Does This Undervalued Stock Have Strong Growth Potential?

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Warren Buffett, chairman and CEO of Berkshire Hathaway (NYSE:BRK.B), loves American Express (NYSE:AXP). Although that may be too strong, he must like it a lot, given that he has held it in his Berkshire Hathaway portfolio since 1991. In fact, not only is it one of his longest-held positions, but it is currently his third-largest holding. He owns more than 151 million shares of American Express, which made up about 6.6% of his portfolio as of June 30.   

Broadly speaking, American Express checks a lot of critical boxes for Buffett, as he likes banks, strong management, a competitive advantage and good value. Right now in particular, American Express is trading at a favorable valuation, but does it have long-term growth potential?

American Express has some key advantages

One of the things Buffett especially likes about a stock is if it has a competitive moat: an advantage so strong and protected that it is hard for competitors to pierce. As the third-largest credit card company, American Express does indeed have a moat. It is one of just four major credit-card processors, so it operates in a very small pond to begin with.

However, American Express is also unique among its competitors because it has a closed-loop network, meaning it is both the lender and the processor on its own network. Thus, the company makes money on both fees — from swipes, memberships, etc. — and from interest on the loans. Its two larger competitors, Visa (NYSE:V) and Mastercard (NYSE:MA), are not lenders, so they only generate revenue on swipes and other fees.

The other major player, Discover Financial (NYSE:DFS), also has a closed-loop network, although it has a different strength. Discover generates far more revenue from interest on loans, whereas American Express receives little or no interest on many of its cards but makes more on fees.

This key advantage has allowed American Express to perform well in various market cycles. For example, it was only down 8% last year, compared to the S&P 500’s plunge of 19%.  While American Express is a bank and lender, it has not fared as badly as banks have in this high-interest rate environment because it relies more on fees. In fact, the company is coming off a second quarter in which its revenue climbed 12% year over year to $15.1 billion, while its earnings per share also increased 12% to $2.89. Both of these are company records. Overall, spending on its network increased 8% to $426 billion.

American Express’ success has been driven by a few major catalysts. First, as a preferred method for travel spending, American Express has seen a surge in travel and entertainment revenue. In the most recent quarter, the company saw travel spending increase 14% year over year. Second, it caters more to a wealthier clientele that is less impacted by a recession or slowing economy. Third, it is hugely popular with younger generations for its perks and low interest rates — something that bodes well for its future growth.

“Millennial and Gen Z consumers remained our fastest-growing customer cohort, representing over 60% of new consumer accounts acquired globally in the quarter, and spending by this cohort increased 21% over the prior year in the United States,” Chairman and CEO Stephen Squeri said in the second-quarter earnings report.

Valuation metrics are dropping

Despite its strong numbers, American Express is only up about 2.5% year to date. In part, it may be suffering from a negative market sentiment toward banks right now. However, it is built to outperform if the economy takes a dip, given the advantages it enjoys.

Additionally, American Express is currently trading at a very reasonable valuation with a price-to-earnings (P/E) ratio of 15, down from 18 in June, and a forward P/E ratio of 12, down from almost 16 in June. The company’s P/E-to-growth (PEG) ratio is 0.93, and anything less than one is considered undervalued compared to its long-term growth potential.

Analysts also seem bullish on the stock, as the consensus price target for the next 12 months calls for a 20% increase. While there is a lot of uncertainty on where the economy is headed, American Express has shown the ability to weather downturns and spike in bull markets.