Buy JPMorgan Under $37 A Share, Wait For $50

Jun.28.12 | About: JPMorgan Chase (JPM)

JP Morgan (NYSE:JPM) is a bank with about $2.3 trillion in assets, and its current tangible book value is just under $200 billion. If you multiply number of shares outstanding (3.81 billion) by the price target implied in the title ($50/share), you come to a market cap of $190.5 billion.

Headlines were made today (June 28, 2012) by the New York Times, when it publicized the bank's internal reports, which estimated worst-case scenario losses of approximately $8 or $9 billion. This, in addition to weakness in the broader market, has led shares of JPM to take even more damage from sentimentalists (dropping about 4.4% to just above $35/share as I write this).

The original problem was brought about by a hedge intended to protect JP Morgan from losses on eurozone debt. Another position was opened to hedge this position as well, which incurred the losses that are plaguing shares of JPM now due to implementation of the LTRO. This article by fellow author Colin Lokey describes the situation in greater detail, and warns against continuing risk from the original hedge on eurozone debt "IG9."

Despite the huge potential damage that these hedges can do to JP Morgan's balance sheet, the market's sentiment has proven far more toxic and provides ample opportunity for risk-takers to enter positions in JPM stock at very favorable levels.

How do you value large banks anyway? Well, if we look at the "paragon" of the big banks, Wells Fargo (NYSE:WFC), we see that it is trading at a price-to-book ratio of about 1.25 (making tangible book value approximately $135 billion). This is after huge declines brought about by recent market drama too, so we would normally be seeing P/B ratios above 2.

If JP Morgan were considered an equal to Wells Fargo in prospects and traded at the same P/B ratio (1.25), the shares would be trading at $65 apiece. That's a $116 billion dollar discount on JP Morgan just because it's not Wells Fargo.

While JP Morgan is more exposed to declining industries, like investment banking, I don't think the bank should be trading this far below tangible book value. This is a chart of the banks P/B ratio over the last five years.

Click to enlarge

As you can see, the last time JP Morgan shares were this cheap on a P/B basis was in 2011, which equaled the pricing of the shares in the height of the market crash of 2009.

When investors start trading the shares at $.70 for every $1.00 of JPM assets, value investors seem to come in droves. Yes, there is exposure to the volatility of the derivatives market, which might lop off chunks of the bank's assets in bad situations, but buying assets at an overall 30% discount while simultaneously receiving dividend payments yielding over 3.4% on your position is extremely attractive.

If we say JP Morgan has $200 billion of tangible assets, a P/B ratio of .7 would have shares trading near $37/share, which is a level at which the stock's risks are outweighed by its value potential (in my book).

Under this level, shares are even more attractive with every downtick. Once JP Morgan trades above tangible book value (~$50/share), the underlying assets of JP Morgan itself are fully-priced in, which makes it a less attractive investment. This would be a reasonable level to unload the stock, or at least reduce your position.

In conclusion, buy JPM under $37, and patiently wait for $50/share.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JPM over the next 72 hours.