Is Capital One Financial the best bank stock for you?

Banks are important financial institutions that facilitate trade, but not all banks are the same. Capital One Finance (COF -0.21%)For example, has a unique business model that can lead to significant fluctuations in performance. Here’s why some investors will love this big bank while others will want to avoid it.

What does a bank do?

In simple terms, banks take deposits (checking and checking accounts) and then use that money to make loans (mortgages). Banks earn the difference between the interest they charge on loans and the interest they pay on deposits. Although large banks have far surpassed this simple model today, it is still at the core of many of the biggest names in the industry. Capital One does it, too, and regular banking is generally a pretty consistent and perhaps even boring business.

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What does Capital One do?

The thing is, Capital One’s retail banking business only accounted for about a quarter of the net interest income it generated in the second quarter of 2024. A far larger 70% came from the bank’s credit card business. Credit cards are a major business for most banks, but for Capital One Financial, they’re really “the” business.

To be fair, credit cards can be very profitable. And Capital One has a relatively high exposure to lower-credit borrowers, who tend to pay higher interest rates on their cards. So the bank’s card business can generate pretty solid profits. While this is a fairly aggressive approach in the banking sector, it’s also why more aggressive investors will like the stock.

The problem with Capital One’s approach

Credit cards are a valuable means of payment for consumers. When the economy is doing well, transaction fees and interest can generate high profits. But credit cards are usually one of the first forms of debt to go when finances become tight. And problems can crop up pretty quickly, especially during recessions. It should come as no surprise that Capital One’s stock price tends to drop sharply during economic downturns as investors try to offload riskier investments.

COF data from YCharts

To be fair, other bank stocks are falling, too. But with a more diversified and less risky business, economic uncertainty isn’t as troubling a headwind. To get an idea of ​​how quickly things can change for Capital One, one only has to look to the second quarter of 2024. In the first quarter, the company’s card business generated $961 million in profit. That fell to just $91 million in the second quarter. To be fair, there were some one-time items in the quarter, but the big quarterly drop shows how quickly things can change in Capital One’s business. Looking back a little further, Capital One’s net income fell 54% between 2019 and the pandemic-hit 2020.

Capital One continues to grow

However, Capital One Financial has managed to survive the difficult phases and, in particular, to continue to grow its business over time. Most recently, the company agreed to purchase Discover Financialwhich expanded its business significantly (doubling its credit card business). The company’s growth has caused the stock to rise over time despite sometimes jaw-dropping declines – which is why some long-term investors with strong stomachs will like the stock.

More conservative investors, however, are probably better off sticking with a bank that is more diversified and, frankly, boring to own. The upside potential may be less exciting, but that’s often the price to pay for a good night’s sleep.