It was recently disclosed that both Warren Buffett and Seth Klarman bought shares of Synchrony Financial (SYF) in the second quarter of 2017.
Let’s take a look at why.
Synchrony Financial was spun off from GE Capital as a public company in 2014.
It’s the largest issuer of store credit cards in the country. When Amazon, Lowe’s, Walmart, and many other retailers issue branded store credit cards, those are Synchrony’s cards. They also offer CareCredit- a way to pay for medical expenses with debt.
In order to fund those loans, they have a lean online bank that offers high interest rates relative to its peers, thanks to low physical expenses. This allows their clients to save money and earn returns that at least keep up with inflation.
Credit Cards: Cheap but Volatile
A couple weeks ago, in an article on Modest Money called The Safest Banks to Invest In, I discussed the U.S. Federal Reserve’s assessment of the largest financial institutions in the country, and showed this graphic:
It shows the estimated loan loss rates for the top financial institutions in the country if we were to encounter a recession as severe as the one from 2008. At the top of the list of loan loss rates are the banks that focus on credit cards.
American Express (AXP) and Discover Financial Services (DFS) have conservative underwriting standards, meaning they focus on lending to people with high credit scores. However, despite their high standards, they are basically pure-play credit card issuers, and credit card debt takes the biggest hit in recessions.
Capital One (COF) also has a large credit card presence, but is more diversified. It still has high loan loss rates because its not as conservative of a lender as American Express or Discover.
Here’s a chart showing the net charge-off rates of the major card issuers from the first quarter of 2017:
As you can see, Capital One and Synchrony are at the top of the list, meaning the highest rate of people unable to pay back their debts. Capital One is the most aggressive issuer of standard credit cards, while Synchrony is the largest issuer of store cards in the country, and store cards generally have pretty low limits and low credit score minimums.
Since it’s a less critical financial institution, Synchrony doesn’t appear on the Fed’s stress test loan loss chart. However, their stress test results can be found on their website.
The most relevant graphic from that report is here:
Synchrony would have by far the highest loan loss rates according to the latest stress test, as shown above. A full 21% of the portfolio would be wiped out if were to have another “Great Recession” according to the model. That makes Discover’s 13% potential loan loss rate look tame in comparison.
This is because Synchrony is a pure-play credit card issuer, but is not as conservative in its lending as American Express and Discover. Despite that, Synchrony passed its stress test; they have enough capital on hand to take a hit of that magnitude.
Why Synchrony is Popular Among Value Investors
Berkshire Hathway, the company controlled by multi-billionaire Warren Buffett, recently acquired over $500 million worth of Synchrony stock. Since it’s not a large position, it’s unclear if it’s directly Buffett’s decision or one of his portfolio managers, but it’s a brand new position. However, Buffett’s company owns a $13 billion stake in American Express as well; his fifth-largest equity position. He’s clearly bullish on credit cards.
Seth Klarman, the billionaire manager of the Baupost Group, is one of the most famous value investors in the world. His hedge fund is one of the few that have outperformed the market for over three decades. He recently increased his position in Synchrony, and it’s now his second largest holding, representing 10% of his equity portfolio. He’s betting hard on it.
The apparent reason is clear: valuation.
While most of the stock market has rallied year-to-date in 2017, Discover, Capital One, and Synchrony went down this year, and both Buffett and Klarman bought Synchrony on the dip.
Here’s Synchrony’s chart:
The reason that these companies all took a dip is because credit card net charge-off rates started to show signs of rising across the industry. From conservative issuers like Discover to aggressive issuers like Capital One and Synchrony, loan loss rates ticked upward. Investors worried that perhaps big losses were coming soon.
Discover is currently trading at 9.4x estimated forward earnings, while Synchrony is trading at 9.6x estimated forward earnings. Both stocks have a lot of fear built into their valuations, but both of them have comfortably passed stress tests showing that they can withstand unusually severe recessions. Discover is trading at a higher book value multiple (2.1x) to Synchrony (1.7x), because Synchrony has to keep a larger capital hoard around to deal with their potentially larger loan losses during a recession.
I personally prefer Discover because it’s conservative and yet almost as cheap. Their CEO David Nelms has been at the helm for over 13 years, since before Discover was spun off from Morgan Stanley in 2007. Under his leadership, the company remained profitable throughout the financial crisis, and emerged stronger after it.
Synchrony is a newer company, is less conservative, and has not been battle-tested through a recession, but its stock is a bit cheaper than Discover on book value basis. Discover is buying back its cheap shares (a full 2% of its market cap each quarter) while Synchrony is a net issuer of shares.
I’m bullish over the long term on both. These two billionaires seem to prefer Synchrony, most likely because it’s the cheapest and most volatile of the credit card issuers, but fast-growing, and they see value in the industry.
Disclosure: Author is long Discover Financial Services.