After I recently discussed a college friend that is currently focusing on making large share purchases in the four major credit card companies each month, a reader asked me why I wouldn’t do that considering my awareness of the superior returns generated by credit companies. In short, I think there is a tendency to underestimate the technology disruption that can exist in the payment industry.
Generally speaking, there are two types of companies that make good candidates for investment. One is companies with specific products—Nestle chocolate bars, Colgate toothbrushes, Procter & Gamble’s Gillette razors immediately come to mind. People desire those things specifically, pay money to acquire them, and shareholders tend to grow wealthy with each passing decade. The other category, of course, refers to companies that act as hosts to facilitate people getting to the product they want. Wal-Mart is the classic example of this. No one goes specifically to Wal-Mart because they want Wal-Mart goods; rather, they go to Wal-Mart because it is a host to other goods at an attractive price.
Moats that exist because they are hosts are always going to carry a greater risk than brand investing because they lack emotional goodwill. Coca-Cola has lost blind taste tests to Pepsi, Dr. Pepper, and Jones Soda for crying out loud, but the emotional appeal of drinking a Coke has been burnished in the psyche and explains why Coca-Cola does not lose market share despite losing so many blind taste tests. Host companies, on the other hand, can lose to efficiency—look at Wal-Mart’s struggles to develop an online presence compared to Amazon. That is why shareholders are only getting 2% dividend increases. No, this does not mean Wal-Mart shareholders are doomed or anything like that, but it is hard to grow earnings per share at the same historical rate when Amazon is currently winning the battle of convenience, and in some cases, cost.
That distinction is on my mind when I think about the four credit card companies. Sure, once upon a time, using an American Express was a status symbol thing that could be used as a socio-economic signaling device to people. Those days are over. Heck, American Express is no going after the subprime market and is opening up its name to borrowers with defaults in their pasts because that is where the higher profits are. At this point in time, people don’t use Visa because they like to show off Visa cards or have a special affinity for the brand, but rather, they use it because it is accepted everywhere.
The problem? Merchants hate Visa and Mastercard because they charge high fees. That is why you see some businesses institute minimum-purchase policies before you can use a credit card or offer discounts to shoppers that pay in cash. If you’re the local florist, you hate shipping off a slice of every transaction that would otherwise be your profit because everyone goes through the credit card companies when making their purchases.
To be sure, this is something that only exists in the merchant side. If you’re the person whipping out your Discover Card to make purchases, you never see these fees. In fact, if you’re responsible and savvy, you can use credit cards to get discounts here and there. The issue is that merchants hate sacrificing some of their profits out of necessity—they would love nothing more than to have customers pay cash, but the amount of customers that would be lost from declining credit cards is greater than the amount of fees that have to be paid by accepting Visa, American Express, Mastercard, and Discover.
This current state of affairs is relevant in recognizing that merchants would love nothing more than to kick the credit card companies away from the table because they are regularly acting as a tollbooth, taking a share of many consumer purchases. This is why credit card shareholders have gotten so much—the model is lucrative.
Yet, the threat of disruption is possible. You have Applepay, which does not (in its current form) pose a direct threat to the credit card companies, but there is a concern that Apple could one day self-insure against fraud (one of the primary appeals of credit cards) and become ubiquitous (another primary appeal of credit cards).
There are now reports that IBM is working on a payment processing system that would use the blockchain. Essentially, it would be a public ledger that transfers money in a way similar to Bitcoin. But whereas Bitcoin is a virtual currency of dubious long-term sustainability, IBM’s blockchain project would use U.S. dollars, Euros, Yen, Swiss Francs, and other currencies to operate in the digital sphere. The theory is that IBM recognizes it would have to charge lower fees to get people to transfer onto the system, and by charging merchants less, it would have a business class eager to encourage business that arrives through the blockchain. Of course, it could also mean that Visa and Mastercard would lower their fees to compete with an IBM blockchain product.
These comprehensive models require excellent leadership. In the 1990s, Citigroup stock traded at 2x book value because it promised a truly integrated business model. Imagine logging into your Citi account and debiting out your mortgage payment, sending money to your kid at college, ordering 100 shares of Coca-Cola stock to get bought in a Roth IRA, and then sending a separate order to Autozone for a taxable brokerage account. That was the futuristic dream that had been promised by Citi that it failed to truly implement (though, of course, you can find backdoor ways to do these things easily enough today, but it’s still not quite at the click-click-click-done stage yet.
So I recognize that the statuo quo is difficult to dislodge. Still, credit card companies operate in the sector of the economy that is a bit harder to predict. Twenty years ago, you could have guessed that people would be drinking and eating soda and candy bars today, and you could have predictably made money investing in Coca-Cola and Hershey.
Predicting wireless internet, a world obsessed with phones, and heck—ordering pizza online—does not happen in a neat, linear fashion that is neat and tidy to foresee ahead of time. Quick aside: One of my high school friends predicted the rise of online pizza ordering well before it happened because he theorized that people ordering pizza tend to be in an anti-social mood when the pizza order is not connected to a party event. Any technology advance that minimized human interaction would be embraced because people would love nothing more than to have a pepperoni pizza magically appear on their table a moment after the idea enters their head. He was ahead of his time.
That is my long way of saying that, despite my general conclusion that credit card investments deliver excellent returns, the moat is not so safe that it deserves an abandonment of diversification. If I could only own three stocks—it would be something like Nestle, Coca-Cola, and Johnson & Johnson—because those companies are so connected to the human experience in ways that cannot be displaced by technological advancements that making a large commitment carries very remote risk of wipeout over the coming decades. The disruption in the payment industry carries a higher level of disruption risk, and that is why I think American Express, Visa, Mastercard, and Discover shouldn’t take up more than 10-15% of someone’s portfolio.