On Thursday, November 8th, JPMorgan Chase (JPM) disclosed in its Q3 2012 10-Q Report that the Federal Reserve completed a review of the capital plan JPM had resubmitted in August. The Fed did not object to JPM's plan to repurchase up to $3.0 billion worth of common equity in the first quarter of 2013.
That's positive news for investors who think JPM is cheap right now. How positive is a function of how cheap. Let's say you believe fair value for JPM is $52 today, which is a reasonable educated guess. With JPM's Monday closing price of $40.58, that implies fair value is 28% above current price. If JPM can buy in $3 billion worth of shares at today's price, it would be paying $3 billion for about 74 million shares, shares which are actually worth $3.84 billion. The "gain" of $0.84 billion is spread over JPM's pro forma shareholder base of 3.73 billion shares (the buyback would reduce JPM's share count by about 2%), giving shareholders who don't sell their shares a gain of $0.23, or 0.56% on the current share price.
I wasn't being sarcastic in this article's title. This is a no-brainer. JPM should do it, despite only 0.56% value accretion. JPM should make value-accretive decisions, even if modestly positive, and avoid value-destructive decisions, even if modestly negative.
Some investors will disagree with how I estimate the value created by the buyback. They believe that because buybacks shrink the share count and bolster EPS growth, they can potentially improve JPM's P/E multiple, which if true could create much more value than I am estimating. But why is it logical to believe that? What if there was some tradable asset that JPM could buy for $3 billion, knowing it could immediately sell it to someone else for $3.84 billion? In that instance, my calculation would be correct, setting aside taxes on the gain. So why, if that tradable asset is JPM shares, would my logic unravel?
Investors know JPM's CEO Jamie Dimon is eager to buy back shares if the price is right (that last part, the part about the price needing to be right, is a point which, sadly, is lost on some bank CEOs). Dimon's 2011 letter to shareholders told them so, stating, "If you like our businesses, buying back stock at tangible book value is a very good deal." JPM's Q3 2012 tangible book value per share ("TBV-PS") was $37.53, meaning that JPM currently trades at 1.08x TBV-PS. So now's a good time to buy back shares. But investors knew this before the Fed gave approval for the new buyback. It's implausible to think that the execution of the buyback will drive JPM's share price to $52.
It's more likely that investors are currently nervous about the headwinds JPM faces (mediocre asset growth and less than stellar return on equity, even with a degree of leverage that regulators may prohibit in the future), and that if they become less nervous about these headwinds, they'll ascribe a higher valuation to JPM, irrespective of whether buybacks take place. When investors do this will determine when JPM's price gets to $52 and beyond.
One last point about that 0.56%. JPM's closing market cap on Monday was $154 billion. Its total assets at Q3 2012 were $2.3 trillion. So relative to these two figures, $3 billion doesn't seem all that big a number. But it is a big number. And being able to buy an asset at 78% of its fair value, especially one with a $3 billion price tag, is a rare opportunity. When JPM's stock price corrects, this opportunity will disappear, and that will ultimately be a good thing for JPM shareholders. And buybacks are easy from an execution standpoint. Dimon knows exactly what he's buying when he repurchases shares. There's no execution risk.
If you're hoping that JPM will make acquisitions, keep in mind that even if you'd want a deal to provide only 1% value accretion, JPM would need to buy a target "cheap." For example, if it pays $3 billion for a target, that target would need to be worth $4.57 billion. That's a 34% discount to fair value, which is implausible. So a deal would have to be much larger to deliver the 1% accretion. Could JPM get away with paying $15 billion for a target worth $16.69 billion (a 10% discount to fair value)? That's seems less implausible, but still not easy. $30 billion for something worth $31.84 billion (a 6% discount)? Maybe, but few potential targets are that big. So JPM would really have to swing for the fences for an acquisition even to be only 1% value accretive. And swinging for the fences is risky.
So JPM should buy back lots of shares while they're cheap, and then it should stop. Buybacks are icing on the cake, for now. And JPM should be skeptical about the value of acquisitions, given the risk inherent in any deal big enough to matter. Financial engineering won't get JPM's stock price to $52. A change in investor sentiment will.
Whether JPM can force such a change, by delivering robust asset growth or better yet by improving margin, remains to be seen.