A Good Pair

If you invest for the long term (which we do) and want to be successful at it (ditto), then you have to be able to handle both large and fairly enduring declines in the market prices of your holdings. What is interesting is that people will accept this argument quantitatively. Yet when put to the test, it is their emotional attitude that still so often does them in. The good news is that help can be found in the simplest of forms.

Pete the Cat is a children’s book series, one of which is titled I Love My White Shoes, has been required reading at our house over the last year. As we will get to below, the timing could not have been better. But first, let’s get back to Pete:

Pete, as you may have guessed, loves his white shoes, but he also has a habit of stepping in piles of colourful things. So after guessing what colour Pete’s shoes have turned after each misstep, the reader is asked: “Did Pete cry?” To which the answer is always: “Goodness, no! He kept walking along and singing his song.” And naturally, the moral is: “No matter what you step in, keep walking along and singing your song… because it’s all good.”

Simple as it may be, when it comes to investing, Pete’s attitude is the right one to have, because occasionally—you are going to step in it. And the only thing I can think of adding to the moral is: first, make sure you’ve picked a pair of shoes worth the admiration. With that in mind, let’s look at a pair we have been wearing for a while.

You may recall from our 2014 Annual Meeting that [Sheehan Associates] had invested in American Express (Amex) back in 2008. At that point, with our average purchase price below $25 US per share, and the stock having topped $90, it was easy to believe things had been working out. Since then, however, the story has gotten a little more complicated, and with us still holding all those shares, it’s one that matters to us.

So, let’s pick up where we left off, in late 2014, with Amex at a price that was in my view, fully valued. It was also the only one of our larger holdings that had not yet purchased for CRV [Credit River] (launched in 2011) because up until that point, I had thought it the least attractive of the group. During the following year Amex was finally added to CRV—it was a mistake though, for me not to have done so back in 2011.

After peaking in 2014 certain challenges emerged and Amex’s stock price began a fairly steady decline. And then in early 2016 it really got hit, dropping to almost $50. So you may be wondering:

Why didn’t you sell back in 2014, dummy?

The answer is that all things considered (tax implications and alternatives available at that time are the big two) the switch did not seem worthwhile. With the benefit of hindsight, obviously I should have sold. But given that life only moves in one direction, we just had to make do.

You may also be curious about those challenges mentioned earlier, so let’s get to them. And while we are at it, we can try to figure out if the market’s reaction was justified. If it wasn’t, then perhaps we were looking at a blessing in disguise.

Likely the most acute of Amex’s recent challenges was the loss (they may call it a non-renewal) of their affiliation with Costco. This relationship accounted for a fair bit of their business as measured in transaction volume and loan balances. However, given Costco’s bargaining power, it was likely less significant in terms of profits. Apparently Costco was also expecting that disparity to widen upon renewal. So whether Amex was right to walk away from this relationship or not, is hard to know.

Charlie Munger for one (I am paraphrasing here) said “certain companies are just worth being associated with and that Amex should have sucked it up, and done the deal.” And although Munger is a shareholder and a director of Costco, he is also a large shareholder in Amex, via Berkshire, so it is hard to argue he is biased. On the other hand, Costco and Amex had always been, in certain respects, strange bedfellows.

Costco’s business model is based on selling goods at rock bottom prices, operating with the smallest gross margins of pretty much any retailer you can find (or at least of those that actually make money doing so). So low in fact that they can’t really offer much else in the way of pricing and still turn a profit (this is particularly true once you account for their real estate, of which they own a lot, and apply a reasonable share of their profits to it). And Amex, although not often thought of this way, is a buyers club; garnering discounts for their members via the fees they charge sellers that are returned in the form of rewards, services and/or credit, instead of lower initial purchase prices. So for a retailer like Costco that operates on such tight margins, granting Amex customers their usual discount just doesn’t work.

While somewhat hard to quantify, my estimate is that losing Costco knocked at most 5-10% off of Amex’s intrinsic value. Material, to be sure, but by no means did this, on its own, seem to justify the 25% decline in the stock in early 2016—even less so the 45% decline, top to bottom, since 2014. Moreover, based on how the rest of their business has been performing, my guess is that it will take only a few years for Amex to replace all of the lost volume. And the odds are good that both their margins and returns on capital will be higher on this new business as well.

Another challenge Amex has been facing, perhaps somewhat surprisingly, is that funding credit card balances has been very profitable over the last several years. Default rates throughout the industry that are below historic levels and net interest margins which, unlike in most other forms of lending, have not compressed, explain the high profitability. Amex however, is much more dependent on transactions than interest earned on loans when compared to many of their competitors. As such, they have been getting squeezed by firms that are willing to subsidize the transaction side of the business, in order to pile on the loans they really crave (4% cash back anyone).

The good news is that both interest and loss rates are likely to change, eventually. When they do, some may find their current practices are not as profitable as they thought. These types of cyclical periods are also just par for the course—because if you are going to own businesses for the long term, then you will experience both headwinds and tailwinds from time to time.

Last, but certainly not least, is the threat Amex faces (and the entire payments industry for that matter) from some form of technological disruption. And unlike the other challenges,which may be limited in nature or duration, this one is here to stay. It is also very difficult to quantify, because nobody really knows what the industry is going to look like in 10 or 20 years.

Before rushing out to short the stock however, consider that Amex and their brethren are fairly well entrenched; and to a certain extent (think on-line purchases) these incumbents (primarily Visa, Mastercard and Amex) have become even more so of late. Furthermore, most of the new services that have come along—often after having been touted, rightly or wrongly, as some form of threat—only survive if they serve the existing hierarchy (Square and Apple Pay for example).

So now that we know what may have been causing Mr. Market to reassess his view on Amex over the last few years, let’s try and figure out if he was right.

To start, while I may have preferred a different outcome in the first two cases, neither of these events have materially changed my estimate of what Amex is worth. They were also both well within the types of outcomes I expected could happen, back in 2008 when we first bought the stock. By no means does that imply that they were expected or even considered, specifically. It simply means they were within the range of the types of things I thought possible. As for the last threat described above, as significant as it continues to be, it is nothing new and was under consideration back in 2008.

So from my perspective the decline in Amex’s price was greater than warranted given the challenges it faced, which implies that it was becoming more and more attractive as it fell. But it does not mean that it was attractive, yet. To make that call there are a few more things we need to consider.

Back in 2008, when we were first buying shares in Amex at about $24.50, we were paying 10x earnings, or so. And eight years later, when the stock dropped to the mid-fifties, it was selling for 11-12x what I expected them to earn in 2016 (to be clear, this is my estimate of normalized earnings, not the number they recently reported). Based on these numbers, two things seem to jump out.

The first is that Amex’s earnings per share have done pretty well over the last eight years, up roughly 100% (that’s 8-9% compounded annually based on my range). They have also been paying a dividend throughout most of this time, such that even when measured to recent lows, we had earned about 12-13% compounded annually.

The second is that no matter how down you may have been on the economy and/or Amex in early 2016, it is hard to imagine it would have been worse than back in 2008. And even if granted perfect foresight in early 2016, stretching out eleven months or so, I think (or hope, maybe) that would have remained true.

So when a company of the quality of Amex is available for a price that has proven rewarding in the past, and that is only slightly higher than it was when the entire financial system was on the verge of collapse, well that gets my attention. So, as you may have guessed by now, we loaded up, roughly tripling the number of shares held by both partnerships.

For the year Amex was only up 6.5%, but from the average price we paid for the additional shares it was about 30% (measured in US and excluding dividends in both cases). And while that did account for a good part of our results in 2016, it does not prove this new commitment was a wise one. The final answer on that won’t be known until we learn what the stock is worth in five or ten years. That’s true for my decision not to sell back in 2014 as well.