Is It Time to Sell These 2 Wall Street Favorites?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Two stocks that seemingly have no limit to their upside are Visa (NYSE: V) and MasterCard (NYSE: MA). Every time you think a point of resistance has been reached, these two stocks blow through and trade even higher. But are these two stocks still a buy?

A Look At The Business

In the last three years MasterCard valuation has increased 180% and Visa by nearly 160%. These large gains have been created as the global payment processing companies have expanded outside the U.S. and into new emerging markets. In the past, both companies earned the majority of their revenue in the U.S., but with the emergence of China and India, along with 150 other countries, growth and presence is becoming very balanced in this space.

Essentially, companies such as MasterCard and Visa make their money when consumers use credit or debit cards. In terms of volume, credit is more than twice as significant as debit and is also growing faster. Both assessment and transaction fees make up most of the industry’s revenue, while service fees are less than 5%.

Are The Valuations Justified?

The belief that emerging market growth could lead to significant fundamental gains has pushed shares of both Visa and MasterCard to gains that far exceed fundamental growth. For example, in the last three years, Visa’s revenue growth has been 50% total and MasterCard has been near 45%.

In my book Taking Charge With Value Investing (McGraw-Hill, 2013) I identify such trends where stock performance significantly outperforms fundamental growth as a major warning sign that a stock could reverse. This adds reason to the idea that MasterCard and Visa’s valuation is mostly tied to upside potential, rather than current fundamentals.

As an investor, you must wonder if Visa or MasterCard can produce enough fundamental growth to ever validate their valuations. The payment processing segment is a high-margin business. Therefore, margins and P/E ratios should be discounted in favor of tracking top-line growth, due to margins already being squeezed near max.

MasterCard is currently trading at 9.5 times sales and Visa is trading at 11 times sales. Both ratios are a near 100% premium on their price/sales ratios three years ago. To me, this is yet another warning sign, which goes hand-in-hand with the idea of a valuation that far exceeds the rate of growth.

Are They Overvalued?

So, if MasterCard and Visa can maintain their current rate of growth does it mean that both stocks are overvalued? In my opinion, the answer to this question is yes! Sure, there are emerging markets that are seeing high double digit GDP growth and are rapidly adding businesses that will accept Visa and MasterCard payment options, but this growth has been forecasted and priced into both stocks for the last two years; and is not expected to generate more than 5% revenue growth annually.

There is one more area to explore, and that is consumer sentiment and delinquency rates. Naturally, as consumer sentiment rises, as does spending, and consumer sentiment has been on the rise. Moreover, recent data shows that delinquency rates on bank issued credit cards are at their lowest levels since 1990; showing that consumers are better positioned to make their payments.

To me, dropping delinquencies is the wildcard, a catalyst that could boost volume significantly. Yet, still, I can not justify an investment when high single digit, low double digit, growth is all that’s expected. I simply do not believe that either MasterCard or Visa are worthy of such a high premium relative to American Express (2.8 times sales) or Discover Financial (3.5 times sales).

Final Thoughts

 MasterCard and Visa have emerged as Wall Street favorites, but others such as Discover or American Express are presented to the same catalysts that Wall Street finds so lucrative for its two favorites. Hence, while Visa and MasterCard do continue to create new all-time highs, I believe I would begin the process of reassessing the investment and possibly taking profits off the table.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends MasterCard and Visa. The Motley Fool owns shares of MasterCard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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