Category: Articles

No, it’s not a dirty movie….it does leave one feeling a bit soiled though..

The investing thesis behind American Express (AXP) has always been that it has a higher quality of creditor (creditee?) and thus its defaults will be lower than the typical credit card issuer. Unlike Visa (V) and Mastercard (MA) who issue their cards through banks and collect a “toll” each time the card is used, Amex holds the credit balances and is essentially it own bank. This has enabled Amex in good times to earn a high return on equity as it collect the interest payments that go to the banks from the other card issuers.

All that seems to have changed.

It seems, being hit by slowing consumer spending and rising defaults, AmEx is seeking roughly $3.5 billion from the TARP program.

It isn’t clear if the application under the Troubled Asset Relief Program (TARP) came before or after AmEx got Federal Reserve approval Monday to become a bank-holding company.

Why? Even the most affluent AmEx customers are cutting back on discretionary purchases, the company has acknowledged. A spending slowdown is particularly problematic for AmEx because its business model revolves around consumers who pull out plastic for their purchases.

That alone would not cause the problem. What would?

Delinquencies and defaults on credit cards are rising. Meanwhile, the company is virtually locked out of credit markets because investors who buy consumer loans are sitting on the sidelines.

All this is causing a liquidity problem. Again, like other institutions, not a solvency issue, but a liquidity one. It ia also the reason we are hearing stories about AmEx card holders with no credit problems getting credit limits decreased. AmEx is trying to decreased it liabilities.

Not good news for shareholders for two reasons. The decrease in consumer spending reduces the “toll” AmEx get when a customer uses it card. The credit limit decreases they are placing on customers now further reduces that effect and reduces interest AmEx wil earn on outstanding balances. When you add this to the increasing defaults, you have a trouble stew.

This is not the “salad oil” fiasco that hit Amex when Berkshire’s (BRK.A) Warren Buffett bought a huge chunk of the company in the late 1970’s. This is a fundamental change to the company’s structure and the way it does business. The AmEx model back then was to essentially “front” customers money who would then pay it back a month later in full. Now Amex on almost all card extends payment terms and has branched out into business lending. Now, more than ever it is exposed to the consumer and his or her credit condition, not just their current spending patterns.

Previously if you did not pay your AmEx bill each month it was shut off. Now, consumers can continue to rack up debt to their limits while making minimum payments until they are tapped out. In this case, the monetary default risk for AmEx is far higher. This is causing increasing credit losses for AmEx. The old thought that “AmEx is less sensitive to a recession” has never really been tested. The last real recession we had in the US was the 1990 one (the 2000 “recession was a pothole). AmEx then was not nearly as exposed to the consumers credit condition as it is now. Only now are we going to be able to test the thesis. Based on early results, it was wrong.

It also means the old investing thesis need to be rethought as it has now become less valid.

This is not the same AmEx Buffett bought….

Disclosure (“none” means no position):None
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U.S.News & World Report
Bruce Greenwald on Value Investing
Friday November 7, 11:43 am ET
By Kirk Shinkle

Bruce Greenwald, who holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School, is coeditor of the forthcoming sixth edition of the value investing classic Graham and Dodd’s Security Analysis (McGraw Hill).

After watching stocks plummet this year, he’s sizing up the opportunities seen through the lens of value greats like Warren Buffett who perceive a rare chance to start buying on the cheap. Excerpts:

What’s the current environment like for a value guy?

I’ll tell you the one really nice reason to be a value investor: When things like this happen, you cannot help but go nuts at the opportunity. What this looks like is the end of 1974, where good stocks are selling at three times sustainable earnings and stocks that normally wouldn’t have sold at less than 20 times earnings are selling at 10 times earnings. These are exciting times. The short-term issue is that in the near term there will be a painful macroeconomic environment and we don’t know how long it will last.

What should investors eyeing cheap stocks watch out for?

The craziest thing to do is take recent earnings and add a multiple to it. There are a lot of stocks, like steel companies, that have very high recent earnings and trade at only four to five times earnings. They look like a 20 percent return stock, but those earnings won’t be sustainable. If you look at steel companies five years ago before this huge capacity run-up, their earnings were about a third to a quarter of what they are now. You have to stay away from those kinds of enthusiasms–things that look cheap on the basis of peak earnings. You’re looking for [stocks] that are protected by assets.

How should you approach earnings predictions?

What you don’t want to do is use unmoderated price-to-earnings. Never look at current or even recent earning, especially in areas like oil companies where we know they are inflated and coming down. Typically, what a value investor will do first is get a sustainable earnings number, an average PE over a business cycle. You really have to go back 10-12 years to get a feel for what average margins typically look like in these businesses. That’s what you use for earnings. The second thing, when you look at a PE, you’re always assuming it’s sustainable. You always want to make sure it’s protected either by assets or the kind of moat that Buffet talks about. Otherwise, even if it’s been making lots of money, it’s a business that will be competitively vulnerable.

Does the weak credit environment change the value investing proposition?

The first thing is that for value investors, you are not going to try to forecast the future. Most value investors would say if it’s anything like credit crunches we’ve seen in the past, it will be gone in a year. That’s what the betting has to be. It’s a short-term problem and not something you focus on. It has, however created opportunities in debt markets. Banks are dumping senior secured debt, selling it on the market for 50-60-70 cents on the dollar. The implied returns are north of 15 percent, and because you’re senior to everybody else in the event of bankruptcy, you’re likely to get paid. That’s where opportunities have been created by the credit crunch. If you listen to Buffet, it’s where he’s been investing up until now. Those opportunities are still there, but my guess is they’re going to go a way.

Any advice for investors who are still nervous?

If you look at any (mutual) fund and you look at the average annual return–a dollar invested every year through the life of the fund–and then you look at the returns weighted by how much money was in the fund . . . , the difference in those two returns is 6 percent a year. That’s true almost across every category of funds. What that means is investors are buying in at exactly the wrong time and dumping things at the exactly wrong time. In this environment, the people who are dumping things are getting out at almost exactly the wrong time. What you want to have is a steady, well-developed policy you stick to.

What do you think of Warren Buffett’s move so far into Goldman Sachs (GS) and General Electric (GE)?

First of all, Goldman and GE are not real Warren Buffett moves. They’re literally what he did at Solomon Brothers. He got paid very handsomely both in terms of a high return and protection on the downside. His preferred carries a significant interest return on it and is protected in event of a catastrophe. He got a very favorable deal. This is not the kind of real investment he’s making. He has talked about accumulating further positions in one of two financial services companies. I don’t know if he’s had to reveal which one yet, but it’s either American Express or Wells Fargo. There you can see what he’s looking at. American Express is easier because it doesn’t have all the complexity of a bank.

Greenwald on the best value bets in the market now:

American Express (AXP):
If you ask yourself what the average yearly earnings should be even in a fairly distressed economic environment, it’s probably about $3.50 a share. Typically, they commit to pay out at least half of those earnings to you in cash, so you’re getting a 7 percent cash return either in buybacks or the dividend. Then they reinvest 7 percent of your money. In the short run, where that money is going is cash to protect themselves financially against any catastrophic drop in credit card repayments, but in the long run it’s going to credit card loans, and the economics of those are fairly transparent: They lend at 15 percent, borrow at 4 or 5 percent, have a 10 percent margin, and the default rate is around 5 percent. So they make 5 percent on every dollar of loans, and they leverage up because you can because it’s fairly safe. Even if they do 7 to 1, which is a fairly conservative ratio, you’re making 5 percent times seven on your unemployed equity capital which is 35 percent, or 20-percent-plus post-tax. And billings by American Express just grow over time. It’s probably faster than GDP because they have high-income customers, and spending is skewed towards services, which are growing faster than (spending) on goods. You probably get another 5 percent even making conservative growth (projections). You’re looking at returns, without any improvement in the multiple, of well over 20 percent. That’s the sort of investment (Buffett) sees. It gives you an enormous margin of safety for long-lived bad economic conditions.

WellPoint (WLP):
You’ve got an annual earnings return of 14 to 15 percent, and mostly its going into cash. You know they’re just a toll on medical expenditures in certain parts of the country, and those will be growing at 5 percent no matter how you look at that. That’s a 20 percent return. Buffett’s not greedy. He’ll live with that all day long. These are safe companies with dominant market positions and trustworthy managements. They may go down in value before they go up, but the long-run prospects are so stable and attractive that I think he’s right to be investing in these things.

Magna (MGA):
It recently traded at a market capitalization of $3.6 billion, and it’s got $1.7 billion in net cash. They’re not going to run out of money, so you’re paying $1.8 billion or $1.9 billion for the business. That business this year, if you look at average margins–and this year it’s a little lower because they’re at the trough of the cycle–is going to earn about 5 percent on sales of about $26 billion, so you’re talking about $1.3 billion of pretax earnings you can buy for $1.9 billion. Then, if you look at the assets and the cost of reproducing those, you have about $8 billion of assets in the business to protect you. If you just take that earnings power, after tax, of about $1 billion, and you say in a risky industry like autos you want a 12 percent return, that’s an 8 multiple. That’s a case where you’re being very conservative about earnings, you’re backed by assets, there’s a lot of cash, and, even though autos are a fraught place to be, you’re buying those $8 billion in assets less than $2 billion. That’s got to be the kind of bargain you’re looking for.

Comcast (CMCSA)

Comcast, when you take out excess depreciation, is trading at an earning return of about 10 percent. Even if everything goes to hell in a basket, the one thing we’ll do is transact over the Internet. They and the phone companies have an incredibly valuable monopoly unless they screw it up. The one encouraging thing that hasn’t appeared in cable company [share] prices is price wars among some companies seem to be moderating.

Microsoft (MSFT)

Microsoft, if you take out $20-30 billion in cash, is trading at about a 10 percent earnings return or so. It’s a business that doesn’t require any incremental capital and will grow at least as fast as global GDP.

Disclosure (“none” means no position): Long GE, GS, none
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