We Study Billionaires - The Investor’s Podcast Network - TIP281: Intrinsic Value Assessment of Mastercard w/ Sean Stannard-Stockton (Investing Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we bring back an awesome guest, Mr. Sean Standard Stockton. I love this kind of interview because we have the chance to deep dive on an individual company and learn about the nuances of a particular industry. And on today's show, Sean provides a deep analysis on the credit card industry by conducting an intrinsic value assessment of MasterCard. Sean is the president of Ensemble Capital, which manages over $900 million in assets under management and his firm practices the value investing principles and techniques like Warren Buffett.

Starting point is 00:00:33 So without further delay, here's our discussion with Sean. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host Dick Bruterson, and as always, I'm accompanied by my co-host, Preston Pish. We are excited to bring back Sean Standard Stockton Front Asimbal Capital here today. Sean, welcome to the Amherst's podcast. Big.

Starting point is 00:01:16 Thank you so much for having me back. So, Sean, we featured you back in October, and back then, you pitts First Republic Bank. Back then, whenever we released the show, the stock was trading 107. And today, it's trading 117. We're recording here late January, so far, so good. And we are very excited to have you pitch another stock today. So, Sean, thank you again for coming back on our show. And please go ahead and talk about MasterCard for our audience.

Starting point is 00:01:46 Thanks so much. Yeah, we've owned MasterCard for almost a decade at this point. You might think about MasterCard and First Public that I spoke about last time and think, oh, they're both financials. You know, these guys are into financial stocks. But actually, most financials we don't think are terribly interesting. First Public's kind of a unique business. model. But MasterCard, I think it's important to recognize that it's just not a financial. I mean,

Starting point is 00:02:09 this is not a business that lends any money, which most people say, what are you talking about? It's a credit card company. So I'll walk through all of that. I will say kind of at the outset, we do think MasterCard is a compelling stock to own, to buy at these prices. The stock is up over 20% since I agreed to come on the show a couple months ago, and we think the valuation is closer to fair now. But some people might look at it and think it's expensive, which we think's wrong. And so when we get into that later in the show, we'll kind of dig into how we think about this sort of business. But at the outset, it's important to recognize that MasterCard just has an amazing business model. I mean, if you could design a kind of set of financials, this is what you'd

Starting point is 00:02:49 want to see, right? So over the last decade, revenues grown 330% or about 13% per year. Their operating expenses have grown just 270 or about 10% a year. And this led profit margins to rise from an already incredible, 47% to an amazing 57% operating margin growth. And we think that those numbers actually understate the earnings power of this business. And that's because MasterCard, along with Visa has basically own payments in the developed world. But rather than just kind of sit on that and kind of milk that for cash flow, like a lot of kind of legacy incumbent businesses that have deep competitive advantages, they get late. right? And they stop investing for growth. And MasterCard is like the diametric opposite. So over the last

Starting point is 00:03:40 couple years, they've been investing very aggressively in other companies in the payment industry to do things like crack open enormous markets such as business to business payments. So most businesses today still mail checks back and forth. They do wire transfers at $25 a pop. That infrastructure around payments for businesses is not very robust. And so MasterCard's been investing heavily as has Visa in building out into those areas, as well as staying on the cutting edge of technology. And so when you think about their operating expenses, despite the fact that profit margins have jumped 10%, at the same time, we think that the operating expenses in the business today are not needed to sustain the business.

Starting point is 00:04:20 In other words, it's investment that's running through their income statement. And so we think a cleaner kind of understanding is that their profit margins are even above 57%, and then they're reinvesting a fair bit to continue growing. And so, you know, when you think about a classic kind of business, say, you know, a pre-internet sort of business, you know, like a retail store. The way you grow is you invest capital, right? You build new stores. And then those costs run through your cash flow statement or the depreciation comes through your income statement, but you're investing off your balance sheet. MasterCard is what we call a capitalite compounder. They don't need to reinvest capital to grow. basically none, right? And so the growth, the way that they fuel growth is investing in their income statement. And so this means that they're able to produce to return almost all their cash flow to shareholders, right? If you think about like a retail store, it's cash flow needs to be reinvested to keep growing. So they pay out some of that cash via dividend and

Starting point is 00:05:20 use the rest to buyback stocks. And so these buybacks have had a really positive ongoing effect to earnings, which along with the corporate tax reform of 2017, is why earnings are up 640% or 20% per year for the last decade. So Michael Mobuson is a strategist who's been in different firms. He just recently moved back to Morgan Stanley. But he's not a lot of work on what's called base rate analysis. Like if a business is growing 15% per year this year, it's a growth business. It's likely to grow faster than other businesses in the future, right?

Starting point is 00:05:52 I mean, I would guess they've imagined you have two businesses. One's 15% a year, one's 5% a year. And then what are they going to grow next year? Well, it's probably a good bet the faster growing business is going to grow faster. in the following year. But this doesn't tend to persist. Most growth businesses slow down pretty rapidly, especially over periods like a decade.

Starting point is 00:06:10 So the idea that MasterCard is still growing double digits, a decade after we first bought it, is unusual, right? And it shows kind of how deep their competitive advantages are. So what we like so much about MasterCard is this thing is just a cash machine, right? It produces buckets of cash. It returns most to all of that cash flow to shareholders or uses it for acquisitions. And yet it's able to continue growing rapidization. rapidly. So revenue growth still is in the kind of a low double digit sort of rate. So that's kind of

Starting point is 00:06:37 the financial model. That's what we like at the business. And then what is the business, right? I mean, that's the most important thing as an investor. I think some people get lost in financial statements and forget that this is an entity that's creating value for its stakeholder ecosystem. And how does it do that? And why can it uniquely do that versus other people? So kind of briefly on the MasterCard business model, banks are the ones that lend money. Right. So if you look at your credit card, going to say MasterCard or Visa on it and it's going to be issued by Capital One or whoever it is, there's the merchant that accepts your credit card and then there's the customer that actually swipes it, right? And so when you swipe a credit card, I know, you know, retailers might tell

Starting point is 00:07:14 you, well, it's a two and a quarter percent fee to us or whatever it might be. But really, MasterCard and Visa get 0.2 percent or less of the transaction. Most of those other fees go to the banks. And people forget, you know, the banks are fronting money, right? People do, like, there is fraud. there is like people don't pay, right? So there's real costs incurred here. We think there's good evidence that credit cards are cheaper for merchants to accept than cash. You could look at cash and say, what do you mean? There's no cost, but there is cost, right? You have to carry it to the bank in a secure manner. Employees steal from you. You miscount. You have to change out the drawer. You have to make change, right? People get sick from handling cash. There's an enormous number of expenses associated with accepting

Starting point is 00:07:55 cash. Credit cards is just much more explicit. And so you can see in areas like say the barrier where I live, a lot of new places, they don't accept cash, new bars, new restaurants. It's very common they don't accept cash. Why would they do that if credit cards were more expensive for them than accepting cash? They do it because especially if you are all in, it's actually cheaper than accepting cash. And so the thing that MasterCard and Visa did was they created this network so that you, I'm sure you have a Visa MasterCard in your wallet right now. I do. You're in Denmark. And if I flew to Denmark, they'd accept the card in my wallet and you flew to here, they accept it. That's an amazing, amazing achievement, right? And so there is this chicken and

Starting point is 00:08:35 egg problem with setting up networks like this. Imagine a new credit card company. Credit card plus, it's this amazing product. There's some features about it that's just incredible. So I, as a consumer, say, I want that. But I go to the store, it's not accepted because very few people carry it. Well, then I'll stop carrying it pretty quickly. If the stores get some great benefit and they accept it, but no one carries it, why are they going to go to the trouble starting to accept it, right? If nobody carries it. So Visa and MasterCraft have won that problem. And that's why today, there's just no competition. Nobody is working on displacing them through setting up a new credit card network. There is various attempts to change payments in important ways, but almost all of those run on top

Starting point is 00:09:17 of the MasterCard and Visa Rails, as they're referred to. So especially early in our ownership, almost a decade ago, people talked about FinTech innovation and how it was going to disrupt Visa and MasterCard. But what we've learned over time is that pretty much everybody has built on top of Visa and MasterCard. So if you talk to venture capitalists, no one's out there saying, oh, I'm funding companies that are looking to disrupt MasterCard or Visa. They're trying to build on top of MasterCard or Visa or do something entirely different, cash-to-cash payments using checking accounts and things like that. But the event that in our mind solidified the thesis here was when Apple Pay came out. So this has been quite some time now, right? But if you look back at kind of the notes that we took, we were owners of Apple at the time.

Starting point is 00:09:58 And if you look back, people thought, well, look, Apple has all of these credit cards on file. They have links to checking accounts. They have engineers. They have billions of dollars of excess cash. They might just use the iTunes credit and debit network and just start running their own payment system. And despite kind of all this money and resources, engineers and smarts and basically 15% of the wealthiest people in the world carrying their device in their pocket, they still said, Nope, let's just bill on top of Visa and MasterCard. So what is Apple Pay?

Starting point is 00:10:27 It is nothing but an easy way to use your Visa or MasterCard, right? When you swipe your watch at the store or wave your phone, what is it doing? It's billing your credit card, right? It's transacting. It may be connecting to your checking account, much like PayPal does. But look, PayPal's been around for a quarter century, right? This isn't some new thing that's going to come along where cash-to-cash transfers, banks to banks are going to totally disrupt Visa and MasterCard.

Starting point is 00:10:52 It's real. It'll continue. growing, but it's not new. And I think that the last thing, and then I'll wrap up and you go to some Q&A is most of what I've just talked about is really about the develop market. How does the U.S. and Europe work, right? But emerging markets are still in play, and China is lost, right? So in China, FISA MasterCard were kept out. Tencent and Alibaba launched Weechat pay and Alibay pay, and Ali Pay. And those businesses have won, right? I was in China last October. And, you know, People, you'll sometimes read they don't accept cards. They do. If you go to Beijing or Shanghai,

Starting point is 00:11:28 kind of anywhere that Westerners or people travel to, credit cards are accepted more and more. They're starting to be more inroads for MasterCard and Visa. But the country as a whole is lost. I mean, Tencent and Alibaba did what Visa MasterCard did in the rest of the world. But then if you look at the kind of in India, it is still an open playing field. And so when we think about the growth opportunity for MasterCard, in the developed market, they'll continue growing because there is continually a shift first of growing consumer spending, but also a shift away from cash and check towards Visa MasterCard powered payments. That's not done yet.

Starting point is 00:12:03 But we don't think that investors have to worry much about Alley Pay or WeChat Pay in the U.S. So in Silicon Valley here, if you go into Target or Walgreens near my house, you'll see a little sticker saying they accept Alley Pay. And there's a lot of Chinese tourists that come to Silicon Valley, and I'm sure it gets used from time to time. But when I went to Target a couple months ago, there was an Allie Pay. we accept AliPay sticker on the cash register. And I asked the cashier, I was like, oh, how often do people use that? And she looked at me kind of blankly.

Starting point is 00:12:30 And I said, you know, the alley pay. And she said, I don't know what that is. And I was like, well, it says right here, you accept AlliPay. And she said, I know, but nobody's ever asked about it before. You know, just because you accept it, if no one carries it, it doesn't get done, right? So you can go back. And for like five years now, every year, you'll see an article about, you know, like cabs in Las Vegas except Allipay or, you know, high-end boutiques in New York City,

Starting point is 00:12:53 WeChat pay. And that's going to happen, but it's a small, small thing. So big picture, we think they are this dominant player, this duopoly with Visa that powers payments. They'll continue growing pretty significantly as more and more payments continuing, even the developed market, to move away from cash and checks. And it's a much more competitive playing field and emerging markets, but they're going to win some of that, right? And those markets are going to grow dramatically. in India, only 5% of retailers even accept credit cards, 5%. Maybe they don't get dominant. Maybe they only ever get to 20%.

Starting point is 00:13:26 That's a huge amount of growth, right? Especially in a growing economy. So we like the business very much, owned it for a very long time, and we think it deserves a place in the portfolio of anyone who cares about owning kind of very dominant, competitively managed businesses. So, Sean, let's just start off with the really easy basics. Let's say I went to Target and spent $100 on my MasterCard. How is revenue generated and additionally talk to us about what this looks like on a global scale?

Starting point is 00:13:55 There are things called merchant acquires companies that go out and sign up merchants to accept payments, right? And so that's like you see a little terminal when you go to a store, right? Whether it's a square-based iPad or it's a classic terminal or whatever it might be, there's a business that's going out and acquiring those merchants and signing them up and getting them on the network. And then there's the banks that issue the credit cards, right, to the consumer, right? And so you can get that. When you get rewards from using your credit card, all that's coming from the bank, right? The bank's the one with the relationship with the consumer. And they're the ones that go out and sign up consumers for credit cards.

Starting point is 00:14:30 And then MasterCard sits in the middle and basically processes these payments, kind of make sure all the money gets where it's supposed to go and connects everything up. And so when you swipe your credit card, the merchant is going to get their money, regardless of whether or not you actually have in, you know, pay your bill, your credit card bill when it comes, you know, a month later, whether you pay it all at once or paid over time or even default, right? The merch, that's what's valuable. That the merchant gets their money, right? And that's a really important thing. Trust is what fuels economic transactions. One of the big benefits the United States have is as much as Americans will say that we've lost trust in government and all these sorts of things that we actually have this super high level of trust. And so in America and the developed market, we're used to this idea that, like, we're not going to get excessively ripped off. No one's going to give us like a fake bill or something like that, right? But this is something that was built over time, right? And so today, merchants just have 100% trust in MasterCard and Visa-based cards, right?

Starting point is 00:15:29 Even if the bank is something they haven't heard of. So if I take like some credit union issued card from some bank no one's heard of and I fly down to Peru and I go into a little bodega and I swipe my card and ask for a Coke, like total trust, right? It's going to work. It's going to go through and they accept it. So MasterCard and Visa get, depending on the type of transaction, about 0.2% or less of the amount of transaction. So it's less if it's a debit. It's more if it's a credit card.

Starting point is 00:15:56 If it's cross-border, it has higher fees, if it's cross-currency. There's lots of different elements that go into that. But the most important thing is it's a very small amount, right? I think that's where a lot of the kind of pushback in credit cards is like, well, we need to disrupt them because the fees are like 2%. And that's outrageous and we should get it lower. But that's all the bank's fees, right? And the bank is collecting that money to pay for having acquired the customer, right? And for dealing for the, you know, there's the risk of default, all sorts of things.

Starting point is 00:16:24 Banks do rebate a fair bit of that back in the form of rewards, especially for high spending users, right? And so one thing that could happen is you could see some sort of pushback on that. But think about who the incentives are. I, as a consumer, I kind of like the rewards, right? So I don't pay that two and a quarter. I get paid 2% to use my credit card, right? I get cash back, right? And so that piece of this whole equation is unlikely to break down.

Starting point is 00:16:49 But so MasterCard basically processes this. The reason their margins are so high and keep going higher is that there's not a whole lot of incremental cost to one more swipe, right? They need to keep building out their infrastructure, but it's not like there's actually like a cost to them of that swipe, right? It's like if you have all the servers and everything set up and you're doing a billion transactions, you do a billion to one, there's no additional cost. If you go from a billion to two billion, you're going to need more servers and more systems and more people, but not twice as many, right?

Starting point is 00:17:16 And so because of that, you have this kind of fantastic, scalable model. Very interesting. So, Sean, let's talk more about the impressive network that you also mentioned there in the pitch. You mean, the network that's been built out over the years has just been impressive. And they have this duopoly with Visa, like you mentioned, especially here in the West, where the card is accepted almost. everywhere. Now, keeping that in mind, I think investors listening to this podcast is a little surprised whenever they heard about those growth numbers that you just mentioned before. Like, they might perceive it as a saturated market, but if you look at the 10-year average

Starting point is 00:17:57 revenue growth, I mean, it's nice double digits. We're looking at year over year, and revenue has gone from $5 billion in 2009 to more than $16 billion trailing 12 months. and there seems to be no signs slowing down. What has been the primary driver of the revenue growth over the past decade? Yeah, and this is why we think it's such a valuable business, like from a valuation standpoint, right? And we'll talk more about valuation in a bit. But fast growth tends to slow over time, right? Like I talked about earlier, that's just kind of the nature of when you get bigger,

Starting point is 00:18:33 it's harder to keep growing, right? What is more interesting to us is business that grow at solid rates, like MasterCard's kind of low double digit rate, but have a very long duration to that growth, right, that are able to grow at solid levels for 20 years, as opposed to businesses that can grow at 30 to 40 percent. Those are exciting, but they just don't tend to last very long. So what's driving MasterCard's growth and the reason why it's persisted and we think it'll continue to persist is right off the bat, they're basically getting 0.2% of consumer spending. And consumer spending on globally grows like 4 to 6% per year.

Starting point is 00:19:06 So you're going to get this kind of toll on just economic growth as a baseline, right? Even without any growth in what they do, without signing anybody else up, just kind of their existing people, right? Then you get roughly another 4% growth just from the shift away from cash and checks to credit and debit. So if you look at kind of every year across developed and emerging markets that where MasterCard is currently operating, and you look at how much money consumers are spending on cash and checks or kind of non-mastercard powered payments. And then you look at the next year, it goes down every year, right? And so every year you get this kind of market share gain, not against a competitor

Starting point is 00:19:48 unless you recognize that cash and checks are their competitor, right? So you get this kind of high single-digit growth just from that. On top of that, then you get actual kind of company's sorts of growth, like them going out and entering a new country, right, or rolling out. out new strategies or doing whatever they can to accelerate their own growth or to steal growth from Visa. So, for instance, one thing that MasterCard Visa compete over is corporate branded cards. So, you know, if you have a card that's like the new Apple card that's so hot, well,

Starting point is 00:20:18 Goldman Sachs is the bank. Credit card is issued by a bank. Apple doesn't issue credit cards. They're just the co-brand, just like United Airlines card still has, I believe, it's a Capital One bank behind it. And so MasterCard Visa might compete for new corporate brands. and when they flip a brand, well, then that's more transactions across their network. So MasterCard's also been successful in winning more corporate deals.

Starting point is 00:20:40 And importantly, it appears to us that many kind of new FinTech or kind of modern payment brands are going with MasterCard. So the Apple card is one that's a MasterCard. Brex is become a very popular credit card that's targeted towards startups. And that's a MasterCard product. And so we do think that MasterCard has proven to be superior to view. in serving both kind of FinTech customers as well as being more aggressive in emerging markets where obviously there's a lot more long-term growth.

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Starting point is 00:25:14 That's Shopify. dot com slash WSB. All right, back to the show. So let's talk about the growth opportunities here. About 35% of MasterCard payments are domestic here in the United States, and then 65% are international. And where I'm kind of interested is in the Asian Pacific area, which encompasses part of that 65%.

Starting point is 00:25:38 What is the competitive advantage look like over in that space? You know, sometimes we get asked, well, why do you own MasterCard instead of Visa. And, you know, one of the reasons is they have more non-U.S. exposure, non-U.S. Euro exposure, right? So both Europe and U.S. are pretty mature markets for them. You still have mixed shift. You still have a lot of people using cash and checks. It's surprising to people, especially maybe younger listeners might say, like, what do you mean? I go to the ATM like every other month, right? But that's not true for Americans as a group or Europeans as a group, right? And so you still have that that shift going on. But Asia Pacific is clearly where like the next 30 years of growth is going to

Starting point is 00:26:18 come from. And that's important. You know, Visa's headquartered in Foster City, actually just down 101 from my offices here. They're very much like a U.S. business, you know, in terms of how they operate and everything. MasterCard is a very global business. Their CEO is from India. Their executive team is from all around the world. And we really think that they just have a strong. stronger cultural focus on the globe and emerging markets. I'm sure Visa would disagree, but that's just our sense as having looked at both businesses. And so we think that they're very focused in the right areas. I won't get too deep into it, but don't forget Africa, right? I mean, you think about Africa, and I think a lot of American or European investors would say,

Starting point is 00:27:04 well, there's not too many businesses that are selling products into that, but there is payments being made in Africa, right? And so it's also another big market that's going to, over time, more and more digital. And so, you know, I think what MasterCard is needing to do is understand how each of those markets is developing. So I'll give you an example, a QR code, right? That's that funny looking barcode thing. You can scan with your phone. Well, in the U.S., that's not a common way to make payments, but in much of Asia-Pacific it is, right, where you go into a store, there's that code there. You scan it. When I was in China, I used a QR code to buy something from a vending machine. You could wave your phone there, right? And one of the reasons that's popular.

Starting point is 00:27:43 in India is because it's very cheap for the merchant to start accepting credit cards that way. It's like a sticker that you stick on your counter and now suddenly you're able to start acceptance with some online setup as opposed to getting that terminal and all those sorts of things. And so MasterCard needs to make sure that they don't force other countries to adopt whatever the default that evolved in the U.S. and Europe just out of happenstance and adapt to whatever the right sorts of payment systems are there. Another example of that is e-commerce in India has been challenging historically because Indian consumers, especially outside of major cities, are used to the idea that they pay on delivery so that when the products arrive and the delivery person delivers it to you, you open the box and check it out and decide, okay, I want to keep this and I'll pay you now, right? And so that you can't have prepaid like Amazon where you pay when you click the button, right?

Starting point is 00:28:34 So there's different things that need to happen there. But one of the reasons why the fintech, which was long seen as a disruptor, actually accelerates all this as something, think about something like square, like the original square little square thing you could plug into your iPhone and accept credit cards. So the gardener, the babysitter, whoever could accept credit cards. MasterCard doesn't need to do all that innovation. They just need to be part of that ecosystem that powers that innovation and then recognize and support those innovations that take off. So we think it's a really positive dynamic that they don't have to invent everything in house, the way like, say, business like Apple does, right? In MasterCard's case, they can kind of allow innovation to happen on top of their platform as long as they keep seeking to support those, which is why we've been pleased that they are winning things like the Apple credit card or Brex and a lot of emerging market sorts of innovations because it shows that they're supporting those ecosystems. Yeah, it's very interesting you would mention that, you know, all that tailwind that they're getting from other people. And you mentioned Apple before, that now Apple paid for,

Starting point is 00:29:37 the invention of a phone that you can pay with, so now more people can make money for MasterCard. It's kind of an interesting way of looking at it. Now, talk to us more about the competitive environment in the US and Europe, that you mentioned are more mature, especially Visa and MasterCard has been dominating in these areas for a long, long time, both for credit and debit cards. Who are the main competitors for MasterCard in the next decade and why? We think it's just game over. And it's not that we're like, well, nobody can compete. It's that networks are winner take-all industries naturally, right?

Starting point is 00:30:15 So a network that benefits from more participants becomes more valuable as it grows. So I mentioned this idea that it's because every merchant accepts a MasterCard that I carry a MasterCard. It's because every consumer carries one that merchants accept them, right? And so you can imagine if, let's say earlier on, there was like three networks and they each where it had 10% acceptance, right? Well, as they grew, one of them would almost certainly emerge as the winner of everything because once it got a higher penetration, so it had 30%, everyone else had 10, everyone would only sign up for the one that had 30.

Starting point is 00:30:53 So networks would benefit from what's called a network effect and competitive advantage lingo that basically says that it becomes more valuable as more participants get added to it. So at this point, it seems like almost impossible to make payments incrementally better, right? So even if you signed everybody up, what would be the reason that somebody would switch? Because payments just work in developed markets, right? And since VisaMasker only getting 0.2%, can't undercut them a whole lot. So we just think that the idea that in developed markets will be disrupted is just not a particularly relevant competitive angle.

Starting point is 00:31:24 I mean, of course, we're always watching it. The relevant analysis is in undeveloped markets where the game's still being played and fought, right? And it's clearly 10 cent that owns WeChat Pay and Alibaba that owns Ali Pay. And we think those are very viable products, especially in India, right, which is, you know, they already won China. India is kind of the next big market for them. And that is a robust competitive market where MasterCard is making real headway. They have real business in India.

Starting point is 00:31:54 They're going to win share. They're going to keep growing there rapidly. But it's going to be a bruising fight. and we don't think that they're going to have the same level of dominance, you know, even in 30 years. And yet, it's only 5% of merchants even accept the credit card, right? And so you can see how much growth there is ahead of them without them having to be dominant. I mean, if they ended up dominating the way they did the U.S. and Europe, you would never want to sell this stock. Right.

Starting point is 00:32:19 I mean, like, that would be an unbelievable opportunity for them. Amazing. So, Sean, I would make the argument that not a lot of people are very selective about which type of debit or credit card that they have. I could be completely wrong. I'm looking here at myself, and I think I have five cards. So, you know, I would go to my bank and I would say, you know, these are the needs I have, you know, privately and I also have a business. And they would give me, you know, a selection of five different cards. For me, specifically, it's four recent cards and one a master card. But to me, it really doesn't make any difference, like which card it is. It's just

Starting point is 00:32:53 that was what I was handed over and I don't care what it says on the front. Now, are there any differences in terms of the functionalities that I don't know, say, between MasterCard Visa or even American Express, or is the real competition really who gets that bank or whatever provider that is first? Is that the real competition among those and not, you know, me as a consumer or business person? So if you think about MasterCard Visa, when you said you don't care what card it is, what you really mean is you don't care what card it is so long as it's a Visa and MasterCard. If your bank said, oh, we've got these five credit cards. They have these different features.

Starting point is 00:33:33 They're all Visa MasterCard. But this other one, it's called Brand X. It's not accepted anywhere, but it's 10% cash back. You'd be like, well, no, I don't care. I don't want that. And so you have just internalized this assumption that anything the bank offers you will be accepted everywhere. And by definition, that means that you know it'll be a Visa or MasterCard.

Starting point is 00:33:54 So the real question is, well, why one versus the other? And so this is a duopoly market, not a monopoly. market. And so when you're studying kind of a duopoly situation, what you care about is kind of how rational the two players are against them, it could be that Visa was to say, we're going to really go after a MasterCard, we're going to slash the fees that we charge to banks and everything, and we're going to just bring this way, way, way down. And they could win share from MasterCard. They would destroy their own business in the process of doing that, right? So you would kind of win the war versus Mastercard and lose the war in terms of making money, right? And so when you have that sort of

Starting point is 00:34:30 stable duopoly, they certainly compete for brands and all of that, but they don't tend to do it heavily on price in a way that erodes kind of how much they're generating long term. And so those two clearly compete, especially for corporate co-branded cards. And there's flips back and forth, but it's a very stable sort of environment. So it's really interesting to hear you say that because historically, anytime there's this duopoly, there's really no advantage to rocking the boat very much. Effectively, both companies have great margins because there's no other competition, and if one adjust their prices up or down, it creates an unstable situation. So what are your thoughts there? And there's a really important thing because the Warren Buffett tells us the most

Starting point is 00:35:14 important thing is pricing power. But we think there are two types of pricing power. There is the ability to raise prices because you have trapped your customers and they can do nothing about it and they hate you, but you do it anyway. And then there is pricing power in which you create so much value for your customers that they don't mind when you raise prices. And so we think those are two very different dynamics. And we really don't want to be invested in businesses that are exploiting their customer base. And the reason is, is because at some point, your customers will find a way around you. At some point, innovation will come along where you say, oh my goodness. So like we were invested in Netflix. You know, cable companies, just people hated them. They charged so much money.

Starting point is 00:35:55 They had type of customer service. And so early on, when Netflix starts streaming, some people cut the core just despite the cable companies. They're like, I'll just go with this because I hate having to pay $100 a month and I barely even watch any of those channels, right? So with Visa and MasterCard, this is why this analysis around, yes, merchants complain about them. But merchants are more and more accepting them. And in some cases, it's not even accepting cash anymore. Because even though they complain about it, it still is creating value for them relative to carrying cash, right? And so having this ability for you don't have to take money out of the ATM, you always have all of your money in your pocket at all times to be able to pay securely to any bank in the world. It creates so much

Starting point is 00:36:34 value in the world that they're 0.2% we think is just a small portion of the value they're creating, which is important only because when you talk about how Visa MasterCard have no real incentive to cut prices, one thing that you might say the other thing is that they are kind of exploiting or sucking value out of the system. And we don't think that's the case. But it is a common criticism. And we think it's a legitimate point of view, but we just think that they're actually adding tons of value. And we would point to when the Federal Reserve through the, during the Durbin Amendment period, when they did reduce some of the fees around debits, the Federal Reserve basically looked at this and said, it works. Payments work in the United States.

Starting point is 00:37:11 Why would we disrupt this? There's nothing to change here. And so, you know, even when there was regulatory review, there wasn't big changes to their fees. Very interesting. So, Sean, let's look east again and let's talk about LEPA and Vechad pay that you also mentioned before. And I think you used the term game over in the West. And you might say the same thing in China. It would be extremely difficult to compete.

Starting point is 00:37:34 I mean, just as Google and Amazon if you want. But I think to understand the competitive situation in the faster growing Asia-Pacific, how are MasterCard different than LEPA and Vichet pay? and how they're different from each other. And I guess as a third question in that, who's best position for those markets and why? So AliPay and WeChat Pay, Alibaba and Tencent are very different businesses. But those products, WeChat Pay and AlliPay are functionally the same thing

Starting point is 00:38:05 from the consumer standpoint. But they are totally different than Visa and MasterCard. So they're much more like PayPal. But both of them are a digital wallet that you fund, from your bank, you transfer cash into your WeChat wallet or your Allipay account, and you have money in there to pay for stuff with. And so there is no credit extended. There is no credit card processing fees. They're enabling both sides of the transactions. So with Allipay and WeChat pay, both sides of the transaction have a wallet with that provider. And so that's why PayPal can be

Starting point is 00:38:42 seen as a threat in the United States. You can say, well, maybe we'll all just carry money in our PayPal wallet and we'll go around and pay things. So I remember a number of years ago, PayPal came out with a debit card and it was accepted at Home Depot and you're basically just swiping and using money from your PayPal wallet. And yet that hasn't kind of taken off in the West, right? And there's lots of things that it's, you know, you have to keep funding your wallet, how much money you have in any given time. But in China, when it came out, the country was almost entirely cash-based.

Starting point is 00:39:14 It was an enormous positive development. It was so superior to using cash that it took off, right? And Tencent particularly, it's something amazing. There is a tradition of giving red envelopes of cash to people as a gift in China. And so a number of years ago, when they were trying to get the WeChat pay wallet to take off, they injected billions of dollars of cash. They just gave it away. It was like spending into these wallets to enable people.

Starting point is 00:39:44 to gift it back and forth. And they were small amounts, but it got everybody kind of hooked in and created this kind of viral thing. So much like, remember, the old hot mail, like you would send it, you'd see, so you click on the link to sign up. And so the passing of these gifts kicked off the flywheel effective transactions. And that's what networks payment transactions need is payment volume to get going, right? And so they really kicked that process off. And so it's developed that way. People use WeChat pay to like pay their rent and utilities and stuff like that. It's not like just person-to-person payments. And so we just think it's a developed system.

Starting point is 00:40:16 And so MasterCard and Visa are now going into China directly, getting licensed to do all of that. Their cards are accepted. But there's just not a big incremental benefit to switch over to that model, right? And so that's the thing about these chicken and egg network effect models are hard to get going. And then the key thing is that if someone can come out with a totally better system, then you can topple the old one. So that's why, like, Instagram can topple Facebook is because from a consumer preference standpoint, many people were like, I like Instagram better. And so it can topple Facebook. Facebook bought them and

Starting point is 00:40:45 sent that off. But we're not arguing that network effects based businesses are unstoppable. It's just that you have to have a hugely better value proposition to topple them. And in payments, it's hard. It's like, you just want payments to work. You don't want it to like work better, right? It's like, once they work, you want to forget about them. And so it's really hard to disrupt these networks once they're in place. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:44:26 This is a paid advertisement. All right. Back to the show. So, Sean, we've talked about all the good things here, but I'm really curious about the risks that you see moving forward. Regulatory risk, I think is the clear one. So there is this risk of innovation. It could be in five years. There's some entirely new way that we're all starting to use to make payments. That was kind of the worry with Apple pay, right, that you had this hugely well-funded

Starting point is 00:44:54 player who needed to move into new markets and could have decided to make this big effort and they chose not to. And to us, that really kind of, you know, it didn't seal the deal forever, but it really spoke to the threshold and the complexity of trying to compete directly. But that's still something we monitor, of course, and AliPay and we chat pay as much as we don't think they're going to make inroads in the United States. They could, right? There didn't used to be, we accept AliPay stickers at Target and Walmart near my house, and now there are. No one's using it, right, but they're still there. So it's something to track. But I think that the bigger risk is regulatory. This is a, you know, payments, every country needs to make sure that payments function,

Starting point is 00:45:33 the economy would come to a screeching stop if master current visa payment systems stopped working, right? And so that that's a good place to be in, that the economy is dependent on you, but it also means that you are rightly subject to regulatory risk and not just the United States, but on a global basis, right? And so there's been more and more countries that have been demanding that payment data be stored in country, right, from like a data security standpoint, and that's create costs for them. And then the Durbin Amendment in the United States was when they basically reduced the amount that the companies could charge for debit transactions, right? And so you could have somebody step in and say, we're changing the rules here. The

Starting point is 00:46:12 Federal Reserve has that power, right? And in politics in the United States, you'll see politicians screaming about, you know, either banks or the credit card networks. And usually you'll recognize that they operate in a district that has large retailers. Like maybe they have, like, Target is headquartered in their district, right? And so, you know, you can always have some sort of regulatory or political risk that changes things. We've done, we've handled that by basically reserving a portion of their cash flow for regulatory risks. So that's just in our own modeling. We recognize that there's some probability that some portion of their future cash flows will need to be utilized either to subsidize a reduction of price or to invest in new systems or to do

Starting point is 00:46:57 something in reaction to regulatory risk. But it's a hard thing to frame very discreetly and quantitatively, but it's something to be aware of for sure. So now I would like to talk more about your valuation process. And I've seen in one of the analysis that you've done here of MasterCat that I looked at before the show that you stated that the key metric for MasterCard is global consumer spending. And even during a session, you remark that it doesn't decline by more than a few percentage points. Now, does that mean that the intrinsic value will be narrow? Like, that range won't be as large because it's just easier to forecast for a company like MasterCard.

Starting point is 00:47:38 I guess that's the first part of the question. The other part of the question is, does it also mean that your margin of safety when you make an investment something like MasterCard is different? We think about our conviction in a business as well as how cheap it is in deciding how much of a stock that we want to own. And as you point out, I think it's exactly right, the narrower the potential range of forecasts, the more valuable something is, because the more sure of it you can be. So like a 30-year treasury is a good example, right? So this is a business that, or not business, it's a financial instrument, right, that people pay 50 times earnings for. That's

Starting point is 00:48:16 a 2% yield, right? And with no growth, right? And why is that? Well, it's because it's guaranteed, And so when you know exactly what you're going to get, you don't have to have much risk premium in the return you're going to expect from it, and therefore valuations can be higher. So yes, we think that this is definitely a high conviction business. It's one of the reasons we've owned it for a long time, and we have a lot of confidence in it. And modeling it is not terribly difficult. If anything, we have just overestimated how much they would need to spend to keep growing

Starting point is 00:48:46 the business. And they've been able to raise profit margins even more than we would have guessed in the past. So that narrowness of potential outcomes is very important one. And as you point out, so if you think about like a, I don't know, a steelmaker, right? I mean, revenue can fall like 40% in a recession, but consumer spending only falls a couple percentage points. You don't have like 20% declines in consumer spending during recession. So it's a much narrower range of outcomes. With all of that being set and with like keep in mind your thesis and the competitive situation, basically everything that we in

Starting point is 00:49:21 included here in the interview, what is the intrinsic value of MasterCard and how do you come up with that number? So if you look at the business today, it trades at a PE on 2020 estimated earnings in the kind of mid-30s. It's the highest earnings multiple since we've owned the stock. We, like most investors, will look at what is the historical multiples for a business been, right? So if we assess a business and we say, hey, we think it's worth 23 times earnings, and then we look at the history, and historically it's traded between 10 and 14 times earnings.

Starting point is 00:49:55 We'd be like, so markets are not perfectly efficient. That's how come we have a living to make, but they're pretty efficient, right? And typically you don't have businesses that are undervalued for decades at a time, right? However, if you simply go back and said, well, MasterCard, we now know in retrospect, was deeply undervalued in the past because it's generated like 20% annual returns for a long time. The stock has, right? So one thing that we sometimes do is we'll go back and look at like, well, if the stock had returned 9% per year for the last decade, what would it have had to have been priced at?

Starting point is 00:50:29 So yes, we know it did trade at, say, 16 times earnings in the past, but we also know it generated 20% annual returns from there. So that's not a good fair value. That was in retrospect known to be cheap. If you go back and you look at, well, if MasterCard had generated market-like rates of return, it would have traded at P-E multiples in the 40s and 50s for a lot of the. the last decade, right? And so we think that the multiple where it stands today is really quite reasonable. Remember, they don't have to reinvest that earnings in growing the business. So almost all of

Starting point is 00:50:59 those earnings are available as cash flow. So it's say just 33 times earnings to make the math easy, you're talking about over 3% current free cash flow yield that can be used for buybacks and dividends. And then you have growth in the top line in the low double digits, plus their margins are still expanding, right? So you're going to have like mid-teens kind of earnings growth. And so we think that the stock is getting close to pretty fairly valued now. However, this is a super high quality company. So, you know, I think that the classic value investor is the type of person who says, well, I buy it at a discount and I sell it when it gets to fair value. But think about if you own all of MasterCard. Imagine it's your business, right, and you're operating it. And so, and you think

Starting point is 00:51:39 it's worth $100 just to use a round number, right? And someone comes along and says, well, I'll pay $100 for it. Well, you wouldn't sell it. That's why when there's mergers and acquisitions or take somebody private, they pay a premium, right? Because to get a high-quality business out of the owner's hands, you need to pay up for it. And so we think this is a super high-quality company, and we wouldn't be sellers of it at fair value. But our size would be less, right? So MasterCard's been one of our biggest positions for the last decade. It's starting to work its way down.

Starting point is 00:52:06 We've certainly been trimming it some. But in a brand-new account that we're managing, we would still want to own a couple of percentage points of MasterCard, say, three to four percent of our portfolio. We own kind of 20, 25 companies. So, you know, when we think about what is this thing worth, the big question is the duration of that growth, right? And so how long can this growth last for? It's really hard to forecast out beyond, say, five years, really, really hard. And so we don't typically in our evaluation can assume growth beyond, say, five or a couple extra years. But this is a business that a decade from now, if they're still growing revenue at kind of 10% a year or something like that, that's a totally

Starting point is 00:52:46 plausible outcome and the stock's still very cheap if you assume that's going to happen, right? I mean, if they can keep growing at this level for another 10 years or 15 years, business is insanely valuable. Just as we now know, you could have paid 50 times earnings a decade ago and gotten that 10% growth for a decade and have done very, very well, right? And so, you know, when I say that we think it's approached kind of fair value now, We mean that in the context of recognizing that there's limitations in our ability to forecast the future,

Starting point is 00:53:15 recognizing that there will be concerns that crop up that we haven't even thought of yet in the years ahead. And yet it certainly isn't at priced at a level that we think is extreme or expensive. Perfect. And just like to emphasize that the day of recording here is January 21 and the current price is 325 for one share of MasterCard. But, Sean, let's talk more about your research process. It has some very interesting thoughts on that. And you're clearly highly knowledgeable about MasterCard. Which resources do you use when researching the stock?

Starting point is 00:53:50 And how much time do you spend to stay updated on a company like MasterCard? So we own, as I mentioned just a bit ago, kind of 20 to 25 businesses in our portfolio. And we think that to be an active manager, you really need to be focused in your portfolio. portfolio, right? I mean, for basically no fee, you can buy every stock out there, right? The average mutual fund in the United States owns 150 securities. Well, that's a third of the S&P 500, and there's a reason why they don't tend to outperform as a group, right? I just know it's hard to pick stocks that outperform. I can't imagine what my 150th best idea would do. I would have no conviction in my ability to select 150 securities, all of which I thought were going to outperform, right? To have the belief that the stocks

Starting point is 00:54:36 that we own are going to outperform, we need to know them inside out the way that we know MasterCard, right? And so we have four people on our research team, right? And so when you own 2025 companies, you're only talking about, you know, say, five to 10 businesses that each analyst needs to kind of know inside out. And we tend to own these businesses for a long time, right? So why do I know MasterCard? Well, I've owned it for a long time, right? So it wasn't just like reading the 10K or research reports. It was, you know, living and breathing this business as we developed our firm and we owned it, you know, listened to 40 earnings calls, right? I mean, like, listen to the CFO, retire and her relationship with the CEO and all of those sorts of things, you know, and,

Starting point is 00:55:13 and all of those little kind of like scuttlebut that you pick up along the way. So, you know, our view is that really knowing businesses is kind of the key thing, not stocks. You got to know stocks, but you really know the businesses, right, in these competitive dynamics. And no, you can't do that just through, you know, even an intensive, say, two-month-long research process. So we go through a multi-month intensive research process to even initiate on a stock, but initially we'll buy very little at that level because we know that no matter how much we think we know the business, we don't really know it all yet, you know, and that as you own a business, your brain starts reorienting towards things that connect to that, right? So for instance,

Starting point is 00:55:54 there's a business called Stripe, a private company. It's an amazing, fast-growing business that allows websites to add just a little snippet of code and suddenly start accepting credit cards, right. Stripes is a sort of business that it's a private company, it could be off your radar. If you were brand new to investing, you know, researching MasterCard, you might not ever come across it. But when you own the business for a long time, you kind of, you know, live and breathe payments as part of your day job, then you learn about stuff like that and you start paying attention to those things. Sean, what a great discussion. I always learn so much hearing you you talk about the intricacies of different businesses. And I know our audience is gleaning a ton

Starting point is 00:56:30 from this. So if people want to learn more about you, where should they look? So Ensemble Capital Management is in Burlingame, California. It's Ensemblecapital.com. We manage about $1 billion in assets for private clients and the Ensemble fund, which is a mutual fund. And then intrinsic investing.com is our blog that we write regularly about our holdings and our thoughts on the economy and the market and stock picking in general. Fantastic. We'll definitely make sure to link to all that in the show notes. Sean, thank you so much for taking the time out of your busy day to speak with us here today on the Amherstas podcast. Thanks so much for having me.

Starting point is 00:57:06 Real pleasure. All right, guys. So at this point in time on the show, we'll play a question from the audience. And this question comes from Heidi. Hello, my name is Heidi. I'm a beginning investor. And I've been searching for a simple answer to what I feel like should be a pretty simple question. But I haven't been able to find one.

Starting point is 00:57:25 So I just wanted to ask you guys, what would be a. an ideal number of stocks to start out with as a beginning investor. I think that's a great question. And thank you, Heidi, for giving Preston Me perspective when we do deep dives into stocks as we do here with MasterCard. Not everyone has the same experience as Sean Stockton or some of the other experts on our show. So it's a great question that you bring up.

Starting point is 00:57:51 So the answer I have for you might be a little surprising because I think you should hold very few stocks. In your case, perhaps just a handful. So please allow me to provide more context to this. What we typically recommend to new investors is that the buy a market ETF are similar and have hundreds, if not thousands, of stocks in the portfolio. And I think that's a great approach for the vast majority of investors, especially if you're a beginner.

Starting point is 00:58:20 But how many stocks should you hold if you want to be an active investor and you're just getting started, which is how I understand your question? So when I say a handful of stocks, I'm not talking about putting in 100% of your portfolio into five different stocks with 20% each. No, if you have, say, $100,000 and have never been investing in stocks before, you might be putting in $1,000 into five different stocks. Because when you're just starting, there's so many things to learn. First, you have to cope with the emotional pressure of potential losing money.

Starting point is 00:58:53 That is why I do not suggest that you put all your money into the market and even, Even less, I suggest that you do it in just a few picks. You really need to learn how to react when the stock might go down and thereby experiencing if stock investing is even something for you in the first place. And another thing is that as you get more experience and you learn more and more about the businesses you invest in, and you might end up with something like Sean Stockton's 20 or 25 stock picks in your portfolio. Again, I suggest a very different approach as you're getting started, because someone as capable, again, as say, Sean Stockton might have more than a hundred stocks on his watch list, and he's just constantly monitoring how they perform

Starting point is 00:59:37 and the current price to the intrinsic value. Now, that is not the situation that you're in. You are perhaps just learning how to value a stock, and the stocks on your radar might be well-known brands like Coca-Cola, Starbucks, or Apple, and they're on your radar more due to the familiarity that you have with the products, more than the analysis that you already made about the company. So what I would suggest is for you to pick 10 or perhaps 20 stocks and put them on your watch list and learn as much about the businesses as you can. And then just pick a few stocks on that list that trades at a good price to value ratio, and then invest very little in them and continue to learn.

Starting point is 01:00:19 And I know this might sound a little counterintuitive, but as many experienced investors know, you don't really start learning about a stock before you own it, or at least you learn about the stock in a different way as soon as you own it. And as you become more experienced as an investor, you can start to add more and more stocks on your watch list, and then you can go from those five picks, which is too concentrated to those 20 or 25 of how many picks that you would have being a more concentrated and experienced active investor. So, Heidi, I don't have too much more to add, but I think it's important for people to understand that if you own both ETFs and stocks in your portfolio, you need to think about the correlation and more importantly the variance a little bit differently.

Starting point is 01:01:06 A lot of the times you'll hear people say 10 to 15 uncorrelated positions, but that math can change depending on your position sizes and if you're incorporating ETFs or indexes. Let me give you an extreme example. Let's say you had 90% of your portfolio principle in the S&P 500 index, call it SPY, and 10% in an individual company. In this situation and in general terms, your volatility for the whole portfolio would be similar to owning 10 or 15 individual companies. Now, we can't speak to the correlation of those to the S&P 500 and an individual company, but my point is simply addressing the impact that index funds have on that volatility that you'll see inside of your portfolio. So when you deal with individual stocks, the volatility is extremely high. For example, if you went and looked at Tesla, I mean, the volatility on that is just sky high.

Starting point is 01:02:02 And if you own 10 companies with extreme volatility, it's going to be an interesting portfolio mix. Most people can't stomach large volatility swings. So you address this by having multiple picks. I don't want to go too far into this comment because I don't want it to add confusion to many of the important concepts that Stig already addressed. But always remember that an ETF will reduce, most likely reduce your volatility exposure relative to an individual stock pick. And one of the nice things, I just want to throw this out there, one of the nice things

Starting point is 01:02:38 on our TFP finance tool that we have on our site is every single company and every single ETF, we have the annual volatility for those companies and those ETFs right there on our momentum tool. So people can look at that and kind of get an idea as they're kind of putting a portfolio mix together. So I hope that comment helps you think about it in a little bit different context because when you are adding ETFs and I think a lot of people are adding ETFs into their portfolio, that is definitely something that is reducing that volatility relative to an individual company.

Starting point is 01:03:11 So, Heidi, for asking such a great question, we're going to give you free access to our intrinsic value course for anyone wanting to check out the course. Go to tipintrinsicvalue.com. That's tip intrinsic value.com. The course also comes with access to our TIP finance tool, which helps you find and filter undervalued stock picks. If anyone else wants to get a question played on the show, go to Ask theInvesters.com and you can record your question there. If it gets played on the show, you get a bunch of free and valuable stock picks. All right, guys, that was all Presti and I had for this week's episode of The Ambassador's podcast. We see each other again next week. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvesterspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by the Investors Podcast Network.

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