On November 8th, 1991, Ron Suskind of the Wall Street Journal wrote an article titled “Legend Revisited: Warren Buffett’s Aura as Folksy Sage Masks Tough, Polished Man.” The article was one of the first of its kind for recognizing that the image of Warren Buffett as a Midwestern bumpkin did not adequately convey the sophistication or the ruthlessness of Buffett’s personality.
On one hand, you had Buffett letting his sister file for bankruptcy, viewing the emotional matter in contractual terms (Buffett felt that the lenders needed to learn something about adequately appraising risk, and he wanted to keep his money). He would also regularly charge his daughter parking fees associated with picking her up at the airport. On the other hand, Buffett had a litany of friends publicly telling the media that “money wasn’t all that important to him.”
What caught my attention was this passage from Suskind: “His egalitarian philosophy notwithstanding, Warren Buffett is also a man who happily, and frequently, uses his financial clout and squeaky- clean image to get sweet deals not available to the everyday investor. And his billions in past investment profits notwithstanding, he has made huge bets of late on companies whose fortunes have soured – not just Salomon Inc. but also USAir Inc., American Express Co. and Champion International Corp. And his billions in past investment profits notwithstanding, he has made huge bets of late on companies whose fortunes have soured – not just Salomon Inc. but also USAir Inc., American Express Co. and Champion International Corp. In spite of his reputation as a penny-pincher who doesn’t need or care to spend his estimated $4.3 billion of net worth, he has some expensive tastes. Those suits? They’re actually Zegnas, hand-tailored Italian numbers–at $1,500 a pop. When in New York, Mr. Buffett often stays in a $1,400 a night suite at the Plaza Hotel, complete with a bar and spectacular view of Central Park.”
Even back in 1991, Warren Buffett was receiving criticism for his long-term investment in American Express. The media of the early 1990s voiced many of the same concerns you hear today–McDonald’s and Coca-Cola are under siege as the world aims to eat healthier, Procter & Gamble is having trouble growing volumes, and American Express is losing its lustre in the credit card industry.
Had you purchased American Express stock on November 8, 1991 in response to that Suskind article, you would have compounded at 12.19% annually through the present day so that every $10,000 put into American Express stock twenty-five years ago would be worth $162,000 today. It’s not that people are wrong when they make these predictions–it’s just that there are other countervailing forces that mitigate and then overwhelm the superficial observations (e.g. it is true that American Express is being out-competed by Visa and Mastercard, but it is also true that the gross volumes and number of accounts using American Express are increasing worldwide).
In the 1977 letter to Berkshire Hathaway shareholders, Buffett indicated the characteristic that makes credit card companies such attractive long-term investments: “Most companies define ‘record’ as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising earnings each year because of compounding…We believe a more appropriate measure of managerial economic performance to be return on equity capital.”
The return on equity capital in the credit card industry is extraordinary. American Express has 24.0% returns on equity capital, Mastercard has 28.5% returns on equity capital, and Visa has 21.5% returns on equity capital. These exceptional figures explain why Visa has returned 24% annually since its IPO in 2008, Mastercard has returned 35.76% annually since its IPO in 2006, and American Express has returned 16.23% annually since the salad oil scandal days of November 1963.
The credit card industry continues to pound out wealth for shareholders because so much of the profits are extractable from the business itself–the amount of money that is necessary to build out a network doesn’t have a corresponding expense when it comes to user growth. If you build subdivisions, you might be able to buy bulk supplies and hire aggregated labor so that you can construct 100 houses total for $175,000 each instead of paying $220,000 just to build one house. The 100th house may be cheaper than just building one, but the expenses are still substantial.
Some of the best businesses are those where the cost of each incremental product hardly costs anything. Johnson & Johnson had to put a lot of money up front creating Tylenol, but now a bottle of pills only costs a dollar to manufacture because a substantial amount of the price is the intellectual property that costs Johnson & Johnson $0 (once the sunk cost is committed, it doesn’t matter whether there are ten thousand or ten billion customers beyond the material costs).
Something similar happens with Coke and Pepsi, which only cost a few cents in syrup and water to produce (the container is where Coca-Cola spends most of its money). With the credit cards, there is not a meaningful cost to Visa or Mastercard regarding whether there are 10,000,000 or 10 billion swipes in a day. Any additional cost to build out a network is not proportional to the amount of interchange fees that it is able to collect–this observation explains why credit card investors do so well, and in particular, why American Express stock continues to deliver strong long-term returns even though the financial media treats as a perpetual has been. It’s not that the media observations are wrong; it’s that the credit card industry’s orientation towards profit is so strong that it overwhelms the blunders.
Personally, I like the fact that credit card companies are instantaneously adjustable to inflation because of the interchange policy of charging a percentage of the transaction costs. If inflation is 6%, you will spend 6% more, and then Visa will collect 6% more because its returns are based on a percentage-based system. It is true that developed economies have been capping these rates, so this observation does not hold up in periods of hyperinflation.
The returns on equity in the credit card industry are extraordinary, and even a blundering firm can still create a lot of shareholder wealth. American Express is trading at $53 per share–it’s a price where a lot of bad is priced into the stock, and as I discussed earlier with Gilead, it doesn’t take a whole lot to go right for you to do well when you’re starting at such an attractive valuation. Even with the poor performance of late from American Express, you still would have compounded at 12% annually if you bought on the day of Suskind’s article in 1991 ridiculing Buffett for sticking with it. The lessons are both a testament to the strength of the credit card industry because it earns a lot of profit compared to the capital it must deploy, and it is also a testament to Benjamin Graham’s margin of safety principal because buying at the lows of 1991 prepared you well for double-digit returns even as American Express approaches the lows of the current cycle.
Sources Consulted: http://www.berkshirehathaway.com/letters/1977.html
Ron Suskind, “Legend Revisited: Warren Buffett’s Aura as Folksy Sage Masks Tough, Polished Man”, Wall Street Journal, November 8, 1991.