We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investment in Mastercard Inc Class-A (MA)

Excerpt (Sean Stannard-Stockton speaking):

We know that there are a lot of good companies that we don’t own. Our goal isn’t to have an informed opinion on every stock in the market, but only to find 15 to 30 stocks that possess all of the characteristics that we look for and also trade at a discount to what we believe they are worth. The truth is, stock picking is hard. While there are lots of stocks that we think might be a good investment, we are looking for a very select group of stocks where we think the odds are stacked heavily in our favor. Sticking to the discipline Todd just described is critical to our process.

So now let’s talk about a company we’ve owned in our portfolio for a long time and which we believe ranks near the top of our portfolio in terms of meeting and exceeding our requirements in each of the core areas of our assessment process.

Mastercard is a company that pretty much everyone has heard of. In fact, if you are listening to this call or reading the transcript, no matter where you live in the world as long as it’s not China, there is a very good chance you have a Mastercard in your wallet or purse. If you don’t, then you have a Visa card. You probably have both. These two companies hold an effective duopoly on the processing of credit and debit card payments.

Importantly, these companies do not lend any money. If you look at your credit or debit card, you’ll find that it is issued by a bank. If it has the name of a non-bank company on it, such as American Airlines or Apple, these companies have just partnered with a bank to issue the card. In American Airlines case, its Citibank and the new Apple credit card is issued by Goldman Sachs. The issuing bank is the one whose checking account a debit card is tied to and they are the ones lending the money to fund credit card payments.

On the other side of the transaction is the merchant and its bank. No matter whether you swipe your card, or wave your Apple Watch with Apple Pay, or use Paypal to process a payment via your credit or debit card, or use Google Pay or Amazon Pay to facilitate an online transaction, in each case your bank and the merchants bank need to exchange information across a communication network. And that network is almost always provided by Visa or Mastercard. While you might hear about how merchants pay 2% or more in credit card fees, Visa and Mastercard are only collecting about 1/20th of that fee, with the banks, the ones taking the credit risk, earning the bulk of the fee.

Americans are so used to using debit and credit cards that it is easy to lose sight of how amazing the Visa and Mastercard networks are. The fact is that when you walk into a store anywhere in the United States, you take it for granted that the merchant will allow you to swipe a little piece of plastic with either the Mastercard or Visa logo on it and they will then let you walk out with your purchase. The reason you carry a Visa or Mastercard is because you know they are accepted everywhere. And the reason they are accepted everywhere is because everyone carries one. This is a classic example of a “chicken and egg problem”. Before everyone accepted these cards, it was difficult to convince consumers to carry one. And before everyone carried one, it was difficult to get merchants to accept them.

Having solved this problem, Mastercard and Visa now have a competitive moat around their businesses, which makes it very difficult for any new company to compete with them. Recently I was at a Target in the middle of Silicon Valley. At the checkout stand I noticed a sticker advertising that they accepted Alipay, the payment network founded by the Chinese company Alibaba. When I asked the cashier how often people used Alipay, she actually didn’t know what I was talking about. Despite having noticed the sticker, no manager had ever thought to explain it to her, and no customer had ever asked to use it. Why wasn’t she trained on how to process Alipay transactions? Because her manager knows that few people carry this form of payment. Why don’t customers carry this form of payment? Because few stores accept it. Building a globally accepted payment network was hard in the past. But today it is even harder because not only must a new company in the payment industry solve the chicken and egg problem themselves, but now that it has already been solved, a new competitor must solve the problem in a way that is much better than the existing solution.

So let’s finish looking at Mastercard though the lens that Todd just introduced; moat, management and forecastability.

First of all, we think Mastercard has a very strong moat for the reasons just explained. We also think this moat will remain valuable because we think it is highly likely that a decade and more from now, the service Mastercard provides will remain critical to facilitating commerce and valuable to both merchants and consumers.

We also believe Mastercard’s management team is top notch. Not content to sit still and milk cash earnings from their network, Mastercard’s management team is forging ahead into business to business transactions. While a large portion of consumers transactions occur via cards, business to business transactions, the payment of invoice to vendors and other payments between business, is still a slow, manual process. So Mastercard has been investing earnings from their credit and debit card network into solving the B2B payments problem. They’ve also been aggressively forging ahead in emerging markets, where they have been a leader in using new technologies and adopting their systems to local markets.

While Americans are used to their cards being accepted everywhere, in India, the birthplace of Mastercard’s CEO and a country with a population four times larger than the US, only 5% of merchants accept credit cards. With the chicken and egg problem not yet solved in this country as well as some other emerging markets, the competition is fierce, but the opportunity for Mastercard is very large. Despite reinvesting in their business, Mastercard produces far more excess cash than they need to grow the business. So we are also glad that they have shown themselves to be smart allocators of capital, buying back significant levels of their own stock at very attractive prices, paying a dividend, and increasing the amount of debt in their capital structure in a prudent manner.

Finally, we believe that the company’s long-term economics and thus the value of the business, is reasonably forecastable. This is partial because of the domain expertise our team has built over the years and our confidence that we have a strong understanding of the payments industry in which Mastercard operates. But just as importantly, it is because we believe Mastercard’s business to demonstrate high levels of intrinsic forecastability.

While some companies are subject to highly unpredictable changes in macro factors, such as an oil company being dependent on the price of oil, Mastercard’s business is driven by far more stable trends. The key metric for them global consumer spending trends, which even during recessions do not decline by more than a couple percentage points and which we are confident will grow at a modest, but steady rate over the very long term. On top of that growth driver, the company benefits from the relentless shift of consumer spending from cash and checks to credit and debit. While it might seem that much of this shift has already played out in developed markets, we can look to near cashless country like Sweden to see that even US consumers are likely see continued declines in the use of cash and checks. I had a little example in my own life recently when my utility company emailed to say that rather than directly billing my checking account for my monthly bill, they were now offering the option to have by bill linked to my credit card. And in the bay area, we see more and more new stores opening which simply do not accept cash payment.

Of course, while we have very high levels of conviction in Mastercard, it doesn’t come close to being a risk free investment. All investments in equities involve accepting relatively high levels of uncertainty. It is the requirement of accepting uncertainty that explains why stocks offer higher rates of returns than bonds. But in seeking investments for our focused portfolio, we require every company to exhibit relatively low levels of uncertainty compared to the average public company on the core issues of the longevity and relevance of the their competitive positioning, the management teams capabilities in creating economic value and allocating excess cash flow, and both the intrinsic forecastability of the business as well as our own team’s capabilities and circle of competence.

You can read the full transcript HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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