Don't Leave Home Without This Stock
We dig into the Ultimate Stock-Picker's Portfolio's Amex position.
In managing The Morningstar Ultimate Stock-Picker's Portfolio, I'm on a constant search to buy a great business at a good price. You can imagine my excitement, then, when I discovered that not only do a large percentage of the managers I follow own American Express (AXP), but my colleague at Morningstar, Michael Kon, also has it rated 5 stars.
I initially added American Express to the portfolio in late March, and it almost immediately started adding positive alpha. In the last month, though, coinciding with the sell-off of almost all financial stocks amid credit concerns related to the mortgage market, American Express' stock has fallen back almost to my initial purchase price. As such, I thought it would be a good time to check in with Michael to see if the thesis on the company has changed, or if this is simply another good buying opportunity for what I think is an absolutely fantastic business. (As a reminder please be sure to sign up for my free e-mail alerts to get additional portfolio position updates over time.)
Justin Fuller: Michael, for several years now, American Express has been a great company. What do you think are the source(s) of the company's wide economic moat?
Michael Kon: I think there are three things that help American Express earn a wide economic moat rating: its spend-centric business model, its closed-loop processing network, and its strong brand identity.
JF: Could you elaborate a bit more on how each of these strengths helps contribute to the moat?
MK: Sure. Let's start with the network. The end users of any card network are the cardholders and the merchants, who ultimately pay the fees and finance charges for use of the network. In a traditional open-loop network, the network operator, Visa or MasterCard (MA) for example, has to share these revenues with intermediaries that issue the cards, the banks that extend credit card loans, and the processors who facilitate the transaction. Since each intermediary demands its cut, players like Visa or MasterCard earn only a small piece of the pie.
What sets American Express' network apart is that there are no intermediaries in a closed-loop network. The network operator--in this case Amex--issues the cards, provides credit card loans, and processes the transaction. Now, you can invest all the money in the world to build an extensive closed-loop network, but you still won't make a dime if nobody uses your cards. This is where American Express' strong brand and spend-centric business model come into play, as a key factor in the success of any card network is giving each cardholder a reason to use the card. American Express provides cardholders with qualitative and monetary rewards to encourage them to use the card as much as possible, creating what I think is a virtuous cycle for the company. Cardholders desiring to use the Amex card as much as possible forces merchants--who want customers to buy as much as possible--to accept the card and pay American Express' higher rates.
JF: How does Amex stack up against its peers in the credit card industry? Who are the stronger and who are the weaker players?
MK: I have a lot of respect for Capital One (COF). I think their credit card business is one of the best out there. But they don't have a network. Their business is consumer lending, so it's not truly comparable to American Express. Discover (DFS) is the other closed-loop network, but Discover isn't spend-centric focused, and its brand isn't nearly as good as American Express', not to mention Discover's limited international presence. Visa and MasterCard are obviously great businesses with a strong global presence, but these are open-loop networks, so their economics are quite different. In my view, American Express is truly one of a kind in the card business.
JF: In financial-services companies, a talented management team is incredibly important. What do you think has made American Express' management team so successful?
MK: I think it all comes down to constantly evaluating the risks and opportunities, and being able to use your assets in an intelligent way. While the credit card market is mature, it is also very dynamic. Legal issues, new technologies, and consolidation create both risks and opportunities. Weak managers stumble on the risks while strong managers take advantage of the opportunities. It's all about using your assets in a way that creates value rather than destroys value, and American Express' management excels in that respect.
JF: It looks like management has really started to focus even more intently on the things that matter to shareholders with the spin-off of Ameriprise a couple of years ago. Can you talk about how this will benefit shareholders going forward?
MK: The Ameriprise spin-off is a good example of a wise use of assets. A good management team shouldn't be on a mission to build an empire. If you have an asset that requires your attention but doesn't add value to your firm, the right thing to do is to get rid of it. That's exactly what American Express did with Ameriprise. There were no synergies between the card business and Ameriprise's financial advisory network, so they made the prudent decision, and spun it off.
JF: Let's talk valuation. Why do you think American Express is such a compelling value right now?
MK: Mr. Market's recent panic over credit risk has resulted in a massive sell-off of almost any stock in the financial-services sector. So, in a matter of a few days, Amex lost about $8 billion in market cap. But besides being fearful in the near term, the market has also failed to grasp the sustainability of American Express' competitive advantages as well as the firm's profit potential over the next several years.
JF: What are the upside scenarios to your fair value estimate?
MK: On the upside, I didn't take into account the possibility of acquiring Discover Financial. I think such an acquisition can create a lot of value if it's done at the right price. Another upside is acceleration in domestic growth. Amex is in the process of expanding its reach in the U.S. by collaborating with third-party issuers. If this business accelerates, we will see acceleration of top-line growth. Another upside can come from credit quality. I currently model charge-offs getting back to historic levels, but if good credit quality persists, the bottom line will be better than my current expectations. All in, I think the upside to my current fair value is an additional $5-$8 per share.
JF: What do you think is the downside risk to an investment in Amex?
MK: The main risk, in my view, is a recession. Any economic downturn will most likely hit consumer spending. Since Amex relies on spending rather than lending, any decline in consumer spending will hit the top line. That said, I still think the stock is a compelling value right now, and I'll note that it remains well within 5-star territory.
JF: Thanks, Michael.
I agree with Michael's viewpoints on American Express, as I also believe that it's a truly great business, presently trading at a very reasonable valuation.
American Express' management targets a long-term return on equity of between 33% and 36%--which is very good, though in recent quarters they have even exceeded these lofty goals by a few percentage points. In addition, despite being a mature firm, American Express still has a lot of runway in front of it, given the continued trend toward plastic over paper, especially in the small to mid-sized business and corporate sector. And on the capital discipline front--not over-investing to grow--management has shown great stewardship, routinely returning around two thirds of excess cash annually to shareholders in the form of additional buybacks and higher dividends.
So, in summary, with American Express, you've got a high-return business that spits out a lot of cash, an opportunity set to reinvest that cash at high incremental rates of return, and a management team focused on optimizing the capital structure by returning excess cash to owners. Not surprisingly, Berkshire Hathaway (BRK.B) CEO Warren Buffett observed the sustainability of American Express' economics decades ago, and I'll note that he continues to hold a sizable position in the stock.
The key question for today's investors, though, is that despite these fantastic characteristics, is the stock still cheap enough for current investors to earn a good return on their capital over the next three to five years? At Morningstar we certainly think they do. I think Michael has made relatively conservative assumptions in his valuation model, with overall revenue expanding by just over 8% annually over the next five years. What's more, Michael has forecast net income climbing by a very reasonable 10.5% annually, on average, over the next few years. And despite these conservative assumptions, he still sees upside in the stock, with a $70 fair value estimate. However, if management were to hit on a few more growth levers faster than anticipated, or potentially acquire Discover Financial--strategically removing a major closed-loop network competitor from the credit card landscape--Michael feels there could be another 10%-11% upside in the stock over time.
In addition to our view at Morningstar, several of the managers I follow for The Ultimate Stock-Picker's Portfolio have also recently expressed their favorable views of American Express during our video interviews. Specifically, Larry Coats, manager of the Oak Value Fund , Mohnish Pabrai, manager of the Pabrai Funds, and more recently Tom Gayner, chief investment officer at Markel (MKL) (stay tuned for the Gayner interview next week), all indicated that they see upside in American Express. In addition to Michael's excellent analysis, these similar viewpoints give me a good comfort level that American Express' stock is still poised to generate pleasing returns for our model portfolio over time, and if the stock were to fall even further, I might consider adding to the position if appropriate. If I do, you can be among the first to know by signing up for my free e-mail alerts.
Justin Fuller has a position in the following securities mentioned above: AXP, COF. Find out about Morningstar’s editorial policies.