Card Networks Like Visa and Mastercard Don't Take Credit Losses. American Express Does. Here's Why That Matters for the Stock.

Visa and Mastercard enable global commerce to function smoothly, processing trillions of dollars in payment volume on a quarterly basis. But they don't issue cards directly to consumers. Instead, they rely on their banking partners to manage this important task.

So, the leading card networks Visa and Mastercard operate business models that allow them to avoid taking on credit risk and the potential losses this may bring. This shows up in their financials in the form of incredible profitability. And it's why investors value these companies so highly.

American Express (NYSE: AXP), on the other hand, runs what's known as a closed-loop system. It not only handles payment processing through its own network infrastructure, but it's also the issuer of its premium credit cards. Consequently, it must deal with borrower risk and any possible related operational headaches this may cause.

It's important that investors understanding what makes American Express different from Visa and Mastercard.

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Open or closed

The open-loop systems that Visa and Mastercard run are extremely lucrative. During the three-month period that ended Sept. 30, both businesses reported operating margins of nearly 60%. Shareholders gravitate to these companies because of how profitable they are. Since their technical infrastructure is built out, every incremental transaction carries high margins.

Even though they bring in far less revenue than Amex, the ability to generate substantial cash in a capital-light manner is precisely why the market capitalizations of Visa and Mastercard are more than double and triple, respectively, what Amex is worth.

Amex should be viewed more like a traditional bank than a tech platform. It has to underwrite new cardholders, open accounts, accept payments, manage risk, and handle the entire customer relationship.

It funds customer purchases directly as a lender, so it's exposed to the credit cycle. This means that a severe recession would certainly hurt the company more than it would impact Visa and Mastercard, as losses could rise dramatically.

During the third quarter, American Express did bring in $4.9 billion in net interest income. However, it holds $215 billion in card balances on its books. And its provisions for credit losses, which are an expense item, totaled $3.3 billion in the last nine months.

Premium positioning

Visa and Mastercard have superior business models. They operate capital-light payment platforms that post tremendous profits. It makes sense why they trade at earnings multiples that are significantly higher than what American Express shares go for.

But don't completely disregard Amex. It's also an extremely high-quality company. Warren Buffett thought so. Berkshire Hathaway owns 22.6% of the outstanding shares, making this financial stock its second largest holding. It has produced a market-beating total return in the past five years (as of Nov. 11).

The company takes on credit risk, but it's not like the rest of the industry. It targets affluent customers, who don't present as much of a financial threat. Management deliberately positions the brand as a lifestyle partner associated with status and prestige. People are drawn to these card products, despite their high annual fees, because they appreciate the perks and rewards they have access to.

According to Fitch Ratings, Amex's net charge-off rates are the lowest in its peer group. Its customers are known to use cards as spending tools, not to hold revolving balances. And these customers are generally better insulated, versus rivals, from macroeconomic pressures, which controls credit risk.

American Express shares trade at a forward price-to-earnings ratio of 16.1. The discount to Visa and Mastercard will probably always persist since these open-loop networks don't have capital tied up in lending activities. Investors need to know this if they're thinking of owning any of these companies.

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