Of the 30 components in the Dow Jones Industrial Average, Visa (V -0.97%) was my top pick for August. The stock had sold off due to a mediocre earnings report, but the long-term investment thesis was intact.
Visa stock has continued languishing and remains a compelling buying opportunity. Here's why.
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The impact of lower interest rates
Investors and economists expect the Federal Reserve to begin lowering interest rates in September. This is great news for consumers looking to finance a home, car, or other big-ticket item.
Lower interest rates tend to spur spending and economic growth. The Fed kept interest rates high to slow the pace of inflation, even at the expense of consumer spending. The strategy worked, but mortgage interest rates and credit card debt are around their highest levels in more than a decade, and the job market is weakening. The Fed had been waiting to cut rates until these indicators got worse, but not so bad that the economy fell into a recession.
It remains to be seen if lower interest rates will raise inflation and erase much of the progress the Fed has made during the past couple of years.
At its core, Visa benefits from transactions. The higher the transaction volume in terms of dollars and the number of times customers swipe or tap their Visa credit or debit cards, the more money it makes.
Banks benefit by collecting interest from consumers with high credit card balances. Visa does not. If consumers cut spending to pay down credit card debt, that isn't good for Visa. In this vein, higher interest rates have benefited banks. Visa would prefer that consumers use cards to buy as many goods and services as possible and then pay off the full amount each month to keep the ball rolling.
Although economic growth certainty benefits Visa, a recession does not. So while the broader market rallied on Friday in response to the Fed news, Visa and Mastercard (NYSE: MA) actually fell slightly during the session -- possibly due to recession fears.
In sum, lower interest rates benefit many companies, but they don't automatically mean faster growth for Visa.
An established foothold in the global payment processing industry
Monetary policy, economic growth, consumer spending, and many other economic factors affect Visa. However, in the long term, the key driver is the long-term transition from cash to physical or digital credit and debit cards and mobile payments. The more market share Visa can capture, the greater its network effect.
Visa's business model depends on consumers and business clients using its cards, and merchants accept those cards worldwide. But merchants lose out on a percentage of sales due to credit card fees. So the trick is to make fees lower than the potential loss of sales for not accepting Visa.
On the consumer front, Visa's partnerships with banks and other financial institutions are essential for encouraging entities to choose Visa as their network processor over rivals like Mastercard or American Express. Management's commentary during the recent earnings call suggests that Visa continues to partner with credible financial institutions in both developed and developing economies abroad.
Visa has expanded its international business while maintaining its industry-leading position in the U.S. In 2022, Visa accounted for more than half of purchase volume on general-purpose credit cards.
Visa is becoming a compelling value
Since Visa doesn't face the loan default risk or credit risk of a bank, it has historically traded at a premium valuation to the broader financial sector. Its three-year, five-year, seven-year, and 10-year median price-to-earnings (P/E) ratios are all over 30, while its P/E ratio based on trailing 12-month earnings is 28.7, and its forward P/E ratio based on the average of analyst estimates for the next 12 months is just 24. One reason Visa's valuation has come down is that growth has slowed across several key markets. But Visa is still generating plenty of profit to support its huge stock repurchase program and increasing dividend.
Visa yields just 0.8%, mainly because it spends much more on share buybacks than on dividends. If Visa's capital return program were just dividend payments, it would yield 3.6%. With a payout ratio of just 21.5%, Visa has plenty of room to raise the dividend faster than earnings while still repurchasing stock.
Visa is built to thrive
For decades, Visa has faced consumer backlash and antitrust civil lawsuits over its swipe fees, or the charges for using its payment processing network. Credit card companies face competition from peer-to-peer payment options like PayPal, Venmo, Zelle, and other services that avoid payment processors. Or moving away from fiat currency toward cryptocurrency. But many digital payment options still rely on traditional payment processors like Visa, and cryptocurrency has failed to disrupt government-backed currencies.
For example, Apple Pay lets users carry a digital wallet that includes their Visa cards. And Apple Card is a Mastercard, so it still depends on a major payment processing network.
Visa has a wide competitive moat and plenty of runway for capturing market share abroad. Although its performance can ebb and flow with the economic cycle, the business isn't so cyclical that it would take a major hit during a recession.
Add it all up, and Visa's winning formula, paired with its valuation, makes it a compelling buy for September.
