Will Discover Feel the Love?

04/22/2009 12:00 pm EST

Focus: STOCKS

Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

Andrea Kramer of Schaeffer’s Investment Research says the credit card company’s stock is facing some key technical challenges in its effort to move higher.

In search of an "unloved" stock, the Motley Fool screened for equities that are trading at least 60% below their 12-month high, boast a return on equity greater than 10%, and have a minimum market capitalization threshold of $100 million (“Are These Cinderellas Worth a Shot?,” April 8th). This criteria helps search for stocks that "have factored in bad news already," and eliminates some of the small-cap firms that might not have much information available.

Digging through the results the Fool points to Discover Financial Services (NYSE: DFS) as an intriguing contrarian play, as the Street seems overly skeptical of the security. For instance, many analysts are forecasting "the death of credit cards"—a prediction the columnist says seems unlikely. The author also highlights Discover's net tangible assets of $11.51 per share, significantly lower than the stock's recent selling range, and concludes that the company could potentially "absorb a 12% default rate and still have more value than the market is giving it credit for."

As the article pointed out, Discover Financial has few fans on the Street. The equity currently harbors only three ratings of Buy or better, according to Zacks, compared to eight Hold or worse ratings. In addition, the average 12-month price target on DFS rests at $8.08, Thomson Reuters reports, [just below Tuesday’s close of $8.23—Editor.]. However, to be a successful contrarian candidate, the struggling shares must be on the brink of a significant rebound. On that note, let's take a look at DFS from a technical perspective.

Since grazing the $20 level in mid-2008, the shares of DFS more than halved themselves, surrendering 28% just in 2009. But, since falling to the $5 region in early March, the security has pared a fraction of its losses, advancing [more than] 50%.

While this turnaround is quite impressive, the equity still faces a couple of layers of resistance on the charts. First, the stock's 20-week moving average is hovering just overhead, and has capped all but a handful of DFS's rally attempts since mid-2008.

In addition, peak call open interest in the front-month April series of options rests at the $7.50 strike. As April expiration fast approaches, this heavy accumulation of bullish bets could act as options-related resistance in the near term.

If DFS can manage to conquer resistance in the $7.50 neighborhood, the skeptics on the Street could get spooked. A noteworthy display of muscle on the charts could inspire analysts to issue upgrades and/or price-target boosts, which could serve as additional catalysts to the up side. (It recently broke through that level and hit intraday highs below $9 before retreating—Editor.)

Subscribe to the Option Advisor here…

Related Articles on STOCKS