JPMorgan (NYSE:JPM) made news last week announcing a $2 billion trading loss on credit derivatives and disclosing a major weakness in its risk management system. As annoying this might be for any JPM shareholder, I consider this loss not to be recurring. JPM lost about $15 billion of its market capitalization after the announcement of the loss to the public.
A $2 billion loss equates to a roughly $1 billion after-tax loss indicating that the market values the loss by a multiple of 15, while at the same time investors value JPM's 2013 earnings at only 6.6x. Investors seem to use different benchmarks when it comes to valuing gains and losses, which is evident in this case, and indicates to me a pricing inefficiency is present. I assume that most of the discrepancy in the multiple is attributed to future losses in the derivatives contract.
Remarks from Jamie Dimon about a possible widening of the loss instilled further uncertainty into JPM shares and spilled over to other financial stocks. Since I am an utter believer in the resurgence of the United States as the economic leader going forward, I did not hide in my previous article that I am long almost all major US financial institutions. The financial firms are going to come back and come back massively once the economy picks up steam. One-time losses should not cloud the long-term earnings potential of an entire industry.
The trading loss in perspective
JPM is set to lose about $2bn before tax based on current market values of the derivative contracts. This event, technically, exposes a failed hedging strategy, and should the risk management deficiencies be addressed, should be fairly valued as what it is: a one time, non-recurring event that need not be extrapolated. The most interesting aspect about this loss is the survival of the regulation debate that made headlines in most financial publications.
For value investors, this could not be a better time to buy. In the short-term, sentiment is turning more heavily against financial institutions even when their long-term viability is not in question. I predict that JPM will earn about $18 billion in this fiscal year and can easily absorb the loss and will have no problem to pay its dividend whatsoever.
Instead of giving in to the sentiment I rather followed the proven value investor maxim to buy on bad news. Since I am already long Goldman Sachs (NYSE:GS), Citigroup (NYSE:C), Bank of America (NYSE:BAC), AIG (NYSE:AIG) and JPM, I used the short-term negative sentiment to add to my positions. My underlying thesis about financial stocks has not changed at all.
BAC is still tremendously cheap. Its metrics are almost unreal: P/B of 0.34 and a leading P/E of 7 indicates how pessimistic the market is regarding Bank of America. I predict that not only BAC, but also the entire housing sector as well as mortgage-backed securities will be the winners of the continued recovery.
Citigroup fell from over $36 per share in April to $28 in May within a month. There is no reason I can find to justify this discount. Citigroup currently trades a P/B of 0.45 and a forward P/E of 5.90. I have added to my Citigroup common stock position as well as my long-term warrants.
I also added to my position in JPM taking bold advantage of the overdramatization of its trading loss. Long-term, JPM's earnings potential is not affected. Its share price is currently more driven by headlines and negative regulation scenarios rather than fundamentals. With a forward P/E of 6.6x I consider the stock to be extremely cheap and undervalued.
The multiples are nowhere near of what could be reasonably justified for the largest financial conglomerates at the core of the financial system. I think the risk-reward trade-off in the financial sector is just fantastic for long-term investors who are not too emotional. I am going to continue to buy financials on unjustified major setbacks.