TBR: The Electronic Rails of MA, V & AXP

Electronic Rails & Great Business Models

CA2I recently came across two articles, one from 2011 and the other from 2012, where Chuck Akre from Akre Capital Management gives his view on MasterCard and Visa.

In these articles Akre talks about how MasterCard and Visa both “principally own the ‘rails’ over which electronic payments travel worldwide.” Akre thinks both MasterCard and Visa are examples of great businesses.

Emphasis in quotes and excerpts below are my own.

“Another example of a great business model, which is new to our portfolio in the past year, is MasterCard [MA]. It and Visa principally own the ‘rails’ over which electronic payments travel worldwide. Those rails are exceedingly difficult to replicate, there’s a wonderful tollbooth aspect to revenues, and the business has a giant global wind at its back in the growth of electronic exchange of value away from cash and paper.” (Value Investor Insight)

Below is an excerpt from the interview in the AP article (see link below).

“Q: Shares of Visa and MasterCard have risen sharply. Why do you continue to like these stocks for the long-term?

A: These are extraordinary businesses. They have ‘toll booth’ models and operate in much the same way that Microsoft did when it became the dominant operating system for personal computers. As the PC market grew, Microsoft owned the operating system, and you were going to pay for it. Visa and MasterCard are the dominant players in what we might call the ‘rails’ over which electronic transactions take place worldwide, among the millions of merchants where their cards are accepted.

Their customers on both ends are banks — those that issue cards to customers and banks for the merchants on the other end. It doesn’t make any difference whether it’s a card swipe or a payment made using a mobile device. Many of those transactions are going over the rails of MasterCard and Visa. There’s a lot of growth potential, because 85 percent of the world’s transactions involving an exchange of value are still done by cash or check. The 15 percent done electronically can only go up. It’s a phenomenon that will continue to grow worldwide.

Q: Even with such potential, a company must execute well to generate strong profits. What do you think about MasterCard and Visa?

A: It’s not unusual for them to post after-tax profit margins of greater than 30 percent for a given year. Compare that with the single-digit margins that are typical for American businesses. They are doing something unique that causes them to have such high returns on their capital.

Q: Visa and MasterCard last month reached a transaction fee settlement that requires them along with some major banks to pay at least $6 billion to retailers. Some major retailers will be allowed to charge customers more if they pay using a credit card. Is that a risk for Visa and MasterCard? They could make less from transaction fees if some customers switch back to paying with cash or checks.

A: If it works out the way the settlement has been agreed upon, MasterCard and Visa are both fully reserved for it, and it’s been accounted for in their earnings. (Note: For example, Visa increased its litigation provision by $4.1 billion for its recently ended fiscal third quarter, which led the company to post a loss of $1.8 billion.) But that won’t alter their broad outlooks.

Q: Your fund doesn’t own any shares of American Express and Discover Financial Services. Why?

A: Not as many merchants accept American Express, and I like the ubiquity of the Visa and MasterCard acceptance worldwide. As for Discover, it’s an also-ran. That doesn’t mean it always will be, but that’s where it stands now. Also, American Express and Discover are both lenders, in that they issue cards. Visa and MasterCard are more of a pure play in payment processing. They are the rails.”

Links to both of the articles mentioned above are provided below.

Akre also talks about MasterCard and Visa in the third episode of the Value Investing Podcast, which can be found here.

Earnings Record

From reading the articles referred to above, MasterCard and Visa clearly looks like great businesses that I want to research to improve my understanding of the pros and cons of these owners of, at least for the moment highly profitable, electronic rails.

I also included American Express below, since that business also looks like a great one.

VMA2In the table below I have compiled earnings per share data for the ten-year period 2004-2013 (Source: Morningstar.com). Also included are the trailing twelve month (TTM) earnings per share.

At the moment, I have not looked in to any single year to see if there was any non-recurring income or expense affecting the reported earnings per share (see above and the MasterCard and Visa settlement). This will be done later on.

Price per share data also taken from Morningstar.com per September 22, 2014. Bond yield data taken from FRED at the same date.

EPS1Both MasterCard and Visa have shown great growth in earnings per share over the last couple of years. American Express has also posted good earnings per share numbers, doubling earnings per share in the last ten-year period.

Without further digging into the earnings numbers for the moment, I have made a rough estimate of the earning power for each of the three businesses, see table below.

Different values based on a few earnings multipliers are provided in the table below. A reasonable earnings multiplier for each of the three businesses is likely in the range of 15 to 25 times.

At the moment Master Card is trading at 27.5, Visa at 24.5, and American Express at 16.9 times TTM earnings per share, giving an earnings yield (TTM) of 3.6%, 4.1% and 5.9% respectively, compared to the AAA Bond yield that currently stands at 4.1%.

If MasterCard and Visa are able to post high growth in the coming 5-7 years, the current market price looks justified.

What about growth for American Express going forward? If we assume that future growth for American Express won’t be as high as for MasterCard and Visa, a reasonable value likely lies somewhere in the $80 to $110 range, probably in the mid to high end. A mid value in this range gives $95 per share.

But, this is just a brief overview of all three companies. More research will be done to get a better grasp of the business fundamentals, the industry, competitors, profitability and what any significant risks might look like. Before this has been done, all of them will just stay on the watch list (see link below). To watch out for, and learn more about.

EPS2MasterCard, Visa and American Express will be added to the watch watch list.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.


Valuation of AMEX in 1964: Price vs Value (Part 3)

AXPLlIn his 2008 shareholder letter Warren Buffett stated that “Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

In my earlier post Valuation of AMEX in 1964 (Part 2) I concluded with the following questions that I also left unanswered. “Does an intrinsic value of $60 per share seem reasonable? Or is it too high?”

I calculated an intrinsic value per share of approximately $60. But at the moment of my calculation, I did not know the historical share price of American Express during 1963-64. What I did know, was that the share price of American Express took a dive due to the Salad Oil Scandal and that Buffett put a great amount of his capital into the stock.

As Benjamin Graham liked to say “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” So the question was if Mr. Market did in fact overreact or not in the wake of the Salad Oil Scandal?


Source: Business Insider

My earlier valuation of AMEX updated with the share price low of $38 in January 1964 resulted in a margin of safety of approximately one third of the calculated intrinsic value per share. So, looking back we can probably understand why Buffett felt that the decline in the AMEX share price presented a great opportunity to buy into this business.


But, for this to be a real investment opportunity an investor would also have needed a conservative estimate of any potential liability arising from the Salad Oil Scandal. So, without a proper idea about any potential impact from this event, it would be hard to make an investment due to the fact that a thorough analysis was clearly missing.

In the next post I will take a look at what a reasonably and conservative estimate of any liability arising from the Salad Oil Scandal could look like.

Q&A: The Intelligent Investor – Chapter 8: The Investor and Market Fluctuations

Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 8 – The Investor and Market Fluctuations – of the Intelligent Investor written by Benjamin Graham. The Intelligent Investor

But first a short note, before I go on to discuss the questions.

So, here it comes, the infamous chapter eight about Mr. Market that Buffett has been mentioned so many times over the years. In his most recent letter to shareholders Warren wrote “In contrast, Ben’s ideas were explained logically in elegant, easy-to-understand prose (without Greek letters or complicated formulas). For me, the key points were laid out in what later editions labeled Chapters 8 and 20. (The original 1949 edition numbered its chapters differently.) These points guide my investing decisions today.”

Another quote I picked from Warren is “If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of the General Theory (John Maynard Keynes, 1936), you don’t need to read anything else and you can turn off your TV.”

In the preface to the fourth edition of the Intelligent Investor Warren writes “If you follow the behavioral and business principles that Graham advocates—and if you pay special attention to the invaluable advice in Chapters 8 and 20 you will not get a poor result from your investments. (That represents more of an accomplishment than you might think.) Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-market folly that prevail during your investing career. The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.”

So here it is, the much talked about “Chapter 8”. Read it, learn from it, and get back to it every now and then.

1. What quote from this chapter do you think best summarizes the point Graham is making?

“Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. 

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically,
price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

2. How have you seen the parable of Mr. Market play out in your experience?  Any examples of a company that has been grossly mispriced at some point?

One example that comes to mind at the moment is American Express (AXP) back in the financial crisis in 2008-09. Looking at the fundamentals of the business in the years before the financial crisis hit, it’s pretty clear that what we have here is a great business that faced some difficulties due to the financial crisis. The question was the severity of these problems.

See financials below. Source: Morningstar


The AXP price per share, see below (Source: Morningstar), took a dive from $65 in April 2007 to $9.71 in June 2009, a fall of 85%. Having reached this low the share price started to climb up to where it’s trading today, at a price per share of $86, a gain of 686%. If I had had a better understanding of the business I might have had the courage to buy.


3. On page 192 Graham notes that as investing formulas have gained popularity their reliability dwindles due to new market conditions and the widespread use of the formula undermining its previously held advantage. In what ways has Graham’s formula lost reliability? How has it managed to stay useful?

Graham’s formula is still of value. The formula focuses on businesses that has demonstrated an ability to grow earnings without taking on too much risk to do this. In the end, this is what counts, the value creation in a certain business. Then it’s all about paying a fair price for this value creation based on a reasonable and conservative assumption about the intrinsic business value.

4. Graham mentions that one issue with the formula plans is that they leave the potential for the market to “run away” from investors. What steps do you take to ensure that the market doesn’t run away from you, while also protecting yourself from a steep drop in prices such as the bear market of the early 2000s?

Always be on the look out for great businesses selling at fair prices. The most important thing is to never pay too much for a business.

5. Graham seems to advocate that the Intelligent Investor find a way to have “something to do” as an outlet of pent-up energy as the market advances, rather than allowing oneself to become entangled with the market movements.  Do you have any example of what you could do in that regard?

Read about as many businesses as possible to prepare for less good times and for Mr. Market to offer some of them at a good price.

6. What did you think of the chapter overall?

The highlight of the chapter is the parable of Mr. Market. The final section “Fluctuations in bond prices” I read only briefly. Overall a great chapter.

Valuation of AMEX in 1964 (Part 2)

Business operations

AMEX business operations in 1964 was made up of:oldaxp

  • Traveler cheques
  • Travel
  • Credit cards
  • Money orders and utility bills
  • Commercial banking overseas
  • Banking offices – military bases
  • Foreign remittances and exchange
  • International freight
  • Wells Fargo & Company (wholly owned subsidiary) – armored car operations and coin sorting and packaging activities
  • Hertz American Express International, Ltd. (subsidiary, 49% ownership stake)

See annual report for description of the different operating segments.

Earnings Power

American Express (AMEX) back in 1964 was a growing business that had been able to show strong earnings growth and consistent returns on invested capital from 1954 to 1964.

From 1954 to 1964 AMEX grew its revenue from operations at a compounded annual growth rate (CAGR) of 12.1%, from $42,219,000  to $118,144,000. Total revenues, that is including profit on sales of securities, grew at a CAGR of 11.8% from $43,534,000 to $118,441,000. During the same period operating profit and net income grew at a CAGR of 14.0% and 9.7% respectively. Earnings per share in 1964 amounted to $2.81 compared to $1.22 in 1954, a CAGR of 9,7%, and average earnings per share was $1.95.

The undistributed earnings ($442,041) from Hertz in 1964 has not been included in earnings above. Approximately 2-4 percent when compared to net income.

In 1964 the operating margin was 17.2%, this compared to 14.4% in 1954 and to the 10-year average operating margin of 14.7%.

AMEX paid dividends every year that grew from $0.64 per share in 1954 to $1.40 per share in 1964, a CAGR of 9.1%. The ninety-fifth consecutive year of dividend payments.

So far we can see consistency in the financial data. Let’s take a loot at what the business had to invest to be able to generate these profits.

Invested Capital

Total shareholders’ equity amounted to $83,612,591 or $18.74 per share in 1964 compared to $44,296,00 or $9.93 in 1954, a CAGR of 7.3%. During this time period the average dividend payout ratio was approximately 56%.

Return on average equity was 15.5% in 1965, this compared to 13.9% in 1954 and to an average return on average equity of 15.0% during 1954 and 1964.

A quick read of the 1964 consolidated balance sheet shows:

    • Cash and due from banks, $263.841.861 (23.5% of total assets)
    • Total security investments, $507,757,050 (45.2% of total assets)
    • U.S. Government depository bonds, $40,000,000 (3.6% of total assets)
    • Loans and discounts, $186,638,154 (16.6% of total assets)
    • Accounts receivable and accrued interest, $70,703,625 (6.3% of total assets)
    • Travelers Cheques and Travelers Letter of Credit, $525.667.060 (46.8% of total assets)
    • Customers’ deposits and credit balances held by The American Express Company, Incorporated, $387,697,073 (34.5% of total assets)
    • Deposit liability relating to U.S. Government depository bonds, $40,000,000 (3.6% of total assets)
    • Total shareholders’ equity, $83,612,591 (of which Surplus makes up $61,307,301). 6.2% higher compared to prior year and approximately 89% higher compared to 1954.

The business in two words – Consistent growth

So what we can see is that AMEX back in 1964 was a consistently growing business able to maintain high returns on invested equity capital.

The main problem in four words – the Salad Oil Scandal

Before looking at the fraud that occurred, i.e. the Salad Oil Scandal, making an attempt to value the business as a going concern makes sense, because this makes it possible to compare any liabilities arising from the fraud to an estimated intrinsic value of the business.

Valuing AMEX in 1964

As of 1964 AMEX is a high return business with favorable long-term growth prospects. Below is my valuation in summary. Looking first at the downside protection (without considering the fraud at the moment) book value per share of $18.74 per share seems like a conservative estimate of intrinsic value. Assets are liquid and there are no intangibles. The liabilities side of the balance sheet is pretty clean.

A business like AMEX in 1964 should be valued above book value, this due to the high and consistent returns on invested equity capital coupled with favorable growth prospects going forward.

My estimate of intrinsic value, which is at the high end of the value range, points to a value around $60 per share.

Valuation AMEX in 1964

See graph below for the Aaa Corporate Bond Yield from Moody’s in 1964.


So, with an intrinsic value around $60 per share, it’s time to go find the share price data to see where an investor could have bought the stock and become a part owner of the business.

That’s all for now. Please feel free to leave a comment and share your thoughts and insight.

Does an intrinsic value of $60 per share seem reasonable? Or is it too high?

American Express & the Salad Oil Scandal (Part 1)

“Why should we look to the past in order to prepare for the future? Because there is nowhere else to look.” ― James Burke

Warren Buffett’s investment in American Express in the mid 60’s is well known to a lot of investors that have followed and studied in the footsteps of the Oracle of Omaha. AELOGO

Yesterday I ran into the American Express annual report from 1964 — follow this link to read it.

I then had an idea that I would read the annual report and try to come up with a reasonable intrinsic value range of the American Express business and then compare it to the purchase price paid by Warren.

Since I didn’t have a clue about the share price – no anchoring bias – I thought it would be interesting to see how my own calculation and reasoning regarding the intrinsic value stood up compared to the price of the business back in 1963 and 1964.

So what do I know at the moment that could influence me? How do I try not to be swindled by hindsight bias?

I know that…

  • …American Express found itself in the middle of a fraud, the so-called “Salad Oil Scandal”,
  • …Warren Buffett started researching the business fundamentals of the business,
  • …Warren Buffett decided from the results of his research to put a great part of his partnership’s money at work by purchasing shares in the company when the price fell in the aftermath of the the scandal,
  • …American Express is still doing business as of today,
  • …the investment by Warren turned out to be one of his greatest.

I will try to imagine myself right in the 60′ (impossible, I know…) and from reading the annual report get me an understanding of the business of American Express back in 1963 and 1964. From the facts in the annual report I will then calculate a reasonable intrinsic value range per share and see at what price I myself would have been interested in purchasing shares in the business and becoming a part owner in it.

In step two, I will try to find out Warren Buffett’s purchase price and see where my own calculation stands compared to the price he paid.

I will then go back once again, this time to books and articles, to get a better understanding of what happened and how it all played out.

As a final step, I will go back to my own calculation of intrinsic business value per share to see if what I know and if my improved understanding of the Salad Oil Scandal would have had any impact on my thinking and my way of coming up with an intrinsic value.