Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, just made news when he added Capital One Financial to the company's portfolio. Buffett bought nearly 10 million shares; it was the company's first position in the bank.

Capital One is the ninth-largest bank in the country, with most of its revenue coming from its credit card business. Anytime Buffett adds a new position to his portfolio, it creates interest among investors. But if given a choice between Capital One and a similar stock, Discover Financial Services (DFS -1.31%), I'd buy Discover first. Here's why. 

Discover the potential

Capital One and Discover are similar in that they are both banks that generate significant income by issuing loans for credit card customers. But they are different in that Capital One is just an issuer, while Discover is an issuer and payment processor with its own closed loop network.

Discover is just one of four major payment processors, and it is the smallest of the four behind Visa, Mastercard, and American Express. While the first two are simply networks and not issuers or lenders, American Express has a business model that's similar to Discover's as a closed loop credit provider. Closed loop refers to the fact that Discover's network is entirely its own, as it issues the cards, lends the money or credit needed for purchases, and collects the interest payments and fees.

So, Discover generates revenue from interest on its loans, as well as swipe fees when the card is used to purchase something, and other fees. But the bulk of it -- in the most recent quarter about 80% -- comes from interest income.

As banks that rely on consumer spending, both companies are fairly cyclical, but Discover has been far more consistent, outperforming in bear markets and in more difficult economic environments. Over the past 10 years as of May 24, Discover has posted an average annualized return of 7.7% compared to 5% for Capital One. When looking at the total return including reinvested dividends, Discover is at 10.1% while Capital One is at 7.2%.

It should be noted that Discover has had a more consistent dividend, increasing it for 12 years straight, while Capital One was forced to cut its dividend from $0.40 per share to $0.10 per share at the start of the pandemic in 2020.

A better buy

Discover has been the better performer over the past decade, and there is reason to believe it will remain a more consistent stock.

For starters, it is undervalued right now with a trailing price-to-earnings (P/E) ratio of 6.5. Capital One is even cheaper, with a P/E ratio of 5.4, and it is trading below book value with a price-to-book ratio of 0.71. Its low valuation may have been one of the primary factors that attracted Buffett, a noted value investor who likes banks.

Aside from its low valuation, there are a few things I like about Discover. One, while it is the smallest player, Discover has carved out a nice niche for itself as a payment processor and network with its cash back bonus feature, which comes out of its fees. And with only four players in the market, and only two with their own closed loop network, it's a pretty durable business.

Also, because it is not a traditional consumer bank, it has less in deposits than Capital One and other banks, thus lower deposit costs. So, in this period of higher interest rates, which won't likely end anytime soon, Discover will benefit more, with higher net interest margins. At the end of the first quarter, its net interest margin (NIM) was 11.34%, up from 10.85% a year ago and 11.27% at the end of the fourth quarter. Capital One's NIM was 6.60% at the end of Q1, down from 6.84% at the end of Q4.

Finally, I like its efficiency with a high operating margin of 51% and a robust 30% return on equity. That translates to a rising amount of operating cash flow at its disposal, about $7.2 billion in the first quarter, for dividends and other investments. 

Its value, stability, consistency, and efficiency are all reasons I prefer Discover to Capital One.