Berkshire Hathaway owns 14.2% of American Express. Warren Buffett himself owns almost 5% of the entire credit card company. The Berkshire portion consists of 151,610,700 shares. Buffett’s story with American Express began early in his career—1963—and was Buffett’s first big investment in the aftermath of his father’s death.
What happened was this: A businessman named Tino de Angelis took out loans from American Express, Bank Leumi, and a predecessor to Bank of America. He posted barrels of salad oil inventories as collateral to offer the banks a security interest in exchange for the cash they sent his way, and de Angelis cleverly created fictitious salad oil reports to run one of the largest frauds in American history. He got his hands on $150 million that honest accounting would have rejected (to get a handle on the enormity of the figure, it would be the equivalent of $1.3 billion today and fueled robber baron public policy concerns about one man being able to get his hands on such immense wealth from inventory reports alone). American Express was responsible for $58 million to cover its error in judgment. The price fell almost 60%. Buffett entered.
This was a lucrative investment—doubling, and then tripling—over the next three years. Buffett took the capital gain and discarded the stock. What I find interesting about these tales from Buffett’s early career is that merely sitting and buying-and-holding the companies of his early days would have led to immensely lucrative results—a $1,000,000 investment in American Express in 1963 would have compounded at 11.5% over the long term and turned into $384,340,007 today. Fifty-two years of compounding at a slightly above market rate will tend to do that. Just by sitting on his keister for 52 years, Buffett would have propelled himself onto the list of the ten thousand richest people in the world by letting the compounding snowball run down the hill every time American Express collected money from people swiping their cards to make a payment.
When Buffett re-entered American Express in the 1990s, he perhaps learned a thing or two about American Express’s long-term natural compounding rate and decided to play for keeps: he invested $1.28 billion into the company and has seen the investment value balloon into over $13 billion as of the most recent reporting period. Buying American Express, and leaving it undisturbed for long periods of time, is something that does change lives given the high amount of retained profits combined with very high margins that is a typical characteristic of most companies in the credit card industry.
I don’t get a chance to talk about Buffett’s story with American Express all that often, given that I usually limit myself to the most superior businesses in a given industry, and I believe that Visa is a better business than American Express right now and will likely deliver better growth than American Express over the long-term. I have little doubt that if Buffett had no relationships at American Express, wasn’t sitting on a $12 billion capital gain, and had to choose between either company at a valuation of 20x profits, he would load up on Visa in a heartbeat.
Yet, all valuations are not equal, and that is what makes investing more of an art than simply following Peter Lynch’s recommendation to “buy what you know.” At the time that I am writing this, Visa trades at a rate where investors are willing to pay $30 to buy an ownership stake in every $1 of profit that Visa generates. American Express, meanwhile, is working its way through a period of unfashionability: Costco, which has Charlie Munger as a director, just ended its arrangement of only accepting American Express (or jointly branded with American Express) cards at its own stores.
Quick side note: You can use Visa and Mastercard debit cards at Costco, but you cannot use Visa, Mastercard, or Discover credit cards. Additionally, it remains to be seen whether Costco will open up to accepting payment in all forms to democratize the payment process to maximize sales, or whether it will seek to replace American Express with a one-card strategy on the favorable terms that it could not achieve with American Express.
While some people are acting surprised about this, I suspect American Express executives have been preparing for this for a while: absent market-bending kickbacks, it doesn’t make sense for any merchant to limit the forms of payments because it is not in any company’s self-interest to shoo away customers who would buy your product but for the payment method you demand. When the American Express deal ends next year, its profits will decline by 10% (of course, this is without taking into account any other growth initiative American Express plans between now and March 31, 2016).
Right now, American Express makes about $5.75 per share. If you assume it will only earn 90% of that once the deal is done, it works out to $5.17 per share. With the recent decline in price to $78 per share, that would be a P/E ratio of 15x earnings even when you count the Costco impairment and assume no immediate driver of growth in the short term. That valuation spread catches my attention: American Express is selling at a valuation of only half of Visa, and that discrepancy catches my attention even though I find Visa to be the superior business.
Why do I feel that way? Because American Express has been excellent in its own right, even if it is inferior to Visa. Coming out of the recession, it has grown profits per share from $3.35 in 2010 to $5.17 now (assuming a bad case scenario with the Costco aftermath). The $1.04 dividend only accounts for 20% of estimated profits post-Costco, and this is a company that typically traded north of 20x earnings (usually in the 25x profit range) before the financial crisis. It has a loan portfolio that has doubled since the start of the financial crisis from $30 billion to $70 billion (I say this as a counterevidence point to those that consider American Express to be a fading brand).
The company is resilient in its ability to maintain profits during crisis: Profits of $2.8 billion in 2008 fell to $2.1 billion at the worst in 2009, and have popped up to $5.8 billion. Generally, American Express had the lowest default rate in the industry, though I don’t hold that assumption indefinitely into the future given that American Express is now aggressively marketing cards to the euphemistically named “underbanked” portion of the American population. Their strategy seems to be “Visa and Mastercard don’t have cachet and they roll in the dough” and now we are going to do the same thing.
American Express is a business that has the natural characteristics to grow in the 10% range absent superior or inferior management. In guidance calls, American Express’s CEO and Chairman Kenneth I. Chenault said he expects annual earnings per share growth in the 12-15% range. For those coveting Visa but feeling that 30x profits is too high a price to pay for a conservative investor, the recent setback for American Express to trade at 15x earnings provides an interesting alternative arising out of its relative cheapness. It’s a fair bit worse than Visa, but trading at half the price. As far as third fiddles go, American Express is quite lucrative. It’s the kind of spread that shines a light on the difference between value investors and quality, quality, quality investors.