2 Stocks to Buy for 2018

Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel look at two stocks that they feel are excellent choices for investors as 2018 gets under way. Here's why they think Synchrony Financial (NYSE: SYF) has an excellent business model, and why healthcare REIT Welltower (NYSE: HCN) looks attractive for long-term investors.

A full transcript follows the video.

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This video was recorded on Jan. 8, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Jan. 8, and we're kicking off Financials' first New Year's episode by pitching two great stocks to put on your watch list in the new year. I'm your host, Michael Douglass. I'm joined by Matt Frankel. Matt, I know I'm a week late. I was also on vacation last week. So I'm just wishing everybody a Happy New Year today! Happy New Year to you, too! And I hope it's been a great 2018 thus far!

Matt Frankel: Happy New Year to you! Hopefully it's not as cold up there as I think it is.

Douglass: [laughs] It's definitely cold and sunny in Alexandria, Va. But it was a lot colder in Vermont, where I was. In fact, it was so cold that on the drive down, we had the car heated, of course, because that's what you do in the winter, so it was 70 or 72 degrees indoors, but it was so cold as we were driving that the windows iced on the inside. My wife was actually using a scraper on the window while I was driving.

Frankel: Wow! It got down to 12 in South Carolina, where I am, which is unbelievably cold for the state.

Douglass: We were in the negative-20s in Vermont. It was a lot of fun in a lot of ways. I actually got to check a bucket-list item off my list, which was to hike in sub-zero temperatures. I've done that. I don't plan to repeat it. [laughs] I'm certainly glad to be in slightly warmer Alexandria, Va., today.

Frankel: I don't miss the extreme cold of the Northeast at all.

Douglass: No. I'm certainly not missing it right now. But to all of our listeners who are in the Northeast, stay bundled up, stay warm, drink an extra cup of hot cocoa for us. Let's turn to a couple of stocks to pitch for the start of the new year. Matt, why don't you lead us off with Synchrony Financial?

Frankel: Synchrony. I tend to refer to it in articles as the biggest credit card company you've probably never heard of. If you have any store credit cards, you might already be a customer of theirs. To name a couple of the big ones, they issue Wal-Mart store credit cards, Gap, Dick's Sporting Goods. I have a Rooms to Go credit card that's issued by Synchrony. And Amazon's store card, the one that doesn't have the Visa logo on it, is a Synchrony product. They also do the CareCredit product, which allows people to finance medical expenses at 0% interest. It's accepted at a ton of doctor's offices nationwide. We use it to finance our vet bills, actually, because we have one dog that gets sick a lot. But, that's kind of an overview of what Synchrony does, in 30 seconds.

Douglass: Synchrony's ticker symbol, by the way, folks, is SYF. I'll note, as well, it's interesting, because when you look up Synchrony, it functions a lot like a bank. It takes in deposits, usually on, as far as I can tell, just on interest-bearing accounts. We're talking money markets and CDs. And if that reminds you of Bank of the Internet a little bit, it probably should. Then, as you noted, Matt, it's very heavily into credit cards.

Frankel: Yeah, they're becoming more of a deposit-based business model over the past couple of years. Their deposit growth was actually very impressive in 2017. Right now, on Synchrony's website, they have a 12-month CD advertised at 2% interest, which, if you've shopped around for a CD recently, that's pretty much unheard of. They have longer CDs up to 2.4% right now. So their business model is similar to BofI, which we talked about, and some of these other online-based banks, like Goldman Sachs' Marcus Bank, where, because they don't have the cost of making any brick-and-mortar banking branches, can offer higher, more competitive interest rates to attract deposits. And it looks like it's working, at least in their case.

Douglass: Yeah. It's interesting, because you think about it, the financial hacker crowd in particular, the folks who are like, "Let me find how to get an APR that's just a little bit better than my money market account, or a little bit better than my CDs," those are the kind of people that tend to be really attracted to companies like Synchrony Financial and their products on the deposits side. And frankly, those are the sort of really financially savvy people that a bank tends to want to have as their customers, because they're the sort of folks who they can hopefully cross-sell to later on.

Frankel: Definitely. On the surface, if you think of how much they're paying out in interest, and the fact that store cards tend to have a higher default rate than general credit cards, right now, Synchrony's is just under 5%, which means for every $1,000 in purchases that people make on Synchrony, $50 of that is not going to get paid back. Which may sound like a very risky business model. But the flip side of that is, store credit cards tend to have higher interest rates than standard credit cards. I think the standard, Visa, MasterCard, American Express, has about a 16% interest rate these days. And store credit cards tend to be in the upper 20s. So the difference in interest rates actually makes an interesting business dynamic. It more than makes up for the higher cost of deposits, and the higher default rates.

So Synchrony's profit margins are actually pretty sky high. To give you a little bit of context, Synchrony's net interest margin is almost 17% right now. That's more than the average credit card charges in interest, period, before you factor in things like cost of capital and default rates. So it's a huge profit margin that we're talking about.

Douglass: Yeah. Of course, on the flip side is this issue that there's going to be more volatility in a business like this, because they're in not just a riskier pool in general, which is credit cards, but kind of on the riskier end of the credit card pool. And one of the things that's a caution for me, at least, when looking at this company, is that Synchrony hasn't been public for very long. Their IPO was in 2014. So we don't have that much historical data, and we don't really have a clear sense of how bad things got during the Great Recession. And that's something I tend to like to look at when I'm considering a fundamentally loan-based operation like Synchrony. But I have to say, certainly, when times are good, it looks pretty darn good.

Frankel: Definitely. A couple of things worth pointing out. First of all, before the IPO that you just mentioned, Synchrony was a part of General Electric, the GE Capital division. They keep enough in reserves to cover if 7% of their loans wind up defaulting. So they actually have more in reserves than their current charge-off right by about a 2% margin. So even if things got a little bit worse, they could have some cushion to where it could get a lot worse than it is right now, and they would still have enough in reserves to more than cover their losses.

Douglass: And one of the other things that I'll add to that, on the flip side, another green light, if you will, is that it's an incredibly efficient business. When we talk about efficiency ratios, we want to see an efficiency ratio under 60%, generally speaking. Synchrony's is 30.4%.

Frankel: Right. That means for every $1 in revenue they're generating, they're only spending $0.30 to get it. That's a remarkably low efficiency ratio for a bank. The industry standard for return on assets for a bank is 1%. Synchrony's is 2.4%. So this is a very profitable and very efficient business right now. Like you said, I wish I could see what they were doing during the Great Recession, or have some kind of context in an environment where things weren't going great. But for the time being, and in good markets, they're very efficient and very profitable.

Douglass: One of the other things we should touch on here is some of those partnerships. Of course, you mentioned a number of partnerships that they already have. They've also been adding some new ones lately.

Frankel: Yeah. Zulily as one of their newest ones, and they just recently expanded their partnership with PayPal as well. That's becoming one of their bigger ones. The CareCredit medical financing that I mentioned earlier -- they just recently added, I'm not exactly sure what they're calling it, but it's a Visa card as well, so you can use it at places other than doctors' offices, which could be a big deal, because it's becoming a very popular product for people financing their medical expenses with no interest. So there's a bunch of different growth avenues, and I wouldn't be surprised to see them add a few more stores, especially some online retailers to add to their Amazon in the coming years. I think their portfolio is going to get a lot bigger.

Douglass: Yeah, it's a very interesting business. I will say, again, it's definitely only appropriate for the more risk-tolerant investor. But for all of that, it is a very interesting company, and one that certainly has a lot of growth opportunity. The hope is, with those low-cost deposits -- which, again, they're still paying out more than anybody else on them, at least anyone that we're aware of offhand -- but their cost basis is just so darn low that they can afford to do that. You have to think that's a pretty good opportunity for the business' growth long-term.

Frankel: Definitely. It's also worth pointing out that interest rates could be a big catalyst over the next couple of years. Things like mortgages and auto loans are not directly tied to Federal Reserve rate hikes, but credit cards are. If you look at your credit card cardholder agreements, they'll generally say something like prime rate plus a certain percentage. So if the Fed raises rates six or seven more times over the next three years, like they're planning to do, this could really raise Synchrony's profit margins. Generally, their deposit payout rates don't rise at the same speed as the Fed rate hikes, so this could expand their already impressive margin even further.

Douglass: Yeah. I think there's a lot to like there. And I actually plan to do some more due diligence on the company myself. We've done enough for a good summary today, but I'm going to run it through my wringer.

Anyone who's been listening to Industry Focus for a long time knows that Dylan Lewis and I did a whole episode on how I think about investing in companies and how I approach that. If you would like that episode or my write-up on how I approach that, shoot us an email, industryfocus@fool.com, and I'll be happy to dig them both up. But on average, my process takes me about eight hours per company.

I didn't quite have that amount of time this morning. [laughs] Especially because I wanted to talk about another stock, Welltower, that's ticker symbol HCN. Now, I'm hearkening back to my healthcare roots here a little bit, because Welltower is kind of, in a lot of ways, a crossover stock. It's a financial stock, a financial company, because it's a real estate investment trust, or REIT. What that means is, real estate investment trusts, you can tell from the name, invest in real estate. Their real focus is in owning property, usually. There are also mortgage REITs, but I tend to only look at equity REITs, which own actual property. Then they lease that out to, if it's an apartment REIT, they lease it out to renters. If it's a hospital REIT, then they're leasing it out to hospitals. And they have to pay out 90% of their otherwise taxable income to shareholders in the form of dividends. So they can be really powerful dividend stocks.

Welltower specifically invests in healthcare and senior-focused properties, particularly senior housing. Now, thinking really broad brush here, every day from now through 2029, 10,000 baby boomers are turning 65. So there's a lot of reason to like healthcare and senior-focused properties. And let's also face it -- healthcare in general is moving toward cheaper outpatient settings, typically in an attempt to, as all these more people continue accessing the healthcare system, trying to find ways to cut costs so we don't get totally swamped as a society. And as a result, Welltower has really shifted its portfolio toward these lower-cost outpatient settings.

Anyway, that's all the macro stuff, and that's all well and good, but frankly, when you think about macro healthcare, or macro aging of America, there are a lot of companies that could theoretically benefit. So the question then is, why Welltower specifically? And I think there are two key reasons to like it. One of them is, 93% of Welltower's in-place net operating income comes from private payers. That means not a government insurer. Many senior operators are heavily exposed to government payers, so when Medicare or Medicaid decide to cut rates, they get slammed. That's a big problem for them, because sometimes it's a little bit difficult to predict exactly what the government is going to do, particularly when Congress changes parties.

So Welltower has 93% of its revenue not dependent, directly, at least, on the government. And that's a good thing, because that means a lot of that is commercial insurance, or people renting senior housing themselves. That leaves it operating in a stronger position on the whole.

The second thing is, they have what I would consider both geographic density and dispersion. It's very geographically diverse. It operates across the United States, Canada, and the U.K., but also a lot of density in urban markets. About 15% of operating net income is in Los Angeles. About 9.7% in Boston. You get the idea. These tend to be urban areas with high barriers to entry. Permitting isn't easy; building expenses are high. That gives them a really nice spot in the market, where it's going to be hard for a lot more stuff to come on the market, which basically means they and their operators will have some pricing power. And that's a really good thing for shareholders long-term.

Frankel: Yeah, definitely. Welltower considers one of their big competitive advantages to be that their properties are newer than those offered by the competition, and they're in areas where people can afford to utilize their services. As you said, most senior housing is private-pay. That's the right kind, in my mind, of senior property to invest in. The other side is skilled-nursing facilities, which tend to be more Medicare and Medicaid dependent, which have been absolutely getting crushed lately, if you own any of those types of stocks. They tend to like to find properties located in affluent areas. They're actually developing one in Midtown Manhattan right now, which is a very underserved market.

Douglass: And also pretty wealthy.

Frankel: Yeah, definitely. The idea is, the people who live there can actually afford to privately pay for their services, which gives them a competitive advantage over other companies who might own senior housing in less affluent markets.

Douglass: Yeah. It's interesting, because looking at all of that, my initial thought is, fantastic stock. On the flip side, there are a couple of things that I think any investor thinking about Welltower should be aware of. It's one of the largest REITs in the country, so Welltower isn't in the same ballpark as Synchrony Financial in terms of volatility and risk. But when you look at it, there are still a couple of things to consider, one of which is, Welltower is, about 70% of their property is senior housing. Of that 70%, 36% is represented by a single operator, Sunrise Senior Living. And the top five partners add up to 76% of that 70%. So a significant portion of their money is concentrated in just a few businesses. So if you invest in Welltower, you're also investing in a bet that Welltower has picked good businesses to work with, and that those businesses aren't going to have something happened to them.

And this is one of the problems with REITs. Their money is largely dependent on other people. It's not just, do they do a good job of negating risk on their side? It's also, do the people they're serving, do the folks who are tenants and operators, also do a good job at that? And that's an incredibly difficult thing to figure out. So that's definitely for me something that you should always keep an eye on and be aware of.

Frankel: In Welltower's case, it's also interesting to point out that senior housing makes up about 70% of their portfolio. About half of that is structured as operating partnerships with their tenants, like Sunrise. Brookdale is another big one. I'm not sure of the exact percentage. It's less than 35%, but it's still a significant portion. So if the tenant does well, the properties are generating profit, Welltower benefits from that as well. They're not just a landlord collecting a check. Which is an interesting distinction between them and, say, an apartment REIT, which generally just collects a check from their tenants.

Douglass: Yeah. And that does mean, in some ways, that Welltower does get to participate extra in upside, but it's also going to participate extra in downside. So in some ways, that makes them a little bit riskier. Of course, I think, whenever you buy a company, I think it's core that you're betting on management, and you're betting that they're good people who know what they're doing. So I would say both trustworthy and competent. And if you're concerned about that, don't buy. Straight up, don't do it. So, for me, I'm comfortable with Welltower's management team and what they're doing.

Another thing to point out here is, we just talked about, Synchrony Financial will probably benefit, will probably have a catalyst as a result of these interest-rate increases that are signaled by the Fed. REITs as a whole tend to suffer when interest rates increase. So Welltower is on the other side of that, because they're taking out debt to fund new properties, buy other properties, and things like that. So, what that means is that new debt is going to cost them more money, which means that their profit margin on what they're able to make on other properties will decrease, all other things being equal.

So that's kind of a problem for REITs as a whole. It's one of the reasons that Welltower's stock hasn't really done that well in the last year. Of course, the flip side of that is, I tend to think when the tide goes out, you tend to see who's quality and who's not. And that could be really helpful, actually, for investing in, for example, REITs. You look at Welltower's balance sheet, which I think is appropriately levered, and you look at their debt profiles from the rating agencies, the Moody's of the world, and generally, things look pretty good.

So my hope is, while all REITs will suffer, some will suffer a lot more than others. So folks like Welltower, if they have a competitive advantage, that will express itself more fully in the coming years.

Frankel: Yeah, definitely. I already mentioned that the Fed is expected to hike rates several more times over the next few years. The thing to really pay attention to is, if that happens quicker or a little more slowly than expected. If the Fed ends up hiking rates quicker than you think they're going to, that's when you're going to see the REIT sector really take a beating, which is what happened in 2017. REITs were barely up for the year, while the rest of the market was up by 20%-25%.

So this is a thing to keep an eye on. I think a lot of the interest-rate hikes are mainly priced in at this point, which is why Welltower is, I believe, and I think Michael does, too, on sale right now.

Douglass: Yes. [laughs]

Frankel: It's one of the few areas of the market that actually looks really attractively valued, and that's why, it's because they're expecting so many interest rate hikes ahead. In 2017, the economy improved a lot quicker than people thought it would, and that was a very negative thing for most of the REIT sector. Like you said, quality REITs should be fine no matter what, should do better than most. And Welltower is definitely a quality REIT. I like Welltower here. Full disclosure: I own the other big healthcare REIT, HCP, which I say is 90% the same business idea. So this is one area of the market that's still a bargain right now.

Douglass: Yeah, and I'm certainly thinking about my REIT exposure this year in 2018. That's actually one of my New Year's resolutions, to think about rebalancing my portfolio, and thinking through which sectors I think are most attractive in the coming years. So we'll talk, I'm sure, quite a bit more about that, this year.

Matt, as always, thanks for your time. Folks, that's it for this week's Financials show. And by the way, that's also it for next week's Financials show, because we won't be having a Financials show. It's Martin Luther King Jr. Day, and we will be out. Fool HQ is closed. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel owns shares of American Express, HCP, and PayPal Holdings. Michael Douglass owns shares of Amazon, BofI Holding, and Mastercard. The Motley Fool owns shares of and recommends Amazon, BofI Holding, Mastercard, Moody's, PayPal Holdings, and Visa. The Motley Fool recommends American Express, Synchrony Financial, and Welltower. The Motley Fool has a disclosure policy.