Monday, September 19, 2011

J.P. Morgan at Tangible Book

I was reading a recent issue of Grant's (August 12, 2011) and he reminds us that J.P. Morgan Chase (JPM) is trading at close to tangible book value per share.

He also quotes Jamie Dimon, one of my favorite CEOs as saying in April, "Your company earned a record $17 billion in 2010, up 48% from $12 billion in 2009.  As points of reference: In 2008 - which, as you know, was a year filled with unprecendented challenges - we earned $6 billion, and the year before, we earned $15 billion, a then record for us....  Our return on tangible equity for 2010 was 15%.  Given your company's earnings power, these returns should be higher.  In a more normal environment, we believe that we can earn approximately $22 billion to $24 billion..."

$22 to $24 billion in earnings equates to $5.64 - $6.15 in EPS.   With the current stock price at around $32/share, J.P. Morgan, what I think is the best managed bank in the world with one of the best CEO's is trading at 5.2 - 5.7x eps.   That is really, really cheap.   If banks trade in a more normal, non-panic range of 10-15x eps (not a stretch at all), then JPM could be trading in the range of $56.40 - $92/share (10 times the low end of the eps estimate range or 15x the high end.  Taking the mid point of the eps of $5.90/share, that would be a range of $59 - $89/share)

Now wait, you say.  JPM is a bank.  Banks aren't supposed to make a lot of money going forward due to Dodd-Frank.  The Volcker rule will also restrict the amount of money they can make, right?  Also, European debt problems can really spiral out of control and take global financial insitutions down.

Yes, new laws will put a damper on bank earnings going forward, but the Volcker rule will apparently have little impact on JPM as they didn't have much in the way of pure proprietary trading, and the Dodd-Frank rules will just cause a shift in pricing across products so it won't lead to a straight decline in revenues.  Dimon has said that if you restrict how much you can charge for milk, a supermarket will find a way to charge more for the olive oil, or some such thing.   They will find other services to provide that can be profitable.

Tangible Equity
From the above comment by Dimon it is clear that he thinks even with all the new laws, restrictions and European problems, JPM can earn much more than 15% return on tangible equity.   That is good information.  Jamie Dimon is no flakey promoter and he is not the salesman/hyping type of CEO.  He is just about the smartest, most conservative manager in finance.   So if he says JPM should be able to earn much more than 15% return on tangible equity in a more 'normal' environment, then I really believe that they can do it. 

Given that piece of information, it really is amazing that you can buy shares in J.P. Morgan at around tangible book value per share.  That's pretty much saying that you are buying into a business at a price that can earn 15%, at least, over time.  How many investments can you say that about?  If you bought an S&P 500 index fund, I think the best that you can expect over time is 10%/year.  

Stock prices historically has traded at around 15-16x p/e since 1870 or so.  That's an earnings yield of about 6.5%.

And here you have an investment where the prospective earnings (if you buy at this price) is at least 15%.

Recent Trends in Return on Equity and Return on Tangible Equity

JPM's return on equity (ROE) and return on tangible common equity (ROTCE) for the years 2005 through 2010 were as follows:

                  ROE          ROTCE
2005          8%             14%   
2006          12%           22%
2007          13%           21%
2008            4%             6%
2009            7%           11%
2010           10%          15%

The average ROTCE over the past six years is 14.8%.  Note that this 14.8% includes the worst financial crisis since the great depression, and includes massive losses in mortgages, CDOs, credit cards and everything else.  

JPM did not produce a loss in any single quarter throughout this crisis.

Yes, yes, critics say that this is because JPM didn't mark their books correctly.  But anyone who knows Jamie Dimon knows that he is very conservative and hates bogus accounting.    And besides, if phony accounting is all it takes to survive a financial hurricane, how come Bear Stearns, Washington Mutual, AIG, Citigroup, Fannie Mae, Freddie Mac and many others didn't use the same phoney accounting to avoid losses?

I don't think it was phoney accounting.  I think it was just good management.

The government had to bail them out?   Yes, it's true that if the financial system did collapse, JPM would have been in trouble too.  But Dimon was preparing JPM for a 15% unemployment rate.  He said they would have been ready for a more severe recession/crisis.  Again, I believe him.

In any case, the above ROTCE is very impressive and it is not a stretch to believe that they can do better in the future as the economy normalizes. 

A quick comment on dividends; banks have not really boosted dividends yet as they have stopped dividends during the crisis to preserve and increase capital. 

But from JPM's presentation this past spring, we see that analysts expect dividends of $5 billion in 2012 and $6 billion in 2013.  Assuming 3.9 billion shares outstanding (which may decrease due to share repurchases), that would be $1.28 and $1.54 per share.  On a $32 stock price, those are forward dividend yields of 4% an 4.8% respectively.  This compares to a 10 year treasury yield of below 2%.

Even under the 'stressed' scenario where the environment gets worse, dividends per share for 2011, 2012 and 2013 are expected to be $0.63, $1.28 and $1.56 (these are higher than the above base-case figures probably because I just took $5 billion and $6 billion (rounded figures) divided by 3.9 billion shares, whereas per share dividends are from the JPM presentation as stated per share).

Stress Test?
In the April presentation to shareholders, JPM included projections for earnings, capital, dividends etc... based on a stressed analysis; how would the bank do if things got materially worse?

The assumptions for the stress scenario, I think, was that unemployment would get worse and peak out at 12% in the fourth quarter of 2013, the Housing Price Index would have a peak-to-trough decline of 45% by the first quarter of 2012, the S&P 500 index would dcline to 850 in the first half of 2011 and stay there through the fourth quarter of 2013 and the Fed Funds rate would stay at 20 basis points (0.20%) through 2013.

Of course, things can get much worse than that, but it is a good 'bad case' scenario to evaluate to see how JPM would do.

The analysts projections under this 'stressed' scenario would be:

                                                   2011      2012       2013
Net Income                                $12 bn   $13 bn    $14 bn
Total Common Dividends           $2 bn    $ 5 bn     $ 6 bn
Basel I Tier 1 Common Ratio         10%      11%        12%             
Basel III Tier 1 Common Ratio        8%         9%       10%

So even under harsh economic conditions, JPM will be able to pay out good dividends and even manage to increase capital ratios, even under the new, much stricter Basel III.

Many banks and financials are trading very cheaply now including Bank of America (BAC), which Warren Buffett bought preferred shares of (with warrants).  He has endorsed the business model and management of BAC and has put his money where his mouth is.  If he thinks BAC can't survive over the next few years, he would not have done so as he really hates to lose money.

Citigroup and other banks are also trading pretty cheaply; much cheaper than JPM. 

But I wanted to highlight JPM due not just the cheapness of the stock, but because of it's high quality management and incredible track record even through this crisis.  Of course, BAC and other banks may go up MORE in a normalizing global market environment; I am not proposing that JPM will go up the most in that scenario.   But one could only dream of being able to buy into a bank like this at tangible book value in a normal environment.

Also, there are risks.  Market volatility will probably continue for some time and there is no telling if the European situation will completely melt down.  There is no reason for me to believe that J.P. Morgan won't survive this under current management.  We can see how well they did in the financial crisis where the meltdown occured here in the U.S.  J.P. Morgan does not have a lot of exposure in Europe.  I imagine much of their exposure is in the derivatives book, and Dimon is known to be very conservative in that area.  I find it highly unlikely that the derivatives book will blow up under Dimon.

A double dip recession in the U.S. will most likely hurt the stock price, but I see no reason JPM can't get through that either.  Their capital position is better, balance sheets stronger, loan qualities higher than before the last crisis.

As far as I am concerned, the biggest risks is a more severely flattening yield curve.  This will hurt all the banks.  The Fed's operation "twist", switching it's QE2 holdings into longer maturity treasuries to push long term yields down may hurt the net interest margin of all banks.  This would put downward pressure on profits going forward.   

Many banks here earn 3-4% interest spreads, while the big banks in Japan earn slightly more than 1%.  If interest spreads come down to below 2%, this could be problematic for many banks. 

The other is what happens after Jamie Dimon.  Dimon shows no signs of leaving yet, but much of my faith in JPM is based on my trust of Dimon.  I am confident JPM will do well going forward even without Dimon as long as the succession is done well.  Citigroup was a total disaster because Weill left Citigroup to a lawyer with very little financial and/or operational experience.  He was clueless, basically.  I think this was also the case with AIG; Sullivan was an insurance guy but really had no idea about other aspects of AIG's business.

It is highly unlikely that Dimon would pull off such a sloppy, reckless succession.  But it is a risk.

Having said all that, all financials are highly unfavored and hated.  This is one area where value investors should be hunting.  Although JPM is not the cheapest financial stock around (there are many), this is one of the most solid companies with the best managements.

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