Invest in banking like Warren Buffett: Own a ‘castle’
Summary
Among Berkshire Hathaway’s largest holdings is a financial information-services company. The sector’s results speak for themselves.Warren Buffett has said he looks for businesses that are like castles, protected by moats. Some of today’s best moats aren’t filled with sharks, though—they are packed with data and analysis.
Buffett’s Berkshire Hathaway has recently been scaling back its investment in Bank of America. Some view that as part of a shift toward a more defensive, cash-heavy stance. One position at Berkshire that hasn’t changed this year: a stake in Moody’s, valued at more than $12 billion at the current share price.
Moody’s might be a familiar name to many investors because of credit ratings. But, like S&P Global, it has long been diversified well beyond that into many businesses and products that supply or analyze financial data. These businesses provide banks, investors, insurers and others with the tools for highly specialized and highly regulated tasks.
Along with companies such as FactSet Research Systems, MSCI, Equifax, Experian and TransUnion, financial information-services stocks tend to trade at much higher valuations than the lenders or investment managers that rely on them. Generally, they can benefit from having proprietary data, or ways of analyzing data, and supplying benchmarks that everyone must use. They can enjoy high-margin or recurring revenue, such as software subscriptions. In other words, a profitable moat.
One standout in this realm right now is Fair Isaac Corp., often known by its ticker symbol and flagship product, the FICO score. Fair Isaac doesn’t supply credit data itself, but by employing data from credit bureaus or its clients, it produces scoring and analysis that its clients use to make underwriting and other decisions about customers.
Fair Isaac’s shares have been among the top performers in the S&P 500 over a decade, returning in excess of 40% annualized, according to FactSet data. And it has company: Among just S&P financial-sector stocks, as of Wednesday’s close, MSCI, S&P Global and Moody’s have all bested the top-returning bank over 10 years, JPMorgan Chase.
Just this year, Fair Isaac shares have more than doubled. This is in part because the company has demonstrated what theory suggests should be possible for a company selling an industry-standard benchmark, like its credit scoring: changing its pricing.
Fair Isaac recently said it was raising the wholesale price of a FICO score for mortgage originations from $3.50 to $4.95. A couple of years ago, it made the switch from volume-based pricing to fixed pricing.
FICO cited higher unit prices when it reported a nearly 40% year-to-year revenue gain in sales of credit-score services to lenders and other commercial users in its most recent quarter. Mortgage-origination revenue was up 95%, at what is hardly a buoyant time for the mortgage business.
But that kind of growth and strength doesn’t come cheap. Fair Isaac now trades at a forward price-to-earnings ratio above 75 times, according to FactSet data. On average, the eight information-services companies mentioned above trade at an average P/E ratio of around 35 times. That compares with under 15 times for S&P 500 banks.
That raises the question of whether the moats around these information providers are really deep and terrifying enough to help these companies keep up the high growth or profit expectations implied by those stock-price multiples.
Fair Isaac hasn’t only been changing its pricing. It also has been expanding the range of applications of its core platform, aiming to help not just lenders but retailers and others make decisions about how to serve a customer. That has helped propel growth in its software business.
There are some challenges on the horizon. For one, there is the volume question. Information companies can also be exposed to cyclical ups and downs in activity, such as if high rates discourage mortgage borrowing.
Then there is competition. For years, mortgages guaranteed by Fannie Mae or Freddie Mac have needed a FICO score. But the regulator that oversees those entities plans revisions to the requirements: an updated version of the FICO score and the introduction of another score, from VantageScore.
What the upshot of that is isn’t clear. The presidential election will likely result in a change of leadership at that regulator, and there is a swirl of other variables, such as future pricing or what share of the mortgage market is going through Fannie and Freddie. FICO scores are widely used in the mortgage market outside of those enterprises, too.
This could be a reason for some investors to be cautious regarding Fair Isaac at today’s share price. “The current valuation hasn’t really factored in many downside risks related to potential regulatory changes," says Autonomous Research analyst Kelsey Zhu.
Still, investors might be thinking about the potential for an upswing in demand for information related to lending, as well as dealmaking and corporate finance. That could power a strong year across information and analysis merchants in finance.
Castles do change their flags from time to time. But there will always be a need for a moat.
Write to Telis Demos at Telis.Demos@wsj.com