Economic worries, regulatory reforms not as detrimental to issuers as once believed

We’re pretty bullish on the group, said Sanjay Sakhrani, an analyst at Keefe, Bruyette & Woods.

Bullish investors have been well-rewarded. Shares of all five major credit card companies are up double-digit percentages this year, primarily because worries about a new economic downturn have receded, suggesting that recession-scarred consumers might be ready to spend. And the regulatory reforms don’t appear to have been as detrimental to credit card issuers as once feared.

Here’s a look at the industry’s Big Five:

American Express (AXP): AmEx gained 11.6 percent, including dividends, last year, compared with a 2.1 percent return for the overall stock market. In 2012, the stock has returned nearly 26 percent. At $59.06, it yields 1.2 percent and sells for 14 times the $4.25 per share analysts, on average, expect the company to earn in 2012. Meanwhile, analysts see earnings growth of about 11 percent annually during the next three to five years.

Analyst David Darst at money management firm Guggenheim Partners just increased his target price to $63 because the company is repurchasing shares. On March 26, AmEx announced its board had authorized the repurchasing of 150 million shares, as well as an 11 percent increase in the quarterly dividend, to 20 cents a share.

David Rolfe, manager of the RiverPark/Wedgewood Fund, said AmEx’s practice of pouring profits back into the business, largely by paying outsize rewards to premium cardholders, held back the stock in the past.

We think reinvesting in the business has paid off, but at some point you want to tell management to let this horse run, he said. Let’s see what you can really earn.

Capital One Financial (COF): Capital One was flat in 2011. But it’s on a tear this year, with a gain of nearly 35 percent. At $56.98, the stock sells at 10 times estimated 2012 earnings of $5.87 per share, projections that anticipate Capital One will earn less in 2012 than it did in 2011. But most earnings estimates do not factor in Capital One’s purchases of ING Direct and HSBC, which were just approved.

Capital One is Sakhrani’s top pick. He said these deals will ultimately prove profitable for shareholders, making Capital One the fifth-largest bank in the U.S. The company became a bank partially by default; it was looking for a good way to fund its credit card loans, and low-cost deposits fit the bill.

Sakhrani expects the stock to sell for more than $68 within the year.

Discover Financial Services (DFS): Thanks in part to buy ratings in December from analysts at Guggenheim and Alabama-based brokerage firm Sterne Agee, Discover returned a solid 31 percent last year. And it has returned an additional 38 percent this year.

Discover now makes private student loans and residential mortgages, hoping to capitalize on less competition and risk in these areas. Private student loans, once the Wild West of lending, are now made largely with employed co-signers. Mortgage lending has also become more conservative as appraisers and lenders have acknowledged that real estate prices can drop as easily as they can rise.

Discover’s credit quality has improved, said Sterne Agee analyst Henry Coffey. Guggenheim analyst Darst also believes shareholders will benefit from continuing stock buybacks. At $33.16, it sells for nine times estimated earnings of $3.89 per share for the fiscal year that ends in November. Darst expects the stock to sell for $37 within a year.

MasterCard (MA): MasterCard was one of the best-performing stocks of 2011, soaring 67 percent. To some extent, that was compensation for a 12 percent decline the previous year, as investors fretted about the effect of the Dodd-Frank financial reform and cuts to so-called interchange fees, the company’s lifeblood. (Unlike Capital One, American Express and Discover, MasterCard and Visa have no credit exposure. They make their money on transaction fees, leaving the credit risk to the banks that issue their cards.)

But as consumers become increasingly accustomed to paying with plastic debit or credit what MasterCard loses in profit margin, it makes up in volume. Analysts expect earnings to jump 17 percent this year, to $21.95 per share, and by an average of 20 percent annually during the next three to five years.

MasterCard shares have returned 14.7 percent this year. At $427.52, they sell for 19 times estimated earnings, so the stock is no screaming bargain. Indeed, analysts at the Edward Jones brokerage firm recently downgraded it to a hold because they don’t anticipate continued outperformance at today’s prices.

Visa (V): The Visa story largely mirrors that of MasterCard. The company continues to grow rapidly as it persuades an increasing number of customers, particularly overseas, to use its credit and debit cards. Analysts expect Visa’s earnings to grow at a 19 percent clip during the next three to five years. Meanwhile, the company is buying back $500 million of its own stock, which will help maintain double-digit-per-share earnings growth even when revenue growth moderates.

That said, Visa hasn’t been able to boost profits as rapidly as MasterCard, making it a somewhat less compelling value. And, at $119.35, the stock, which returned 45.2 percent last year and has gained 18 percent this year, sells at a pricey 20 times estimated earnings of $5.96 per share for the year that ends in September.

We are trimming back a bit on our holding in Visa, Rolfe said. At these valuations, it would be very difficult for the stock to repeat its performance of last year.