JPMorgan Stock Looks Good And The Warrants Look Better

| About: JPMorgan Chase (JPM)

The market has had a significant run this year and it is getting harder to find cheap stocks. Despite the rally, numerous negative headlines over the past several years have kept JPMorgan's stock (JPM) priced at value levels. Also, its 2.7% yield is high - but not high enough to attract the 'bond alternative' money and it is a large enough company that it isn't attracting growth investors. But the majority of the reasons that investors have stayed away from the company have nothing to do with the company's earnings. This presents an opportunity for the investors who can look through the headline risk and recognize improving fundamentals and the company's long-term value.

This quote from Richard Pzena, CEO of Pzena Investment Management LLC, sums up the current situation well.

If you can combine a company that has a low valuation and should have a sustainable edge, but may, in the present, not be experiencing it for some-and it may be temporary-reason, then you have this unbelievably powerful combination.

JPM currently trades at a PE Ratio of 9. The stock currently trades at 1x book value. The S&P 500 currently has a PE Ratio of 18.5, so JP Morgan currently trades at half the valuation of the S&P 500. The current stock price, at 1x book value, is also significantly below the long-term price to book ratio for large banks.

During the company's recent earnings report, they reported roughly in-line numbers which were good but not great. The most significant negative aspect of the report was the continued drop in net interest margins. As they have said in several previous quarters, the bank expects their net interest margins to stay around current levels for the rest of the year. On the positive side, they reported very good trading and investment banking revenues. Shares didn't react significantly to the earnings report, mostly because there was nothing unexpected so any news was already priced in.

Shares have been hit recently on news that the bank is facing civil and criminal charges over mortgage-backed securities sales from the financial crisis. Also, the company is reportedly working on an agreement to settle with the SEC over 'London Whale' losses with an agreement expected within a few months. New reports over the weekend suggest criminal charges are being prepared against two people involved in the incident as well. These recent reports illustrate the type of short-term headline risks present in the stock. As a result, JPMorgan stock has closed lower every day since August 2nd - 6 consecutive down days.

Litigation has been a continual overhang on large banks for the past several years. Despite the headline risks, JPMorgan continues to increase earnings because the litigation has little impact on the firm's earnings power.

As I profiled several months ago, the JPMorgan warrants provide a lower-cost and leveraged way to gain long term exposure to the stock. Since I wrote the article in February, the warrants have rallied 25%, only keeping pace with the stock's return over the same period. When the initial article was written, JP Morgan's stock needed to rally 18% for the warrants to break even by their expiration date in October 2018. Now, the stock only needs to rally 9% over the next 5 years and 2 months for the warrants to break even by expiration. This low premium in the warrants makes them a great buy to gain exposure to continued growth and improvement in JPMorgan's earnings and a decrease in headline risk which should bring in more investors.

The table below shows the relevant information for the warrants with relation to the current stock price.

JPMorgan Warrant (JPM.WS)
Warrant Strike Price $42.42
Warrant Price $17.05
Warrant Exp. Date 10/28/2018
Time until expiration (years) 5.22
Current Stock Price $54.52
Warrant Break-even Price at Expiration $59.47
Stock CAGR Required for Warrants to Break Even at Expiration 2%

Given the current very low premium priced into the warrants, the stock only needs to appreciate just under 2% per year for the warrants to break even by expiration in just over 5 years. The warrants now present a great low premium and leveraged way to gain long term exposure to the stock.

Another aspect of the warrants that makes them attractive to investors is dividend protection. As the quarterly dividend rises above $0.38 per share, the strike price of the warrants begins to adjust downward. The current quarterly dividend for JPMorgan stock is $0.38 per share, so any increase in the dividend begins to decrease the strike price.

There are few catalysts for JPMorgan over the next several months and this investing thesis is a long term one so investors can be opportunistic and wait for buying opportunities to build positions. Investors looking to build a stake in the warrants could buy a half or third of a position now and continue to build the position as opportunities present themselves. The warrants have a long enough timeframe that the bank should be able to work through their current issues and negative investor perceptions and move up towards more normalized valuations before expiration. A return to normal valuations would result in a significant return for holders of the stock and a much more significant return for holders of the warrants.

Disclosure: I am long JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long JPM warrants.