Down More Than the S&P 500 and Nasdaq, Is Warren Buffett-Led Berkshire Hathaway's Second Largest Holding a Buy Now?

Berkshire Hathaway's (NYSE: BRK.A) (NYSE: BRK.B) assets have changed considerably in recent years. Today, the value of Berkshire's controlled companies exceeds its public equity portfolio. Even Berkshire's cash, cash equivalents, and marketable securities are worth more than its stock holdings.

Berkshire has reduced its stake in top holdings such as Apple and Bank of America. But one position that has stayed the same for decades is American Express (NYSE: AXP) -- which now makes up 14.5% of the equity portfolio, making it the company's second-largest holding behind Apple.

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American Express has crushed the market over the long term. But year to date (YTD), it is underperforming the S&P 500 and Nasdaq Composite.

Here's why investors may want to take a closer look at buying this dividend-paying value stock now.

Image source: Getty Images.

An elite business model

American Express has a fundamentally different business model than pure-play payment processors like Visa and Mastercard), which Berkshire owns smaller positions in.

Visa and Mastercard partner with banks and other financial institutions to issue cards. By passing along the risk to these entities, Visa and Mastercard simply collect fees based on the volume and frequency of card usage. It's a wonderfully simple and highly effective business model leading to steady, relatively low-risk growth over time.

As these networks have grown in size and security, merchants around the world have become more willing to absorb the fees as a necessary cost of doing business. Consumers have bought into the convenience and rewards of using cards instead of alternatives (like cash).

American Express takes this same concept a step further by issuing its own cards. It bears the risk of consumers and small businesses defaulting on their payments. American Express limits this risk by targeting affluent customers who are relatively resilient to swings in the economic cycle. American Express also acts as a bank by offering checking accounts, high-yield savings accounts, and other products. Again, this approach has more risk than what Visa and Mastercard are doing, but when well managed, it offers far more growth potential.

American Express focuses on integrating high-quality, financially healthy customers into its ecosystem and encouraging them to spend a lot to compensate for high fees. American Express cards generally charge higher annual fees than alternatives from Visa and Mastercard. But they offer more generous point-earning potential and perks, so consumers and businesses are incentivized to use the cards for all their purchases.

Over time, American Express has grown its revenue and earnings steadily -- with a big jolt post-pandemic as the company has worked hard to appeal to its fastest-growing age groups, Gen Z and millennials.

AXP Revenue (TTM) data by YCharts. EPS = earnings per share.

American Express is a good value

Given that the business is at the top of its game, investors may be wondering why American Express stock has fallen so much year to date. Part of the answer may be its exposure to affluent customers. As mentioned, these consumers are more resilient to economic downturns, but they can be especially affected when key asset categories -- like stocks -- fall in value. Rapid net worth declines could lead to pullbacks in spending for affluent consumers. Tariffs could also increase the costs of goods, services, vacations, etc.

As the chart shows, American Express has fallen more than the major indexes YTD, while Visa and Mastercard have outperformed.

V data by YCharts.

American Express is now down 22.9% from its all-time high, and the sell-off could present a compelling opportunity for long-term investors willing to look past near-term uncertainty. American Express has historically fetched an inexpensive valuation, with its five-year price-to-earnings (P/E) ratio averaging 18.4 at the median. The current P/E ratio is slightly below that at 17.9, and the company's price-to-free cash flow ratio is just 14.8 -- suggesting American Express is a good value.

Granted, earnings could come down if American Express customers pull back on spending, so investors should prepare for the valuation to look more expensive in the near term. However, even when profit growth slows, American Express has an ace in the hole -- buybacks.

The power of buybacks

Berkshire has held American Express for decades and seen its stake increase from 10% to 21.6%, thanks to buybacks. The same thing has happened with longtime Buffett holding Coca-Cola. Buybacks allow earnings per share (EPS) to outpace net income growth by reducing the outstanding share count. Over the last decade, American Express has reduced its share count by 30%.

To illustrate how this concept works, let's say a company reduced its share count by 30% -- from 100 to 70 shares -- over a decade, just like American Express did. In this case, an investor who owned 14 shares and never sold them started with 14% ownership in the company. But now that there are only 70 shares, they own 20%. If the company's net income is $1,000, it would be $10 in earnings per share for 100 shares, but $14.29 if there were 70 shares -- making the company a better value from a P/E standpoint.

This is how Berkshire has increased its stake in American Express over time without buying more shares. American Express can afford buybacks because of its high profit margins and steady cash flow. American Express is also known to make sizable dividend raises. Its most recent dividend increase -- announced in March -- was a 17% increase, boosting the quarterly payout to $0.82 per share for a yield of 1.3%.

At first glance, American Express' low yield may not seem impressive. But considering the bulk of the capital return program is focused on buybacks, not dividends, the lower yield is understandable.

A high-conviction buy

American Express showcases the effectiveness of quality over quantity in the payment processing industry. Despite issuing magnitudes fewer cards than Visa and Mastercard, the affluence and loyalty of American Express customers lead to much higher spending on average per card.

American Express has done a masterful job appealing to consumers in multiple age brackets and expanding its services. The stock is a good value and a decent source of passive income.

Add it all up, and American Express is a no-brainer buy amid the broader stock market sell-off.

Should you invest $1,000 in American Express right now?

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Bank of America is an advertising partner of Motley Fool Money. American Express is an advertising partner of Motley Fool Money. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Bank of America, Berkshire Hathaway, Mastercard, and Visa. The Motley Fool has a disclosure policy.