The Coronavirus market panic created an opportunity for us to buy companies we’ve wanted to own at great prices. Discover Financial Services (DFS) was one of them.
Consumer financial stocks were hit hard during the market panic. Discover Financial dropped 70% from Jan 22, 2020, to March 20, 2020.
The prevailing fear was that the U.S. was heading for a depression. Mass job losses and business closures meant credit card companies were about to experience rapidly increasing defaults and tremendous business risk.
Things changed when the first stimulus checks went out in early April 2020, the first round of PPP started, and unemployment benefits increased. The Federal Reserve also unleashed all of its monetary programs that had been established during the Great Financial Crisis. The narrative of the next Great Depression melted away and what started to emerge was a K shaped recovery.
In a K shaped recovery parts of the economy like technology, software, and e-commerce recover rapidly while other industries like dining, travel, and entertainment continue to suffer declines.
The K shaped recovery has played out at the individual level too. High earners and those in information-based industries have fared much better in the recovery than lower earners and workers in service related industries.
Discover’s client base tilts towards the high end of credit scores with FICO scores above 660.
“Historically, the company has noted that accounts with FICO scores below 660 have larger delinquencies and credit losses than those with higher credit scores.” – From Discover Financial Services 2020 Annual Report
The table below is Discover Financial’s average credit score per year for its credit card loans, student loans, and personal loans.
Credit scores do not factor in income they just measure credit risk. Income is a part of risk capacity, a person’s ability to pay their bills. Discover focuses on consumers with high credit scores and high risk capacity. We believed that they were well positioned to benefit from the consumer K shaped recovery and that they weren’t at risk of cutting their dividend.
We first bought discover around $45 per share. We thought on the low-end the company was worth around $65 per share and $85 per share on the high end. We expected our investment thesis to play out over a couple of years. We didn’t expect it to be realized and exceeded in less than a year. Because of its strong price run, Discover exceeded our maximum position size rules, but until recently the unrealized gains were all classified as short-term gains (held less than a year). Discover is now a long-term gain and per our position size rules, we trimmed Discover back down to its target weight.
We continue to view the company favorably and have not eliminated it from the dividend strategy.