Regarding the identification of excellent long-term stock investments, Warren Buffett made the following observation in his 1977 shareholder letter:
“Most companies define ‘record’ earnings 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 interest earnings each year because of compounding.
Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”
Generally speaking, the average small American company earns a return on equity of approximately 12%. The average large company, defined as those that have a $1 billion market cap or greater, earn average returns of 8.5% on equity.
If you pay attention to the businesses that Warren Buffett has allocated significant capital to over the years, higher returns on equity is almost always present. Coca-Cola earns 26% returns on equity, American Express earns 29% returns on equity, and Apple earns a staggering 44% return on equity. No wonder Berkshire owns $40 billion worth of it.
What is really mind-blowing is that Mastercard is expected to generate 65% returns on equity over the next year. The company plops down about $200 million in capital spending per year, and boom, out come $6.7 billion in profits. It is asset light in a few that few companies in the entire history of the investment civilization have been.
Of course, I’m not the only person in the world to realize this, as the stock trades at $240 per share in comparison to $7 per share in profits, for a P/E ratio of 34x earnings. That valuation makes it a much tougher call to determine whether fresh capital should be put into it, as companies with a quarter-of-a-trillion dollars eventually find themselves trading at a valuation near 20x earnings sooner or later.
Essentially, it earns a profit override on economic growth because it collects revenue on both transaction volume and dollar volume. If $1 trillion in economic activity gets paid through Mastercard this year, and $1.1 trillion does next year, Mastercard gets a chunk of that $100 billion just because it occurred without having to allocate any additional capital to it (unlike, say, if Coca-Cola wants to see its global shipments increase by 100,000 hectaliters, it actually has to manufacture the syrup and arrange the cans for each bottle and can that contribute to it. As great as Coca-Cola is, it cannot achieve growth without supplying a physical product for each act of consumption). Mastercard can achieve growth without engaging in any specific affirmative act additional to what was necessary to get its system in place.
Mastercard now thinks so highly of its brand logo red and orange circles that it is letting them speak for themselves as it is removing the label “Mastercard” affixed to it, putting it in that rare territory with icons like the Nike swoosh or Cinderella’s slipper.
The profits have increased from $1.4 billion to almost $6 billion over the past seven years. While that is impressive under almost any circumstances, it is especially impressive in the sense that the company only had to put forth $3.5 billion to achieve total cumulative profits of $27 billion. The business model is like a vending machine where you put in a dollar, tap it on the side seven times, and then 31 quarters come out. This is especially exceptional.
The returns on equity are so great, with so much profit growth being generated by such a tiny amount of capital deployed, that you cannot help but find it wise to allocate 10% of your net worth to credit card firms because sustainably high returns on capital result in outsized growth. I’m not buying Mastercard now because its valuation is literally its highest in its entire history of being a publicly traded company, but it’s on the permanent holding list, and the key is to get the cash ready to scoop up shares when the valuation is right. Preparing your household balance sheet so you can swing heavy when Mastercard stock gets cheap (or at least fairly valued by traditional metrics) strikes me as one of the highly intelligent things you can pursue to arrange yourself for financial success.