Whenever a public company reports bad news, be it a poor quarter, management impropriety or departures, or unexpected losses, it is important to ascertain whether or not these are one-off events, or if the business has been damaged in the long-term. The revelation that JPMorgan Chase (JPM) has suffered a $2 billion trading loss has sent the stock plunging, and the market watchers are all debating what this means for the company going forward. We believe that for long-term, patient value investors, this fall presents a buying opportunity.
Before we present our bullish arguments, we must answer a question. Will we be buying JPMorgan on this slide in the stock? The simple answer is no. The more complex answer is this. As a general matter, we do not invest directly in global banks, such as JPMorgan [we hold the stock indirectly through the SPDR Dow Jones Industrial Average ETF (DIA)]. The only global bank stock that we have ever bought is Citigroup (C), and we bought it based on our belief that the company would stabilize its operations quicker than Wall Street anticipated. When that proved to not be the case, we sold. While we have recommended select bank stocks here on Seeking Alpha in the past, such as Citigroup, PNC (PNC) and Wells Fargo (WFC), we are very careful with the financial sector. Our portfolio currently has just 2 financial stocks in it: CME Group (CME) and City National (CYN). These companies do not face the same risks that global banks do. CME thrives on volatility, and market uncertainty is a positive for the company, as it generates volume, which is what has been driving record results at the company. City National is a small bank that caters to select small and mid-sized businesses in a few states, as well as affluent private clients. It is a "vanilla" bank, with none of the complexities of global banks such as JPMorgan.
That being said, we recognize that our position regarding financials may not suit everyone. Many people are baffled by the fact that Warren Buffet has never bought Apple (AAPL), even when he says that he expects Apple to do well. He would much rather avoid the complexity that Apple has in its business. Our feeling regarding global banks is similar. We are not bearish on them per se. Rather, we simply wish to avoid the complexities that all global banks must deal with. However, we recognize that our position is not shared by all. There are many investors that feel perfectly comfortable investing in a company like JPMorgan. And prudent investors should be able to look beyond their own investing preferences and beliefs and know other investors may see as a good buy (or sell). We believe that for long-term, patient value investors (not our investment philosophy, but a perfectly reasonable philosophy nonetheless), the decline JPMorgan Chase has seen presents a good buying opportunity, and we delve into what has happened, as well as our bullish thesis below.
What Happened? The $2.3 Billion Question
After the markets closed on Thursday, May 10, JPMorgan sent out a cryptic press release, which stated only that the company would be hosting a conference call that evening. On the call, it was revealed that JPMorgan had suffered a huge, $2 billion trading loss. What happened? Accordion to CEO Jamie Dimon, the losses stemmed from bets that the Chief Investment Office, the company's risk management arm, had taken. Jamie Dimon conceded that the losses were related to positions taken by Bruno Iksil, a London-based trader that had made such large wagers in the credit derivatives market that they began to affect the entire market itself.
Specifically, Iksil, according to the usual "unnamed sources," had bet on the CDX.NA.IG.9, the largest of many credit indices produced by Markit. JPMorgan would not divulge specifics of the trades, but insists that they were meant to be hedges against risk, specifically default risk in the broader economy, and not speculative trades. According to sources of the Wall Street Journal, Jamie Dimon was briefed regularly on the CIO's (Chief Investment Office) trades. The CEO acknowledged that the bank should not have acted so defensively when reports of Iksil's trades first surfaced, for the bank looks foolish now.
On the call, Jamie Dimon reiterated that while the CIO would have a pretax loss of $800 million in the second quarter, from previous estimates of a $200 million profit. Dimon noted that for the quarter, JPMorgan as a whole would still be solidly profitable, although he declined to give guidance or confirm analyst estimates (which we will discuss later in the article). Sources close to the bank say that the actual loss currently stands at $2.3 billion, not $2 billion. In addition, Jamie Dimon said the company could see future losses of up to $1 billion, due to what he called "market volatility."
Regulation & Reputation: The Real Impacts (But Only in the Short Term)
We believe, as does most of Wall Street, that the real damage to JPMorgan from these losses is not financial in nature. Rather, it is the company's reputation and ability to lobby against regulatory reform that have been damaged.
Investors expect this kind of sloppiness from Citigroup or Bank of America (BAC). But this is JPMorgan, the company that skillfully navigated the financial crisis to supplant Bank of America as the largest bank in the United States. JPMorgan grew through the financial crisis, taking business from its rivals and buying both Bear Stearns and Washington Mutual for nominal amounts (the political aspects of these transactions are beyond the scope of this article). And now, we have JPMorgan announcing that it has lost billions due to trading errors. For a company built on shrewdness and prudence, and one led by a CEO many see as the elder statesman of Wall Street, this is especially humbling. Jamie Dimon admitted that he and other bank executives have "egg on their face" due to this incident. JPMorgan's image as being above the sloppiness of its Wall Street peers has been damaged by this trading loss.
Furthermore, Jamie Dimon's stance against stricter regulatory oversight has lost a good deal of its power. The CEO had been among the most vocal critics of the Volcker Rule, created to ban proprietary trading at banks. While Jamie Dimon was forceful in his argument that the CIO does not engage in proprietary trading, it is unlikely that regulators and Congress will see it that way. Dimon's credibility in Washington has been damaged, for it will be very difficult to parlay his navigation of the financial crisis into meaningful opposition to the Volcker Rule, as well as broader regulatory reforms, now that these losses are known.
That being said, we think that these issues do not present long-term issues for JPMorgan. The risks of increased regulation have been priced in for some time, and JPMorgan is still one of the strongest firms on Wall Street. The real issue is what the bank's clients will do going forward. We do not believe that they will desert the firm over this episode, or that JPMorgan will be unable to attract new clients as a result of these losses.
Market Reactions: The Credit Side
Talk of JPMorgan's trading loss dominated the markets on May 11, and the credit rating agencies weighed in as well. Fitch wasted no time in cutting JPMorgan's credit rating, by one level, from AA- to A+. Short-term ratings were cut as well, from F-1+ to F-1. In its downgrade, Fitch cited concerns about a lack of liquidity in this specific trade (not JPMorgan as a whole). In addition, Fitch is concerned about what this loss says about the banks' risk management and oversight practices. While no downgrade is ever a good thing, we feel that JPMorgan will fix its risk management and oversight practices regarding the CIO. Jamie Dimon will not tolerate a second trading loss of this magnitude on his watch, because his reputation as the elder statesman of Wall Street is at stake. We are confident that he will ensure that such a loss does not happen again, if not for the sake of his shareholder's, than for the sake of his reputation.
S&P also took action, placing JPMorgan on review for a possible downgrade. S&P affirmed JPMorgan's A rating, but said that it views the banks "risk position as 'adequate' and not 'strong' (as our criteria define the terms), partially because of the risk on JPM's balance sheet, which we believe contributes to the need for elaborate hedging strategies...Management's admission that the hedging strategy was 'flawed, complex, poorly reviewed, poorly executed, and poorly monitored' contributes to our negative outlook." We believe that as S&P conducts its review, JPMorgan will work hard to prove to the firm that it has taken concrete steps to overhaul its risk management, and ensure that its hedges are constructed in a proper way. S&P will be focusing on whether or not lapses are limited to this specific portfolio, or if there are company-wide issues present at JPMorgan.
For its part, Moody's has stayed silent. But that is because it is already reviewing JPMorgan for a possible 2-level ratings cut. Moody's review is not tied to this trading loss. The review of JPMorgan is part of the rating firms global review of 17 banks that have global capital market exposure. This trading loss makes a downgrade at Moody's much more likely. That being said, investors should remember that in this business, relative positioning often matters more than absolute positioning. While JPMorgan is on review for a possible 2-level cut, Morgan Stanley (MS), UBS (UBS), and Credit Suisse (CS) are all on review for a 3-level cut. Should Moody's go through with these cuts as stated, JPMorgan, Goldman Sachs (GS), and Deutsche Bank (DB) would be left with some of the highest ratings in the capital markets industry, thus pushing business to them, according to analysts.
Market Reaction: Market Movers, Analysts, and Earnings Estimates
Several market movers have weighed in on this trading loss, and they are bullish on the bank going forward. Barron's is upbeat, saying that the stock will reward patient investors. Barron's notes the stock's 3.25% yield (as of this writing), and that even though the company will need to give a more detailed explanation of what happened, the shares are a bargain at around 8 times earnings.
Hedge fund manager Doug Kass, of Seebreaze Partners, took what he calls a "small long position" in the bank as it was plunging. Kass said that when he weighed the impact of this loss against earnings and the bank's reputation and said that the ability to buy JPMorgan at just $4 above book value ($34 per share) was too tempting to pass up. Kass, however, stated that this investment was not meant as a trade. He said, ""I am not foolish enough to believe that I will be immediately rewarded in this trade. I am putting the shares away as an investment." We take this time to remind readers that JPMorgan is not a buy for the short-term. We are arguing that the stock is suitable for patient, long-term value investors, not those who expect it to bounce back in the next week or month.
Analysts that track JPMorgan are divided over what this means for the banks profits and stock, and we delve into their revisions below, and will provide their updated earnings forecasts, where available, at the end of this section.
- Barclays: The firm maintained its overweight rating and $57 price target. Analyst Jason Goldberg said that investment banking results would be weaker in the second quarter relative to the first, and that consumer & business banking would be adversely impacted by narrowing spreads. Mortgage repurchase losses are set to continue, Goldberg said, but home equity and credit card losses are set to fall.
- FBR: The firm wasted little time in going after JPMorgan, slashing its price target from $50 to $37 and lowering its rating to market perform from outperform. Analyst Paul Miller says that there is uncertainty surrounding the bank, and that although this trading loss is isolated to JPMorgan, the regulatory backlash will increase headline risk for the bank. Furthermore, Miller is concerned that until JPMorgan is certain about the magnitude of its trading losses, it will hold off on buying back shares.
- Stifel Nicolaus: The firm downgraded shares of JPMorgan to hold from buy.
- Argus: The firm maintained its hold rating, citing the large degree of uncertainty it sees around the firm. Analyst David Ritter says that there is no way to be sure that management's loss estimates are accurate. However, Ritter notes that given the bank's strong first quarter earnings and existing capital levels, this loss will not have a meaningful impact on the bank's overall profitability or capital position. Like other analysts, Vitter believes that the reputational damage that this trading loss has done is more serious than the actual financial loss. However, Ritter does not recommend exiting positions due to this event. He sees the dividend yield and stock buybacks as providing support, even if buybacks will slow in the near-term as executives try to put this behind them.
- Goldman Sachs: The firm maintained its buy rating, but cut its price target to $48. Goldman said that while the direct financial loss is manageable, it creates regulatory uncertainty and near-term downside. That being said, the firm believes that share buybacks and the dividend will support the stock going forward, and that the long-term story remains intact.
- Citigroup: The firm cut its price target on JPMorgan to $45 from $52, saying that this trading loss could not have come at a worse time, from a perception standpoint. Citigroup is concerned with JPMorgan's reputation, and says that "to have a loss this size when credit spreads actually widened in the quarter begs the question of what the point of this trade was, and reinforces questions about how much of the activity in the CIO office is hedging."
- UBS: The bank maintained its buy rating, saying that this was a short-term detour and a "rare and isolated" incident.
- Oppenheimer: The firm maintained its outperform rating. Like many other firms, Oppenheimer believes that the reputational fallout for JPMorgan is worse than the actual financial losses. However, the firm thinks that from this point on, the downside is limited.
- Nomura: The firm cut its price target from $50 to $55, but maintained its buy rating. Nomura is not concerned with the financial losses stemming from this episode, citing JPMorgan's strong capital position and earnings run rate. Rather, Nomura is concerned with the reputational damage that JPMorgan has suffered,
- Atlantic: The firm maintained its overweight rating, but cautioned that JPMorgan could swing too far to the side of risk aversion, something that could impact its long-term profitability.
- Deutsche Bank: The bank maintained its buy rating, but cautioned that the premium JPMorgan has to its book value, which is based on its reputation and earnings potential, may be at risk. The bank says that in the near-term, the headlines surrounding all of this are likely to get worse before they get better.
- Credit Suisse: The firm kept its outperform rating and $55 price target. Credit Suisse noted that the impact of this loss to bank capital is manageable, given JPMorgan's 8.2% Basel III Tier 1 ratio, which includes a 20 basis point cut from the 8.4% level previously reported. Nor should this loss have an adverse impact on the bank's capital distribution plans. The firm believes that this issue will be fully resolved in 2012, but that the final tally of losses depends on the actions of outside market participants.
- Merrill Lynch: The firm trimmed its price target from $52 to $50, but kept its buy rating. Unlike many other firms, Merrill Lynch believes that the fall in JPMorgan's stock price will lead the bank to accelerate its share buybacks, not slow them down. The entire swing in the CIO divisions' net income, from a $200 million profit to an $800 million loss amounts to 25 cents/share, something Merrill Lynch sees as manageable.
- Wells Fargo: The bank maintained its outperform rating, arguing that the financial impact of this trading loss is "modest." However, the bank called the timing of this loss "unfortunate."
- Sterne Agee: The firm mainatined its neutral rating, arguing that JPMorgan's fundamentals are unchanged despite headline risk. That being said, the firm is lukewarm on the entire broker sector, citing increased regulatory scrutiny.
- Credit Agricole: Analyst Mike Mayo, seen by many as the most respected banking analyst (alongside Meredith Whitney) actually downgraded JPMorgan on May 4 to underperform. Mayo argues that while JPMorgan may be the best global bank overall, it is not the leader in each of its individual business lines. Mayo stated that this trading loss shows that some of the biggest banks may be simply "too big to manage," and that this was a "big black eye" for JPMorgan.
- RBC: The bank maintained its outperform rating, arguing that the banking industry's "prize fighter is knocked down, but not out." RBC does not see this as a trivial matter, as it raises questions about JPMorgan's risk management practices across the entire company.
Overall, analysts defended JPMorgan, arguing that the financial losses the firm sustained in this trade are manageable, and that the reputational damage is more concerning. That being said, analysts generally expect JPMorgan to successfully navigate this controversy. We provide revises earnings estimates, where available, below.
|Firm||Old Price Target||New Price Target||Old 2012 EPS Estimates||New 2012 EPS Estimates|
Based on analysts that have revised their 2012 earnings targets, JPMorgan trades at 8.57 times forward earnings as of this writing, hardly a sign of overvaluation. And the average revised price target on shares of JPMorgan implies upside of over 32% as of this writing.
It is a bit early to discern just what regulators will do now that JPMorgan's trading losses have been revealed. According to Bloomberg, the Commodity Futures Trading Commission has been investigating the trades in question for at least a month, but has not brought any enforcement action against the bank.
The SEC has also begun a formal investigation. According to sources of the New York Times, the SEC opened a preliminary investigation in April and initiated its formal investigation in recent days, making it public once news of JPMorgan's trading losses broke. The SEC is said to be focusing on JPMorgan's value-at-risk and the accounting the bank used regarding these trades. No one at JPMorgan has been charged, according to these sources.
In addition, Britain's Financial Services Authority is said to be investigating as well, and so is the Federal Reserve. Both institutions were said to be alerted of the situation in April, according to these sources. It is likely than in the days and weeks to come, JPMorgan's stock price will be driven in large part by developments on the regulatory front. That being said, we think that in the long run, JPMorgan's regulatory issues will be spread throughout the entire banking sector, as regulators use this trading loss as evidence of the need to strengthen banking regulations. We think that a good deal of regulatory scrutiny is priced into JPMorgan at this point (as well as many other financial companies).
It may seem counterintuitive that we are recommending that investors buy JPMorgan at this point in time, but are not buying the shares ourselves. We own the SPDR Dow Jones Industrial Average ETF to gain exposure to other companies in the index, not because of a desire to own JPMorgan. It is not because we are bearish on JPMorgan, or the financial industry. Rather, our investment style is one that does not lend itself to large, global financial institutions. The 2 financial stocks that we own, CME Group and City National, have a different risk profile than JPMorgan and other global banks. CME thrives in volatile environments such as these, and its profits serve as proof of that. City National's focus on small and mid-size businesses, as well as affluent individuals, gives it an entirely different risk profile than JPMorgan. In addition, with just $24 billion in total assets, and a "plain vanilla" business model, City National faces a much different regulatory environment than JPMorgan and other global banks.
But for investors who do wish to invest in large, global financials, we think that this selloff presents an opportunity for long-term, patient, and value investors to add to or initiate a position in JPMorgan Chase. The bank will navigate this storm successfully. Earnings estimates have not fallen as sharply as the selloff the stock has seen would suggest, and with the fall the stock has seen, it is possible that JPMorgan will begin to buy back shares at a more rapid pace. Based on what we have seen on the regulatory, credit, and analyst sides of this story, we are comfortable in recommending JPMorgan Chase to investors who have a desire to invest in one of the world's leading financial institutions.