After closing at a 5-year high of $50.63 in early March, JPMorgan (JPM) lost a bit of its footing, sliding as much as 7.5% over a 3-week span on macro-risk aversion stemming from Cyprus and the Federal Reserve's latest stress test results.
With the stock recovering somewhat as the S&P500 has tacked-on new highs, the question investors need to ask themselves is, "Should JPMorgan form part of my financial sector exposure?"
The answer is "Yes."
Investors should consider the recent sell-off in the stock as an opportunity to either increase their exposure to the stock or start a new position for the following reasons:
1. Solid Earnings. JPMorgan reports next Friday (April 12) and the consensus estimate is for earnings of $1.38/share. That represents 16% earnings growth from the same period a year earlier, which is robust considering the economy only began to re-accelerate in the 1st quarter.
However, if JPMorgan's earnings only matched the consensus, this would represent a slight 0.7% decline from the $1.39/share it earned in the prior period. Yet, in each of the past quarters, JPMorgan beat the consensus estimate by an average of 26% -- that includes the 2nd quarter, when it recognized $2 billion in losses following its infamous "London Whale" episode.
In our view, JPMorgan should exceed the consensus 1st quarter estimate but not by as large a margin as it did in the prior 3 quarters. Specifically, if we consider last year's earnings history as guidance, JPMorgan should beat estimates by at least a cent per share. Some analysts believe that this might be understating things: the top range of JPMorgan's earnings estimates pegs its 1st Quarter earnings at 1.65 per share. Regardless, considering the still-nascent stage of the economic recovery, attaining the consensus or even beating it slightly should be considered an accomplishment and cause for future optimism.
2. Forward Prospects. While the name JPMorgan is closely associated with Investment Banking outside of North America, the world's 8th largest bank actually generates a substantial part of its earnings from more traditional banking services such as mortgages, deposits, business lending and consumer credit.
In each of these areas, JPMorgan saw very strong performance in the 4th quarter. In particular, mortgage originations grew by a robust 33% -- and this trend should continue, particularly with the U.S. housing recovery well underway. Supporting this is the fact that the Mortgage Bankers' Association recently forecasted that mortgage originations for new purchases would surge by 42% over 2013 and 2014. It also expects that home prices will rise by over 4% in each of those two years. A strong housing market implies that JPMorgan's 4th quarter performance in this area was not a one-off and that, if anything, its best days in this area are still ahead.
Meanwhile, consumer credit - credit card and auto loans - expanded by 7% in the Federal Reserve's latest G.19 report. This is the highest level of consumer credit expansion since 2008 and is consistent with the 9% rise in credit card volumes that JPMorgan reported in the 4th quarter of 2012. While this may be worrisome in that it carries the risk that consumers may be overextending themselves, it bears noting that JPMorgan has actually seen its net charge-off and delinquency rates decline for 3 consecutive quarters. In that sense, the rise in consumers borrowing is not at all alarming - base effects are largely responsible for the expansion since access to credit was curtailed from 2008 to 2011. Nowadays, people seem to be borrowing more in line with their incomes - as JPMorgan's lower charge-off and delinquency rates can attest.
Wealth Management, one of the areas that proved resilient in the face of the financial travails of 2008/2009, continued to be a source of strength for JPMorgan - it saw net Long-term Assets rise for a 15th consecutive quarter. This is where JPMorgan's geographic diversification displays its value: Asia (particularly China at 53% of GDP) has very high savings rates as a percentage of GDP. JPMorgan retains a strong and dynamic presence in this region, even opening up branch-style banking networks in countries such as China and India, so it is well-placed to take advantage of rising incomes in emerging markets.
Interestingly, JPMorgan's much-maligned investment banking practice received a shot in the arm following the CFTC's ruling to exempt JPMorgan's affiliates (and other banks) from Dodd-Frank rules regarding swap trades. Swaps, particularly those sold Over-the-Counter (OTC) to corporatations, are lucrative for Investment Banks as they have wider spreads on such transactions since pricing is less transparent. Imposing such rules on JPMorgan and its affiliates would have meant substantial compliance costs for the company, potentially shuttering some of its swap desks; and
4. Valuation: Not too Hot, Not too Cold. JPMorgan currently trades at a Price-Earnings ratio of just 9.2x its trailing twelve-month earnings - that's little more than half the 18x trailing earnings that its peer group trades at and quite a bit lower than the 17.7x P/E of the S&P500. Everything else equal, if JPMorgan's earnings were to rise by 16% this year, its forward P/E would be just 7.9x at current market prices.
Moreover, JPMorgan is actually valued quite cheaply in terms of book value at just 0.94x. The typical market valuation for financial firms is 2x book value so JPMorgan is trading at less than half that - meaning that, if JPMorgan were liquidated today, investors who paid just 94 cents would receive a dollar for their trouble. Even using the more stringent measure of Price-to-Tangible Book Value, JPMorgan is trading in-line with its peers at 1.34x - but that does not include JPMorgan's offshore assets, investments and reserves, which means that this measure is overstated.
As if it were not cheap enough, JPMorgan has a dividend yield of 3.2% -- that's 52% more than the 2.1% dividend yield on the other large cap stocks of the S&P500.
The principal risk for JPMorgan is, of course, a sizable macroeconomic contagion. However, Cyprus could actually provide an opportunity for JPMorgan once the dust has settled. Indeed, similar to what happened at the height of the Asian Financial Crisis in 2007, American banks could see net deposit inflows as worried Cypriots might consider American banks to be on surer footing than their Cypriot counterparts. Moreover, the onshore units of offshore or non-national banks could be a legal grey area for the deposit haircut approved by Cypriot government, attracting even more depositors.
Perhaps the most worrying event for JPMorgan is the result of the Federal Reserve's last round of stress tests, in which JPMorgan fared poorly. In particular, the Fed showed that JPMorgan would see its Tier 1 ratio fall to 5.56% (from its current 9.9% using Basel 2.5) in the event of a sharp economic downturn - prompting the Fed to require JPMorgan to submit a revised Capital Planning program.
It ought to be noted that despite this, the Fed did not prevent JPMorgan from announcing a stock repurchase and an increase it its dividend. The reason for this is simple enough: the downturn forecasted by the Fed is a remote scenario and given JPMorgan's deep integration in the financial system and strong performance, it will likely be able to increase its capital base with little difficulty. Additionally, it can easily obtain capital from sovereign wealth funds from Asia and the Middle East where it has notable footprints.
Given all this, any sensible investor would do well to invest a portion of their portfolio in JPMorgan. We believe that the market could tolerate a JPMorgan valuation at 12x earnings, which would imply an upside of 30% for investors buying the stock today.
Additional disclosure: Black Coral Research is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.