Occasionally, you get to hear the personal anecdotes from investors who had that "one stock" that helped propel them towards their goals by compounding at a double-digit growth rate for a 10+ year period of time. A lot of times, people think in terms of tech investments: the guy who bought Apple (NASDAQ:AAPL) in 2002 when it was earning $0.17 per share and rode it all the way up to $44 in earnings per share today, or the guy who bought Microsoft (NASDAQ:MSFT) in the early 1990s when the company was earning $0.02 per share (adjusting for splits) compared to about $2.80 annually today.
And of course, not all lucrative investments have to come from the tech industry. McDonalds (NYSE:MCD) has managed to grow its dividend from a little over $0.10 per share annually in the mid-1990s to $3.08 today. ConocoPhillips (NYSE:COP) tells a similar history of dividend growth, plus long-term shareholders were awarded with the lucrative Phillips 66 (NYSE:PSX) spinoff. Likewise, someone who invested $50,000 into Johnson & Johnson (NYSE:JNJ) in the mid-1980s during the Tylenol crisis would have over $2,000,000 worth of the healthcare giant's stock today. I mention this for an important reason: significant wealth can be created with a well-chosen investment in the large-cap space outside of the technology sector.
Generally, the key to pulling off this kind of investment is identifying a company that has a high probability of generating fifteen percent or higher earnings growth and seems poised to do it for a 10+ year period while you hold tight and watch the earnings climb higher over most 3-5 year rolling periods. There are almost always one of two roadblocks present that prevent an investor from successfully executing such an investment: it is difficult to identify annual earnings growth in the neighborhood of 15% annually before it happens, and even if you do, the P/E ratio is usually so high that the long-term P/E compression offsets the substantial earnings growth, taking away many of the benefits for the long-term investor who shrewdly forecast the high earnings growth and acted on it.
Which brings us to my upcoming investment: Visa Inc. (NYSE:V).
If you look at a stock screener, you might get the wrong initial impression of the stock's current valuation. A basic stock screener demonstrates that the company has only earned $2.19 per share, and seems to be trading at 76x earnings. If that were actually the case, the company would be grossly overvalued to the point where the excessive valuation would mitigate any future earnings growth (a lesson, unfortunately, that Amazon (NASDAQ:AMZN) shareholders will be learning the hard way over the coming 10-15 years).
But as Value Line points out, Visa's normalized earnings power is much higher than what the screeners indicate. Visa is always reshuffling, recategorizing, and marking one-time writedowns to its earnings figures, and this understates the company's normalized earnings power (this is somewhat analogous to when a person lowers his taxable income by contributing to a traditional IRA). The "true" earnings per share figure for Visa is going to be around $7.30 per share this year. Looking at the $167 per share price, the company is more accurately trading at about 22-23x earnings. That tells a much different story than what the 75-76x figure indicates.
Under most circumstances, I agree with Benjamin Graham's counsel that you should not pay more than 20x earnings for a stock, and that you are wading into speculative territory if high earnings growth does not materialize. In other words, if you pay more than 20x earnings for a stock, you'd better be right about the future earnings growth.
We all have our sweet spots as investors, and one of mine is this: I like to see a company with earnings growth (and when applicable, dividend growth) that holds up well during a severe recession. Any time I consider purchasing a stock, one of the first things I look at are the earnings results during The Great Recession in 2008 and 2009. When I look to Visa, I like what I see. The company earned $2.25 in 2008, and then earnings grew to $2.92 in 2009. As we entered the recovery, earnings growth improved even more as profits grew to $3.91 in 2010, $4.99 in 2011, and $6.20 in 2012. Visa passes my all-weather test, and that goes a long way with me.
Additionally, the moat surrounding the company is excellent. The card world is run by Visa, Mastercard (NYSE:MA), Discover Financial (NYSE:DFS), and American Express (NYSE:AXP). It kind of reminds of the tobacco industry in the sense that there is not much opportunity for new competition to emerge. The industry itself also benefits from the nice tailwind as more and more customers use plastic instead of currency to make purchases (particularly in Latin America and Central Europe). Visa is healthy in another regard as well in the sense that it is well isolated from risk. The company's revenues come from processing payments. This is a huge benefit, because it means that the banks and creditors assume the major risks associated with defaults and failures as Visa predominantly acts as a processor.
This incidentally, leads to one of my favorite qualities about Visa: the company is an automatic inflation hedge. As a processor, the amount of money it makes is often in terms of Gross Dollar Volume [GDV]. That means that Visa makes more money from $100 transactions than $5 transactions. When inflation happens and goods get more expensive, Visa stands to automatically adjust to the prevailing inflation figure in any country.
Also, the company is "clean" in the sense that it does not have a lot of balance sheet nuisances tying it down. The company has no pension or defined benefits plan, the company issues no preferred stock, and the company has no debt at all. The capitalization structure is attractive. While companies like United Technologies (NYSE:UTX) have to address pension shortfalls and companies like Anheuser-Busch (NYSE:BUD) have to contend with $40 billion debt loads, Visa does not have pre-existing obligations to weigh down current and future profits.
The other thing to keep in mind about Visa is that it has low reinvestment needs. That means a lot of money can be taken out of the business over the long-term to be returned to shareholders in the form of dividends and stock buybacks. You often see value investors get sucked into steel mills at 8x earnings thinking they are getting a deal, but in reality, there is little profit that can be taken out of the business because the reinvestment needs and capital expenditures are so high.
Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B), once visited a farmer who said, "Take a look at my equipment. That's all my profit from this year." You want to avoid businesses like that, regardless of how attractive they may initially appear. Visa is one of those businesses that does not have heavy capital expenditure requirements, and that makes me feel comfortable paying a premium pricing.
This company will have limited appeal to income oriented investors, as the present yield is less than 1% (although its dividend has been growing substantially, from $0.21 per share in 2008 to $1.32 at the present). Since this investment will be in a taxable account, the low dividend will be an advantage given my long time horizon with this holding. As Charlie Munger puts it:
If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%-or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening….
Obviously, Munger offered that piece of wisdom when the old tax rates were higher (thus making the dividends less disadvantageous for many in taxable accounts today), but the point remains that the tax drag from this holding will be minimal compared to putting something like BP (NYSE:BP) in taxable account.
The analyst earnings consensus predicts just shy of 20% annual earnings growth for Visa through 2017. I'm targeting 15%. Given Visa's record over the past five years (particularly through the last recession), and considering the fact that the company has an excellent balance sheet and serves as a great inflation hedge with a well-protected moat, the odds seem to be good that this company will prove a good investment over the next 10-15 years, despite the current valuation of 23x earnings. There is no guarantee that this "swing for the fences" investment will work out for me over the next decade, but I like my odds given the company's earnings growth near 20% annually, debt-free balance sheet, expansion in emerging markets, and the fact that the company automatically adjusts to inflation due to its gross dollar volume business model. As long as this company trades at less than 25x earnings, I will be a net buyer of shares in the coming months.