Based on his impressive track record during the past few decades, Warren Buffett is a source of inspiration when it comes to investment ideas. Take a peek through Berkshire Hathaway's massive portfolio, and you'll find some dominant companies.
The third largest holding is American Express (AXP -0.62%). The conglomerate owns almost 21% of the shares outstanding in this top financial company. But before you rush to follow in the Oracle of Omaha's footsteps and buy the stock, here are three things you need to know.
Operating a closed-loop system
American Express is similar to Visa and Mastercard in that all of these companies operate payment networks that connect consumers and merchants to facilitate commerce. But Visa and Mastercard don't extend credit themselves. Instead, they rely on banking partners that take on the credit risk.
This is where American Express differs. It operates what's called a closed-loop payment system, so the company acts as the credit card issuer, as well as the payments network.
This means the business has to approve and underwrite borrowers, which adds default risk to the equation. But on the other hand, anytime one of American Express's credit cards is swiped as a method of payment, the company gets to keep most of the revenue from the transaction.
During the third quarter of 2023, American Express generated $8.4 billion of discount revenue. This represents money made from facilitating transactions, which is taken directly from merchants. Additionally, American Express registered $3.4 billion of net interest income that came from borrowers making payments on credit card balances outstanding. These are the two biggest revenue drivers for the business.
Benefiting from key competitive advantages
American Express has a history that spans almost two centuries. And during all of those years, the business has developed competitive advantages that make up its economic moat. This is why the company is able to stand out among the numerous other credit card issuers out there.
In this case, it's hard to deny that American Express is an extremely powerful and well-recognized global brand. The business targets a more affluent demographic, so there's a certain status or signaling factor about being an American Express cardholder. This is attractive to merchants because they want these consumers as their customers, due to their higher incomes and spending power.
Moreover, like any two-sided payment platform, American Express benefits from network effects. There now are 138 million cards in circulation around the world and tens of millions of merchants that accept AmEx as a form of payment. The larger this network grows, the more valuable it becomes to all stakeholders.
Reasonable valuation
In the past five years, American Express shares have returned 82%, matching the performance of the S&P 500. That's not all that impressive. If we zoom out further, though, say 30 years, AmEx is up nearly 2,200%, versus the broader index's 923% rise.
As of this writing, American Express trades at a price-to-earnings ratio of about 17.3. This is in line with the stock's trailing 10-year average.
Despite macroeconomic headwinds, the company's business continues posting strong growth. Revenue (net of interest expense) rose 13% in the most recent quarter, with diluted earnings per share soaring 34% from a year earlier. For 2024, management expects both of these figures to increase by double-digit percentages again, assuming there's no deterioration of economic conditions.
Given what I've outlined above, coupled with American Express's growth potential, the valuation seems totally reasonable right now. And this means the stock should be on your radar.
