Our portfolio at The Fifth Person follows several simple rules:
- Own easy-to-understand, predictable, profitable businesses
- Take advantage of market panic to buy these businesses at discounts (most recently COVID-19, interest rate fears, China regulatory crackdown)
- Ideally, these are capital-light businesses with high recurring revenue streams
Part 3 often draws the most questions from new members or from people who are less familiar with investment jargon.
The concept of ‘capital light vs ‘capital heavy’ may be new to some investors but we’re going to discuss it a little today and, hopefully, you will walk away with a much better framework of what makes a business truly attractive.
First, let us consider the following.
If, you were to bet on a marathon runner, who would you bet on?
A 150-kilogram runner or the 65-kilogram runner (assuming both are equally healthy, equally capable runners)?
Take your time to decide.
No cheating.
Settled?
Alright then.
I think most people would logically bet on the 65-kilogram runner. Why? Because if it’s a marathon, even assuming equal health and capability, the lighter runner has less weight to pull over the long haul. In business, capital intensity (not capital itself) is the ‘weight’ that pulls on a business. What do I mean?
Let us first use a juxtaposed example, tech platform versus oil producer.
To run Facebook (or Meta now), for example, what you need is, let’s see… software, servers, air conditioning, tech engineers, a really nice office, and so on.
To run Exxon Mobil, you need to build oil platforms, fly personnel out to rough seas, having drilling rigs capable of going through to the ocean floor, build pipelines to pipe the oil back to mainland refiners which then refine the oil before serving it to people like you and me who put it in cars to drive to work.
So, which business requires more money to earn profits?
This is a no brainer. Of course, the oil producer requires more money to earn a profit. And this shows up in the balance sheets of both companies. Exxon Mobil’s net property, plant and equipment was 65% of total assets (as of Q3 2021). For Meta? Just a mere 32%.
But of course, the more eagle eyed among you might say, ‘But of course! You’re comparing an oil producer versus a tech platform.’
What about more similar businesses? What about Visa versus American Express? Even though consumers may view both as credit card companies, the main difference between them lies in their business model.
The difference between Visa and American Express
Visa’s entire business is built on being a payment network. When you scan your Visa card at the supermarket, Visa’s network reads your bank/credit balance, assures and communicates to the merchant’s bank that there is enough limit available to make the purchase, and then allows your payment to go through. (The actual process is a little bit more complicated but let’s just leave it at this for now).
American Express while also a payment network, also functions as a bank. When you use your American Express credit card, American Express is the one lending the money to you. The company also holds deposits which clients earn interest on. That is why American Express’s income statement has a ‘net interest income’ line while Visa doesn’t.
Right away, you should be able to tell which is the more capital-heavy business. Visa, the payment network? Or American Express, which must source for funds and loan it out to consumers?
The latter is the more capital-intensive business. To earn that dollar of profit, American Express has to actively lend out money. In fact, over the past five years alone, average net interest income has been 1.5 times the net income to the company. Which is another way of saying net interest income is really the one driving profitability for American Express.
But therein lies the problem, doesn’t it?
I hate to quote Buffett, but the man was right.
‘I have said in an inflationary world that a toll bridge would be a great thing to own … you have laid out the capital costs. You build the bridge in old dollars and you don’t have to keep replacing it.’
Visa built the toll bridge a long time ago. It connects consumers in nearly 200 countries to merchants and banks, and handles millions of transactions. Their fees are earned every time a person with a credit/debit card with Visa on it swipes their card.
And we swipe our cards every day. Maybe we’re eating out. Taking a taxi. Buying movie tickets. A gadget. A book. Whatever. These needs exist because we’re human. But Visa doesn’t spend on the marketing that makes us want that burger, McDonald’s did.
Visa didn’t finance the Avengers, nor does it own the rights to it. But when we buy tickets using a Visa card, Visa earns a fee. Visa didn’t ask us to book the weekend staycation, we saw a YouTube video that piqued our interest. But nonetheless, Visa earns a fee when we book online with our Visa credit cards.
American Express on the other hand is limited by:
- The source of funds it can secure from people
- The number of people who want to borrow from American Express
- The number of people who don’t pay back their loans
- The interest they have to pay on the funds they want to secure
Fundamentally, Visa earns a fee on the products and services of other business. Visa benefits from our spending on these products and services without spending a single cent of their own other than to maintain their payments network which has a fixed cost. So every dollar above what is needed to maintain the network is pure profit. In fact, Visa sports around 50% net margins, while American Express is barely able to maintain 20% net margins.
The fifth perspective
What does all of this translate into for the investor who was able to recognize the difference between Visa and American Express? Since 2010, Visa’s share price has risen approximately 830%. American Express’s share price has risen approximately 324%. A 500-percentage point difference on returns.
Is this because of sentiment or is it linked to business performance? Visa’s revenue in 2010 was US$8 billion. By 2020, it was US$21.9 billion — a 2.7 times increase. American Express’s revenue in 2010 was US$27.6 billion. In 2020, it was US$43.6 billion — a 1.5 times increase.
Capital intensity always matters in a business and paired with a long reinvestment runway plus decent returns on capital, will translate into superior investment returns.
