Classic Value Investing Right Now: American Express Stock at $55

Since June 2014, shareholders of American Express (AXP) have lost 33% of their initial investment (counting dividends). A fair chunk of those declines came today, when a weak earnings report for the New York payment merchant caused the investor community to respond by lowering the price of the stock 12% in a single day. Much of this apprehension is the result of the inadequacy of American Express’s initiatives to keep up with Visa and Mastercard coupled with the loss of the lucrative exclusivity relationship that American Express once shared with Costco.

And for those looking ahead, Marriott’s merger with Starwood may prove detrimental to American Express. JP Morgan has an existing relationship with Marriott, and Starwood has an existing relationship with American Express. Most likely, there will be a renegotiation to bring the hotel chains under one card servicer. If JP Morgan is chosen, then American Express will have to replace Costco and Starwood. And if American Express is chosen, it may gain business (Starwood + Marriott rather than just Starwood) but there is a likelihood that American Express may have to overpay to do so (in an effort to fight the negative perceptions that would accompany both the loss of Costco and Starwood in close temporal proximity.)

I have two thoughts to share on American Express right now–one relating to the sequence of earnings growth, and the other relating to valuation.

When I study American Express, I am reminded of what Professor John Clendenin said forty-nine years ago in the publication “Trusts and Estates”: “Long-range earnings and dividend progress is often made in irregular spurts and market recognition occurs similarly. In consequence, short-term gains of sizable amounts give an impression of high-average speed, and the commencement of a similar trend can occur in reverse.”

American Express ended the year 2005 with $2.43 in earnings per share. By 2015, the profit figure had grown to $5.53 per share. This is a compound annual growth rate of 8.57%. The average dividend yield during this period was 1.3%, meaning the business performance of the stock delivered 9.87% annual business returns (you should keep in mind that I am not talking about total returns experienced by the investor here, as that figure would measure price, but am instead focusing on what the corporation specifically did during this ten-year period).

That is not an asset to lament. If you can spend your life collecting assets that give you earnings per share growth and dividend payments of 9.87%, you are handling the surplus created from your labor in a sound manner.

But as Professor Clendenin points out, those returns don’t come in a neat line, with each year demonstrating earnings per share growth of 8.57% (though this is a benefit of Dividend Aristocrat focused investing, as the annual growth of the dividend payouts is a cherished business custom of predictability). Instead, it comes in spurts.

Between 2005 and 2007, American Express shareholders witnessed rapid earnings growth from $2.43 to $3.39, for a compound annualized growth rate of 18.11%. From 2007 through 2009, earnings went from $3.39 to $1.54 for a compound annual growth rate of -32.60%. And from 2009 through 2011, earnings climbed from $1.54 to $4.09 for a compound annual growth rate of 62.97%. From 2011 through 2013, earnings grew from $4.09 to $4.88 for a compound annual growth rate of 9.23%. And from 2013 through 2015, earnings grew from $4.88 to $5.53 for a compound annual growth rate of 6.45%.

If you break down the past ten years into two-year measuring periods, you collected: 18.11% annual returns, then -32.60% annual returns, then 62.97% annual returns, then 9.23% annual returns, and then 6.45% annual returns. With the exception of the 2011 through 2013 period, you never really got smoothed out performance near the 8.57% earnings per share growth average.

What is worse is that, if you responded to any of these mini-periods by selling your stock, you weren’t acting too smart. The period of -32.60% annual returns coincided with a stock price decline from $50 to under $10, and the period of 6.45% annual returns coincided with a price decline from $96 to $70 (and now a $15 per share fall to start the new year).

Despite the fine business performance at American Express, it has not been in a decade in which the shareholders of the corporation have gotten rich. Although the earnings growth plus dividends have amounted to 9.87%, the starting P/E ratio of American Express was high–it traded at 21x profits in 2005. Adjusting for today’s slide, American Express now trades at $55 compared to $5.53 in earnings for a P/E ratio of 9.94%. Despite this, American Express has still generated 4.13% annual returns with dividends reinvested since 2005.

There is a reason why Benjamin Graham’s lasting legacy is the margin of safety concept. The valuation of American Express stock at under 10x earnings has put prospective shareholders into a position where future returns will almost certainly work out in the favor.

American Express last traded in this range when the stock was at 11x earnings briefly in 2011 (and before that, it traded at 9x earnings in 2009 but that figure isn’t relevant for pattern-seeking because earnings were due for a sharp rebound pop whereas the 2011 figure is analogous because it marked a period of disappointing but not cyclically downtrodden earnings). And guess what has happened to the shareholders that paid 11x earnings in 2011? They have earned 7.77% annual returns from June 2011 through January 2016. Even with the stock at a low point now, the returns are still satisfactory five years out because they stacked the game in their favor by getting the price right.

And from 2011 through 2014, the American Express returns were extraordinary, in the range of 30% annualized, because the stock saw its P/E ratio climb from 11x earnings to 16x earnings while also growing earnings from $4.09 to $5.56.

When you get the price right at the time you make the investment, you have three levels that can get pulled to create wealth on your behalf: (1) the company can pay out and grow the dividend; (2) it can deliver business growth that will raise the price of the stock in order to maintain the same valuation; and (3) the P/E ratio can increase to respond to the improved business performance. It just takes a little bit of each, or a strong delivery from one of those three, for you to do well.

That is the position that American Express currently finds itself. It makes over $5 billion in annual profits, and that figure is expected to grow a bit in the medium term. The dividend didn’t get cut during the financial crisis, and has been rising since 2011. I expect the long-term P/E ratio to settle in the 14-16x earnings range, suggesting valuation expansion for those who buy today at 10x earnings. The dividend only accounts for 20% of the profits, giving American Express nearly $4 billion in retained earnings to deploy. The attractiveness of an investment necessarily depends upon the price of ownership, and at a price of $55 per share, there is a lot to like about American Express even if the capital gains and earnings growth don’t manifest themselves in the short run.