It's no secret that Berkshire Hathaway chief executive Warren Buffett likes financial stocks. About 30% of the conglomerate's portfolio is invested in the sector -- second only to information technology.
What is it about financial stocks? As my colleague Sean Williams writes, Buffett likes the cyclicality of the sector, particularly with regard to banks, as periods of growth typically last much longer than recessions.
We're in a period right now where we have come out of a recession and are experiencing economic growth, which makes it a good time in general to consider financial stocks. There are two stocks in particular from Buffett's portfolio that warrant consideration: American Express (AXP 2.56%) and Moody's (MCO 0.77%). Here's why.
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American Express
American Express is one of Buffett's favorite stocks. It is currently the third-largest holding in his portfolio, as he owns more than 151 million shares and has invested more than $27 billion in the stock. He has owned it since 1993, making it one of his three longest-held stocks.
American Express is a payment processor, but it differs from Visa and Mastercard, the industry's two heavyweights, in that it is also a lender. So it makes money not just on fees from processing transactions and membership, but also on interest from lending money.
One of the things that makes American Express a compelling buy for 2022 is its valuation. The stock took a hit in November, as all payment and credit companies did, on fears of inflation, supply chain issues, and COVID-19 variants slowing down the economy and creating a less than merry Christmas. It also had to do with the high valuations that many of these growth stocks had hit after surging in the third quarter. American Express's price dropped about 20% from late October to the end of November, but a stronger-than-expected December helped American Express finish the year on an upswing.
Yet its valuation is still attractive, as it is trading at about 17 times earnings at recent prices, which is fairly low for a stock with strong growth potential and way down from where it was. It has a five-year price-to-earnings-growth (PEG) ratio of 0.66.
Two other things should help American Express post solid gains in 2022 and beyond. One, interest rates are expected to rise, which is good for banks and lenders like American Express, as it should boost their interest income. And two, the economy is expected to grow, with gross domestic product anticipated to increase about 4%, according to economists, which is higher than average. The better the economy, the more people spend and use credit.
Travel spending is also expected to increase in 2022, while still below pre-pandemic levels. But according to a forecast by the U.S. Travel Association, it will be up about 20% in 2022 and return to pre-pandemic levels in 2023 or 2024. American Express expected travel and entertainment spending to be at 80% of 2019 levels at the end of 2021.
While American Express is facing increased competition from newcomers in the buy now, pay later space, CEO Steve Squeri said on the third-quarter earnings call that he doesn't see it as a competitive threat to American Express, as it appeals to a more affluent clientele.
Moody's
Moody's is the sixth-largest holding in Buffett's portfolio. The Oracle of Omaha owns more than 24 million shares of this credit rating agency, totaling about $9.2 billion. This is a stock that Buffett has held since 2000, and it has been a juggernaut. Over the past 10 years, it has posted an average annual return of more than 25%.
Buffett likes this stock because it has a wide and deep moat as one of only three major credit rating agencies, along with S&P Global and Fitch. Moody's and S&P each represent about 40% of the market, with Fitch at about 15% -- and there's really no other competition, nor any likelihood of new market entrants, as the industry wouldn't benefit from the addition of another major player. The fee-based revenue Moody's gets from credit ratings will fluctuate based on the amount of debt that's issued, but it's always going to be a steady stream of revenue, given Moody's competitive position.
Moody's also has a robust analytics business, which accounts for roughly 37% of its revenue. Moody's provides data, analytics, risk management, and other services to corporate clients to help them improve operations. Moody's has invested heavily in this business, making several recent acquisitions to build out its expertise in areas like ESG (environmental, social, governance) investing, cybersecurity, and cryptocurrency. Over the last five years, revenue in the analytics business has nearly doubled. This business gives Moody's another reliable, and growing, revenue stream, which tends to perform well when markets are down.
This year should be a good one for Moody's, as the outlook for the economy is strong, financing conditions remain favorable, and the $1.2 trillion infrastructure bill should provide a boost in U.S. public finance issuance.
It's no coincidence that Buffett has built and maintained large positions in these two stocks, and they continue to look like good investments as we head into 2022.
