In a world many thousands of years ago, a young girl named Cinderella is at an elegant ball, dancing with a charming prince. She arrived in an extravagant carriage, dressed in fine silk, and wore delicate glass slippers.
And then, as the clock struck midnight, her carriage transformed into a pumpkin. Her fine silk dress turned into rags, and her glass slipper fell from her foot.
For investors in Visa (NYSE:V) and MasterCard (NYSE:MA), this story may have put an empty feeling in your stomach, because when the clock struck midnight on January 1, 2014, something changed in the markets for these two giant payment processors.
The Belle's of the Ball in 2013
The second half of 2013 was a very, very good time to be a Visa or MasterCard shareholder. Both stocks handily beat the S&P 500 (SNPINDEX:^GSPC), with MasterCard gaining over 40% in that six month span.
Year to date in 2014 though is rather different.
Visa? Down 6%. MasterCard? Almost 12%. Neither company able to match the S&P's 6% gain.
So what happened at the stroke of midnight, hardly six months ago? Did the payment processing carriage turn back into a pumpkin?
And if so, will Visa and MasterCard find the same happy ending as young Cinderella will?
Looking at the fundamentals
Neither Visa nor MasterCard are a perfect Cinderella -- the companies are in fact gigantic and the clear industry leaders in payment processing. There is nothing underdog about them.
But even as household names, the market could be mispricing either or both of these giants.
Let's start with revenue. As this chart shows, neither company is showing signs of any top line problems. Visa and MasterCard make money every time one of their cards is used throughout the world. More commerce equates to more revenue. It's just that simple.
Perhaps there is an earnings issue? Could that be what's driving the shares lower?
As this chart shows, profits are as stable as ever (that spike at June 30, 2012 for Visa is a result of a large one time charge related to a legal settlement -- adjusting that out and Visa's profits are as stable as the rest of the chart).
Visa and MasterCard both enjoy fantastic operating margins, meaning that the companies churn out huge profits from every dollar of revenue. For the quarter ended March 31 on a trailing twelve month basis, Visa generated $0.63 of operating profit for every dollar of revenue. MasterCard boasted $0.54.
This translates to incredible returns on equity -- 20% for Visa and 45% for MasterCard.
We could easily keep going, but I think the point is clear. There is nothing fundamentally wrong with either Visa or MasterCard. There are no current competitors challenging either company for significant market share. Both companies continue to be well managed, highly profitable, and investor friendly.
So what gives?!
The market is a funny place. Academics may finger wag about an efficient market with perfect pricing, but reality couldn't be farther from the truth. Warren Buffett's $60 billion net worth stands as proof enough -- the market routinely misprices companies, creating opportunities for value oriented investors.
The market is emotional. It claims to be proactive, but is more often than not reactive. The market can get swept away by group thinking instead of sound reasoning.
That is the basis of my theory for why Visa and MasterCard have lost value in 2014. I think the market misunderstands the relationship between payment processing companies and potential disruptors in the tech space.
The market sees Facebook, Google, or Amazon as threats to Visa and MasterCard. In reality they are allies.
These tech companies have no desire to build a new payment infrastructure. The cost and complexity of attaining scale throughout the globe while providing even the most basic required capabilities is mind boggling -- authorizations, settlements, chargebacks, etc.
Visa and MasterCard make money when an individual transacts over their network. Its irrelevant if that transaction is with a plastic card, a mobile phone, or any other new end point technology. Visa and MasterCard are toll collectors -- the more traffic on their network, from whatever source, is good for business.
When a tech company announces a new entry into "mobile payments", the market reads that announcement as a challenge to Visa or MasterCard. Generally speaking though, it's a partnership, not a challenge. The tech company is simply building a new front end, a newer, easier user interface for consumers to access Visa or MasterCard's network.
For investors, the decline in Visa and MasterCard's stock price could be the opportunity to buy two very strong, potentially undervalued stocks. The growth potential in South America, Asia, and the Middle East is huge. Both companies have world class brand recognition. They're growing. They're stable.
While the markets see Cinderella running from the ball in ragged clothes carrying a pumpkin, you can see the prince holding a single glass slipper, already thinking about how he'll find the girl who wore it.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Facebook, Google (C shares), MasterCard, and Visa. The Motley Fool owns shares of Amazon.com, Facebook, Google (C shares), MasterCard, and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.