Should Warren Buffett Invest in PayPal?

With some help from his portfolio managers, Warren Buffett's investment strategy has slowly evolved over the years from one favoring value investments to one featuring growth investments trading for reasonable prices. As a result, some technology names have begun to feature prominently in the Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%) portfolio.

But some shareholders have been critical of the Oracle of Omaha for not investing more in the two halves of digital payment duopoly Visa (V -0.48%) and Mastercard (MA -1.19%) instead of his longtime favorite American Express (AXP -0.08%). In addition to other bets on the future of consumer and business transactions Buffett and company have made, PayPal (PYPL -1.83%) could also feature prominently in the Berkshire investment universe. 

Image source: The Motley Fool.

PayPal is a second chance at a missed opportunity

Visa and Mastercard were two of the best-performing stocks of the 2010s as digital transactions continued to supplant cash around the globe. American Express -- hobbled by its lending segment and lagging far behind on the lucrative payment processing front -- not so much. It was the wrong stock in the industry for Buffett to be overweight on. 

But PayPal offers a second chance on the largely missed Visa and Mastercard opportunity. The payment network duopoly will do well in the next decade as digital payments continue to rise in frequency, but new trends are beginning to take hold. At the intersection of secular growth stories like e-commerce, payments, and digital wallets (basic banking services provided in a mobile app format), PayPal is far smaller than its two larger peers -- but has continued to grow well north of 20% even during the pandemic, as adoption of PayPal and its subsidiary Venmo rise. In fact, as measured by revenue, PayPal is close to claiming the top spot from Visa.

Data by YCharts.

Attractive valuation on a high-growth modern staple

Given the situation, why is PayPal's market cap valuation still smaller than both Visa's and Mastercard's? Because of profit margins.

Even in the midst of a very challenging year in which massive amounts of in-person transaction volumes have suddenly dried up, Visa and Mastercard boast hands-down some of the best operating profit margins around -- at 64.5% and 54.3%, respectively, over the last 12 months. PayPal only operated at a 15.9% margin over this same stretch.

Data by YCharts.

We might take Visa and Mastercard's ridiculous profit margins for granted today, but they weren't always so shockingly high -- nor was it a turbulence-free ride higher. The key to achieving such high levels of profitability is tech infrastructure, which requires low maintenance and lots of users. And besides still building out its tech capabilities, one reason PayPal has much lower margins is it is still trying to add users at a rapid pace. But as it does, it's beginning to benefit from the same economies of scale that have sent its peers skyrocketing over the last decade. 

This is becoming evident this year, even after a quarter of heavy spending during the summer months and the $4 billion acquisition of Honey at the start of 2020. Investment and marketing expenses are elevated to take advantage of shifting consumer behavior, but PayPal is still growing its bottom line at an even faster rate than sales. 

Pp = percentage point. Data source: PayPal.

Will PayPal eventually boast operating margins north of 50%? If it does, it will be a while. This is, after all, a very different business model from the one Visa and Mastercard rely on. But I do think profitability will average up over time -- and will be a strong tailwind for PayPal, especially paired with the company's fast sales growth from digital payments and banking services. And even though it has continued to grow this year while Visa and Mastercard have contracted, PayPal stock trades for 43 times trailing 12-month free cash flow, compared to 48 times for both Visa and Mastercard. 

The latter two are great bets on the gradual rebound of the global economy and remain core parts of my investment portfolio, but PayPal is quickly becoming a larger holding. And given its growth and profitable scale, it probably belongs in the Berkshire portfolio as well. Whether it ends up there or not is irrelevant, though. I'm in on this fintech stock for the long haul.