualized 10% rate, as an example of management competence. Well, first of all, I didn’t say they had to be a positive example, but my focus is more on the financial than the operations aspect. Yes, they overexposed themselves to a risky credit market, but short of liquidating themselves it’s not immediately clear what they could have done to avoid it (not that they deserve a free pass for it). Given that their chargeoff situation is going to dominate their earnings at least until the recession ends, I cannot say they are an unqualified buy.

In terms of their financial maneuvering, however, Capital One has not done too badly. Like all credit card companies, they rely on securitization of their credit card holdings as a source of funding, In order to diversify their funding sources, in 2006 Capital One acquired North Fork bank. In 2007 they divested the bank’s subprime mortgage origination unit, when the housing situation was still a slowdown instead of a meltdown. Their reason for doing so was that, on top of the housing situation, credit cards are capable of pricing the default rate into the interest charged to people, rather than relying on a potentially nonfunctional foreclosure market. Earlier this year they acquired Chevy Chase bank, for the same reason. Also, during the brief euphoria that accompanied the initial passing of the TARP, when their stock jumped from 30 to nearly 60, they made a secondary offering of stock at 48, which, given the current share price of $20 and change, also shows some fairly prescient timing.

As I mentioned before, the credit card situation allows the issuer to price the default risk into the interest charged. As I shall explain in my next post, this assumption may be called into question by the upcoming legislation.

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