Warren Buffett (Trades, Portfolio), the legendary investor and CEO of Berkshire Hathaway Inc. (BRK.A, Financial) (BKR.B), has emphasized the importance of earnings consistency in his letters to shareholders over the years.
This is evident in his 1984 letter to shareholders. He stated that shareholders of public corporations prefer consistent and predictable dividends, and dividend patterns should reflect long-term expectations for both earnings and returns on incremental capital. However, he also noted that, over time, distributable earnings that have been withheld by managers should earn their keep.
Earnings bobbing around
This idea of earnings bobbing around is further highlighted in Buffett's 1991 letter to shareholders. He discussed the assumption of earnings cyclically bobbing around a certain figure, and how this pattern is common for most businesses. Buffett emphasized that the long-term growth of a business' income stream depends on the willingness of its owners to commit more capital, usually in the form of retained earnings.
He explained that when valuing a company with steady earnings, the valuation is based on a multiple of the after-tax or pre-tax earnings. However, when valuing a company with "bob around" earnings, where the income stream grows only if the owners are willing to commit more capital, the valuation is based on a multiple of the normal earnings power. This means the valuation of a company with "bob around" earnings is lower compared to a company with steady earnings.
View on earnings volatility
In his 1996 letter to shareholders, Buffett said that he and his partner, Charlie Munger (Trades, Portfolio), would much rather earn a lumpy 15% over time than a smooth 12%. He explained that Berkshire Hathaway's earnings swing wildly on a daily and weekly basis, and they are comfortable with this volatility as long as their shareholders can also accept it.
Buffett on earnings decline
While Buffett has emphasized the importance of earnings consistency, he has also acknowledged that actual earnings will sometimes decline due to periodic weakness in the economy or industry-specific events. In his 2016 letter, he mentioned that insurance mega-catastrophes or other industry-specific events may occasionally reduce earnings, even when most American businesses are doing well. However, he reassured shareholders that it is the conglomerate's job to deliver significant growth over time, regardless of occasional bumps in earnings.
Long-term investment philosophy
Overall, Buffett's approach to earnings consistency and the concept of earnings bobbing around reflects his long-term investment philosophy. He understands that businesses may experience fluctuations, but as long as the underlying earning power continues to grow over time, the value of the business and its shareholders' wealth will also increase.
American Express
Berkshire Hathaway has a significant position in American Express Co. (AXP, Financial) and is one of the company's largest shareholders. Buffett has long been a fan, considering it is a well-managed company with a strong brand and competitive advantage in the credit card industry.
With this in mind, let's take a look at the recent "noise" in service fee revenue the company recently reported.
Service Fee Noise
Steve Squeri, chairman and CEO of American Express, emphasized the consistent adjustments made from a risk management perspective, which have contributed to its stable earnings. Squeri's remarks set a positive tone for the call, indicating there were no significant changes in earnings perspective.
Following Squeri's remarks, Chief Financial Officer Jeff Campbell delved into a more detailed review of American Express' financial performance. He addressed a question regarding the unusual noise in the service fees and other revenue line for the quarter. While Campbell acknowledged there was some unusual movement in the service fees and other revenue line in the prior year due to a complicated litigation settlement, he reassured investors that if they take out the noise from this line and consider the consistent high growth in net card fees, they can easily arrive at a number that is very consistent with the guidance provided for the full year.
Campbell emphasized that despite being in a low-growth economy, the volume growth and consistently high growth in net card fees are key factors that contribute to achieving the company's objectives and growth aspirations. His response indicates that the unusual noise in the service fees and other revenue line is a temporary and isolated event from the prior year. He suggested that by focusing on the volume growth and net card fees, which have shown consistent growth even during the pandemic, the company can maintain its growth trajectory.
Financial results
For the second quarter of 2023, the company reported revenue of $15.05 billion. The gross profit stood at the same amount, indicating a gross profit ratio of 100%. Operating expenses were reported at $12.32 billion, resulting in an operating income of $2.73 billion. The net income for the quarter was $2.17 billion, with earnings per share of $2.89.
Comparing these figures to the previous quarter, American Express experienced growth in revenue, gross profit, operating income and net income. This positive trend reflects the company's ability to navigate a low-growth economy while maintaining volume growth and consistently high growth in net card fees.
My perspective
Given the very positive overall results from American Express and Buffett’s repeated guidance to focus on long-term earnings powe,r we can expect very little change in valuation for the stock. The company remains on trend and is expected to deliver similar results in the future as it has in the past. I am only alarmed when a company takes a hit to its competitive advantage that could affect future earnings. This is not one of those cases.
