Betting Alongside Buffett

Legendary investor Warren Buffett often talks about a concept he calls "economic goodwill" – a valuable asset that doesn't appear on any financial statement.

It encompasses many intangible qualities: trust, reputation, the value of a company's name, the value of its customers, and so on.

In August 1914, American Express (NYSE: AXP) heaped up tons of economic goodwill...

As Europe hurtled into World War I, some 150,000 American tourists were stranded and unable to get cash to go home. But word began to spread that American Express was still cashing checks and even honoring "letters of credit" from U.S. banks.

The company wasn't a bank... but it had cash and a presence in every major city in Europe.

Ultimately, nearly all of the 150,000 tourists ended up getting home safely. And many of them remained grateful to American Express for the role it played in their escape.

Today, we know American Express as an $85 billion credit-card colossus. About 115 million American Express cards are in use around the world, with cardholders racking up more than $1 trillion in charges every single year. "AmEx" also collects nearly $3 billion per year in "annual dues" from its customers simply for the right to carry the card.

But its reputation for safety and reliability remains American Express' most valuable asset.

In fact, the "American Express" name is the most valuable part of the company. Market-research firm Interbrand estimates that the American Express brand name is the 24th-ranked brand in the world, worth $19 billion – or almost one-quarter of its current market cap.

Brand value encapsulates a variety of fuzzy, hard-to-value qualities – a company's reputation, competitive moat, loyal customer base, and so on. These are the characteristics that Buffett lumps together under the umbrella of economic goodwill.

Don't confuse that with the "goodwill" you might find on a company's balance sheet, though. Accountants derive "accounting goodwill" based on how much a company pays for the businesses it acquires.

Economic goodwill is different...

You won't find a numeric estimate for the American Express name, its reputation, or any other components of economic goodwill anywhere on its balance sheet. It's a real asset worth billions of dollars that accountants don't bother to value.

That's why, as Buffett has explained many times, investors who focus strictly on net tangible assets – that is, the accounting value of a company's assets less liabilities – are missing a huge part of the story. To find businesses with valuable intangible qualities, you simply look for companies that consistently produce outsized returns on net tangible assets.

To compute this return, we like to compare a company's cash earnings with its net tangible assets. If returns are significantly greater than 10%, the business almost certainly has significant economic goodwill.

AmEx's cash earnings over the last five years have averaged $9.6 billion. (In this case, we're using "free cash flow" to approximate cash earnings. Free cash flow is the cash generated by the business after accounting for ongoing investments in equipment and infrastructure.) Dividing these cash earnings into net tangible assets of $14.3 billion yields a massive return of 67% on net assets. A return that high tells you that American Express clearly has a tremendous amount of economic goodwill.

But for a company with a reputation for reliability, safety, and exclusivity, American Express has periodically landed itself in some bizarre episodes...

The most notorious misstep is the Salad Oil Swindle of 1963. A commodities trader named Anthony "Tino" De Angelis filled oil tanks with seawater... then added a layer of salad oil on top. When a warehouse manager inspected the tanks, he saw oil (which floated on top of the water), assumed the tanks were full, and issued receipts confirming the contents.

De Angelis borrowed money based on the value of the "full" tanks, and when the scam was exposed, the warehouse – which was owned by a seemingly inconsequential subsidiary of American Express – was left holding the bag. Instead of starting a years-long legal battle, American Express repaid De Angelis' duped investors, even as shareholders sued company management for not pursuing legal action. This episode cost the company $58 million – a huge sum in 1963 – and sent the stock plummeting 50%.

We mention this misstep to point out that smart investors recognize incidents like that as buying opportunities. Companies with enduring brands and economic goodwill often survive, and the smart money often scoops up shares when the outlook is bleak.

Buffett understood this... In the wake of the Salad Oil Swindle, he counted on American Express' powerful brand and international financial network to overcome one embarrassing episode. He dumped 40% of his partnership's assets into American Express. Buffett sold in 1968 for a healthy profit – nearly 30% annualized gains.

Today, American Express is still a great company with impressive numbers...

It generates revenue of more than $40 billion. That beats the $35 billion generated by Visa and MasterCard combined. Its operating margins are around 20%. And as we explained earlier, it generates almost $10 billion of free cash flows each year. The last four quarters were even better, as the company produced $14 billion of free cash, or 34% of revenue. Those numbers are a sign of a highly capital-efficient business, with a ton of economic goodwill. (That's one reason why Buffett's holding company Berkshire Hathaway holds an 18% stake in American Express to this day.)

Sometimes investing is simple.