JPMorgan's (JPM) $2 billion dollar trading loss is dominating the financial news while attracting scrutiny from investors and regulators. Shares dropped from $40.60 to $37.30 upon the news of this loss. This equates to a greater than $10 billion loss of market capitalization of JPMorgan shares. The market clearly overreacted to this news, punishing shareholders more than five-fold in terms of market cap. Such an overreaction would make sense if market participants had never or imagined such events.
There is no excuse for this implied naivety and the dramatic overreaction in JP Morgan stock price. In 2012, investors in financial companies should know that they are investing in black boxes which generate huge, sporadic losses. This news should not come as a surprise. In fact, the recent price drop in JPMorgan shares is an attractive buying opportunity for bank investors.
Banks as Black Boxes
Financial companies are not transparent. They are black boxes with incalculable risks. Mark-to-model accounting and high-failure modification programs cast dispersions on the valuations of bank assets. Trading desks and "risk management" are frequently the source of headline losses, so frequently that investors should be used to them by now. In the last decade Credit Suisse, Société Générale, UBS (UBS), Morgan Stanley (MS)…and now JPMorgan have disclosed trading losses of at least $2 Billion. How is JPMorgan's trading loss a surprise worthy of a 7-8% drop in share price?
Assuming investors are capable of learning, they can react in one of two ways to lesson that financial companies are black boxes. One defensible way to act on this knowledge is to abstain from investing in financials. Another way is to keep investments in financial companies small, and only when they are trading at compelling discounts, which can justify taking on risks above and beyond those of other industries.
Remember the Stress Test
Fortunately, the Federal Reserve released stress test results (pdf), which help clarify which banks are well capitalized. Under the extreme scenarios posited in the stress test there is a wide range of tier 1 capital ratios:
2013 Doomsday Tier 1 Capital Ratio
The Bank of New York Mellon
Fifth Third Bancorp
Capital One Financial
Bank of America
These projected capital ratios under extreme scenarios are a measure of risk for these financial companies. Higher risk banks end up with lower capital ratios and lower risk, better capitalized banks will have greater capital rations in dire economic scenarios. These doomsday capitalization ratios were listed next to price-to-book, price-to-earnings, and price to sales ratios, allowing for a direct comparison of risk and value. Banks trading at the deepest discounts tend to have lower price multiples.
Value Investing in Ignorance
Based on price multiples and the hypothetical doomsday Tier 1 Capital Ratio, JPMorgan is now a bargain in an absolute sense and relative to its peers. It's single digit price-to-earnings ratio and discount relative to the accounting value of its equity make it an attractive value play. Moreover, most of the stress-tested banks on this list either have lower stress test capital ratios, trade at higher valuations, or both.
Many other bank stocks have suffered sympathetic price declines with the news of the JP Morgan loss, a phenomenon which has created more opportunities from this news. Some of the names on this table are trading at attractive valuations with comparable or better risk than JP Morgan.
One standout from the table, which registers as a better bargain than JPMorgan, is Capital One. Its capital structure fairs better in the stress test than JPMorgan, a metric which indicates its capital structure is more robust. Better yet, it is trading at lower 7.07 price-to-earnings and 1.63 price-to-sales multiples and a roughly equal 0.85 price-to-book ratio. These metrics indicate how it is an even better bargain than battered JPMorgan shares.
Other interesting bargains are found in Citigroup and KeyCorp shares, which score roughly as well as JPMorgan in the stress test, but trade at lower PB ratios and PE ratios. To sum up, these stocks represent deeper bargains for roughly the same risk as JP Morgan. As financial stocks, their prices have dropped in sympathy with JPMorgan shares, and may continue to do so as this story gains traction. Such events would provide more attractive buying opportunities for value investors.
If a value investor seeks exposure to financial companies, the investor should accept that $2 billion losses come with the territory. That being said, Capital One, JPMorgan, KeyCorp, and Citigroup shares are the most worthy big financial company stocks for value investors.