Three Financials Worth Buying: American Express (Part II)

In my pre-rate cut "only three financials worth buying" list, I said the only financial stocks you can safely be in are US Bancorp (USB), Wells Fargo (WFC), and American Express (AXP). Now that the Fed has rolled over to the rate cuts, every financial out there is suddenly game from the long side – but that still doesn't mean you should own all the lesser companies, especially because the high-quality names went down right next to the low-quality ones, and should rebound more than fairly.

I was originally going to cover Wells Fargo before American Express, but with the Fed cut this stock could easily go off to the races and you shouldn't miss it.

So, what makes American Express so special?

Simply put, American Express has one of the widest moats of any company on Earth… but that doesn't make for much of an article. So let me explain.

The economics behind the credit card industry are much like that of credit the ratings agencies – but even stronger at this point because they haven't drawn the scrutiny of the agencies, which could conceivably result in some forced competition if the people in Washington get the idea that their intervention can only be benevolent. Ahem.

Like the ratings agencies, having a small number of credit card providers means that reputation is supreme in the business, and Amex is intimately aware of that. This is why there is a culture of responsibility running from management down through customer service; read the annual report and the message comes through clear as day. Unlike the ratings agencies, though, nobody is questioning American Express' judgment - and I'd argue that the brand is as strong as ever, particularly overseas in some of the fastest growing parts of the world.

Another factor at work that results in a very limited number of credit card companies is network effects – thanks to the large installed base of merchants who accept Amex cards, having an Amex card is extremely valuable to consumers. Replicating the worldwide network Amex uses to drive transaction volumes would be nearly impossible for all - and even then, there is the reputation issue to consider. Give Citigroup (C) $50 billion and have them try to replicate Amex's business, and they still might not get too far…

These inherently good economics give you a company has averaged a 24% return on equity in the last decade, a number is only going to increase since American Express spun off financial planning and asset management arm Ameriprise Financial (AMP), not to mention the fact that CEO Ken Chenault's pay is heavily geared toward beating an ROE target of 36%.

When you read the financials and take an intuitive understanding of operations, you reach the conclusion that American Express is an excellent business. Businesses like American Express don't often come around at under 14x earnings, so while I can't guarantee this last turn has put us past the bottom, you should be confident that you are getting an excellent company at an excellent price, particularly when you consider the company's target growth rate is in excess of 15% annually for six years out; and again, Ken Chenault won't get paid for sub-par performance. And while a high ROE is nice and consistent growth is nice, all you really care about at the end of the day is whether or not AXP is a good stock to buy. Again, Ken Chenault is paid based on whether or not the stock outperforms the market. The people in charge know what they are doing, and in my opinion they are unequivocally working for shareholders.

It takes an extraordinary concentration of fear to knock a stock like AXP down this far - this is the kind of generational low valuation that might come around once in a decade. So as that fear proves unfounded and unwinds, you'll get the realization of the value here. American Express is simply too good of a company with too many opportunities to trade at the valuations it does; I'd say that 20x earnings comes in on the low end of where the stock "should" trade, and that gives you a $70 stock. When you consider that people are moving away from cash in general, and the world as a whole is becoming wealthier, it translates to plenty of chances for Amex to leverage its existing relationships and increase its base of high-quality customers.

If you look at the chart below, it shows historical and future forecasted earnings relative to the stock price. Certainly something to ponder…

Read Fortune's excellent article on American Express CEO Ken Chenault's pay package.

Disclosure: None

Comments

[good value]

axp article is very good

[Jake2]

Excellent piece. A few more base level numbers would have made it even better. However, this article is more than a cut above what usually appears here. Thanks very much!