Want a Dow Jones Blue Chip? Try American Express

In uncertain times like these, investors seeking lower risks may be looking toward the Dow Jones Industrial Average for large-cap stocks. Founded in 1896, the Dow serves as a benchmark for some of the largest U.S. companies. However, while the Dow includes a few big FAANG stocks, it has outsized exposure to many economically sensitive businesses in industrial and financial sectors. These sectors are generally lagging behind technology, as they're more heavily affected by the COVID-19 economic downturn.

Nevertheless, the Dow could be prime hunting ground for recovery stocks. If we get more stimulus money and a vaccine this winter or next year, these economically sensitive stocks could pick up in a big way. 

Here's why one of the safer ways to play a recovery is Dow component American Express.

Image source: Getty Images.

American Express' defensive characteristics 

In contrast to large U.S. banks, American Express has a unique business model that helps insulate it from severe recessions. Amex isn't by any means immune, but its differentiated model makes it much less likely to have capital and liquidity problems during tough times than other large banks.

First, Amex is a hybrid company. It generates revenue from discount card revenue, or "swipe" fees, like its rivals Visa (V 0.05%) and Mastercard (MA -0.08%). It also earns revenue on net interest income from loans and credit card balances, like a traditional bank.

While discount revenue will of course decrease when consumer spending goes down, it's generally a safer business with more variable expenses than the business of lending. Fortunately, only about 25% of Amex's revenue comes from net interest income on loans, with the rest coming from discount revenue, fees, and other sources.

Data source: American Express Q2 2020 earnings presentation. Table by author. YOY=year over year.

The second defensive characteristic is that American Express' franchise is skewed more heavily toward well-off prime customers and business customers, rather than the mass-market clientele targeted by other card companies. Thus, in times of trouble, American Express' customer base is less likely than other card issuers to suffer a lot of loan losses.

During the second quarter, Amex's provision for loan losses came in at $1.6 billion -- much lower than analysts' consensus estimates of $1.85 billion. That allowed Amex to handily beat estimates for earnings per share, recording a $0.29 profit even during what should have been the worst quarter of this recession, and even as many traditional banks recorded net losses. Given the new dividend rules coming from the Federal Reserve, many traditional banks may have to cut their payouts later this year, but American Express doesn't appear to be one of them.

The final proof of American Express' defensive characteristics is that longtime shareholder Warren Buffett didn't touch his significant $14.4 billion stake in Amex during the second quarter. This is notable because he sold off significant amounts of most of his other bank holdings, likely due to fears of a prolonged downturn and dividend cuts.

Image source: Getty Images.

Upside is there, too

Of course, at $97, American Express still finds its stock price about 30% below the early 2020 highs of $138. That means that should we get a vaccine and economic recovery, there still appears to be significant upside in American Express shares.

As you can see above, despite skewing toward well-to-do customers, Amex still saw its spending decline heavily in the pandemic-fueled quarter. That's because a good portion of American Express' spending -- about 30% -- came from travel and entertainment prior to the pandemic. Should we get a vaccine in the months ahead, American Express is a prime candidate to experience a big recovery in discount fee revenue.

Moreover, Amex also has a number of new tech-oriented growth initiatives in mobile, loan servicing, and automation. Recently, the company agreed to purchase Kabbage, a new-age fintech company that specializes in small business loans. Notably, Amex isn't purchasing Kabbage's loans, but rather its technology, data, intellectual property, and customer base.

Another big potential upside for Amex could come from China. In June, American Express became the first U.S. company to gain final approval to build its own payment network in the Middle Kingdom. Should Amex's China joint venture prove successful, it could lead to a much larger addressable market in the years ahead, given China's population of 1.44 billion people, increasing standard of living, and relatively low payments industry competition.

A great risk-reward within the Dow

Even with this great risk-reward profile, American Express appears cheap, as it trades at only around 12 times its 2019 pre-pandemic earnings. With solid defensive characteristics, a safe 1.8% yield, and upside opportunities on a travel recovery and Chinese growth, large-cap investors shouldn't ignore American Express as a blue chip addition to their portfolios today.