The first four articles in this series focused on big-picture issues such as the income statement, balance sheet, return on equity and cash flow. Narrowing prospective investments based on the big picture may still yield too many candidates. How can we find the real diamonds in the rough? By analyzing the details.

Analyzing the details involves examining many similar companies and finding little accounting and operational differences that can show when there is the potential for “gaming the system” and when a company is being so conservative that you can believe the numbers.

We got caught in the downdraft that affected the stock price of Capital One Financial since last summer. The company stunned the world on July 16, 2002 when it announced that it had entered into a Memorandum of Understanding (MOU) with banking regulators. As it turned out, regulators had started applying new, unwritten guidelines to Capital One in response to problems at other companies that lend to subprime borrowers (i.e., people with shaky credit). Under the new definition, Capital One had more subprime loans than was previously believed, reinforcing the bears’ argument that this was just a subprime lender rather than a broad-based lender. The stock fell 40% the next day.

The company also forecasted that bad debt would rise. Reports over the coming months and quarters confirmed that forecast and further reinforced the perception that Capital One was just a subprime lender. But, was it?

How could we get at the truth? We performed a careful comparison to a company that was considered much cleaner, credit card lender MBNA. MBNA was considered to be a “prime” lender, lending to people with higher incomes and better credit than the subprime market. The comparisons were startling.

The preliminary rules that had been first applied to Capital One were finalized last fall and MBNA needed to change its policy for recognizing bad loans. MBNA had previously charged off debt after it was delinquent for 210 days, while the new standard called for 180 days. Capital One had already been charging off bad debt after 180 days even before the regulatory crackdown. Capital One charges off loans to customers that declare bankruptcy within 30 days while MBNA is within 60 days. Fraud losses are charged off within 60 days at Capital One, but 90 at MBNA. Despite its fast growth, Capital One had actually taken the more conservative route.

Capital One also appears to be more conservatively reserved than MBNA against increases in bad loans. Take a look at their respective Allowance for Loan Losses (ALL or “bad debt reserve”) as a percent of chargeoffs and delinquencies as of 12/31. The ALL represents a provision for bad debts that may occur in the future and has already been counted as an expense on the income statement. Capital One had a reserve of 150% of 2002 chargeoffs while MBNA was less than 100%. Capital One’s ALL covered 95% of delinquencies as of 12/31 while MBNA's ALL covered 89% of delinquencies. Again, Capital One had taken a conservative approach to guard well against increases in bad loans.

One of the new rules applied to the credit card industry involved how the companies account for “recovering” (i.e., getting paid back) debt that had been previously charged off. MBNA incurred a "one-time" charge of $263.7 mill., dwarfing COF's $50.6 mill. (net) charge for the same thing. MBNA's charge was 5x Capital One's charge even though their portfolios are about the same size. This further underscores my previous point that Capital One has been more conservative than most people think.

Despite the challenges that faced Capital One in the nine months following the July 16 bombshell, the above facts encouraged us to stay with the stock. As of this writing, Capital One is up 55% since the close on July 17, 2002.

Essential takeaways:

1. Try to identify several small details about companies in which you consider investing and compare the company to several good competitors.
2. The problem is that each industry has its own norms and reporting nuances, so generalizations won’t work.
3. Once a company has passed your big-picture criteria, it is often the little things that make the difference between a great investment and a mediocre one.

This illustration is provided for educational purposes only. No securities recommendations are intended. The author owns shares of Capital One Financial.