There may be plenty of apparent values in the banking sector these days, but investors aren't biting. Take the case of JPMorgan Chase (NYSE: JPM) – most analysts seem happy enough to crown them as the best-run major bank in America, but that didn't keep the stock from losing about 20% of its value in 2011. At least part of the problem here is timing and the absence of any real near-term momentum. Although there are plenty of long-term factors in the bank's favor, the list of what could go wrong in the short term is a fair bit longer than the list of things that could go right.
Good Capital … Or Is It?
Unlike major rivals like Citigroup (NYSE: C) and Bank Of America (NYSE: BAC), JPMorgan has been lauded for how it managed its credit exposures through the crisis and recovery. In terms of metrics like Tier 1 capital, JPMorgan does look to be reasonably well off and credit losses have been improving apace.
Unfortunately, that is not all of the story. JPMorgan still has a relative low ratio of tangible equity to tangible assets.
What's more, the company's huge derivatives business suggests that investors cannot rest entirely easy that the credit is as good as it seems.
Additionally, while the bank's exposure to the European sovereign debt crisis is somewhat limited (less than 10% of shareholder equity), the company's sizable businesses in residential and consumer lending (credit cards, especially) could sour if the U.S. economy hits the skids.
The Feds Won't Break Every Honey Pot
One of the issues that seems to bother investors when valuing bank stocks today is the question of how much high-margin business the banks are going to lose from changes in the regulatory environment. For starters, there have been the much-publicized changes to the rules governing the sort of fees that banks like JPMorgan can collect and these have long been sweet sources of high-margin profits.
There's also the question of the investment banking and investment businesses. New regulations have curbed the extent to which companies like JPMorgan and Goldman Sachs (NYSE: GS) can participate in private equity, and there are valid reasons to think that the regulators aren't through yet when it comes to derivatives.
Plenty Of Chances For Profitable Growth
Regulators may be making it a little harder for banks to make a buck, but creative greed has a way of finding new loopholes. For starters, JPMorgan is in significantly better shape than Citi and BofA, to say nothing of most Western European banks. That gives JPMorgan a very good chance of capturing business in Europe – business that other healthy American banks like Wells Fargo (NYSE: WFC) and US Bancorp (NYSE: USB) don't seem all that inclined to pursue.
JPMorgan also seems to be managing its retail banking and credit card businesses for solid long-term growth. This company seems content to let Capital One (NYSE: COF) have the lower end of the market, while targeting American Express (NYSE: AXP) in more affluent tiers. At the same time, the bank is recommitting itself to organic retail banking growth – it really can't growth through acquisitions anymore, but it is looking to compete fiercely to draw in more deposits from rivals.
The Bottom Line
Right now, JPMorgan's price presumes that the bank will never again earn its cost of capital (and/or there are still major writedowns left to take). That seems like a harsh assessment given the quality of JPMorgan's management and its strong position in multiple markets. True, the near-term outlook for net interest income is not all that favorable, loan growth is weak, and a double-dip recession would drive credit losses up again. None of those scenarios represent a long-term hobbling of JPMorgan's profit potential.
Assuming that JPMorgan can drive a long-term return on equity of 10%, an excess returns model suggests the stock is worth at least a third more than today's price. Bump that long-term target to 11% and the undervaluation jumps to nearly 60%. That seems like a worthwhile long-term gain to stick with this bank through some short-term pain.
Disclosure: I am long JPM.