Why Morningstar Doesn't Understand JPMorgan

It is hard to imagine something more difficult than trying to determine the intrinsic value of a bank right now.  The combination of complexity and a tendency towards subterfuge make understanding the risks involved near impossible.

Morningstar, a company that provides independent advice to the average Joe on equities and mutual funds, appears to have taken a liking to JPMorgan (JPM). Warren Buffett clearly thinks highly of their CEO.

It appears that Morningstar blindly regurgitates JPMorgan’s unchallenged assumption that they have a “fortress” balance sheet. The investment advice company argues that this strength makes JPM a good investment. The logic is simple enough – if a company has a fortress balance sheet then they are likely able to grow intrinsic value in tough economic environments such as this one.

Morningstar places a “fair value” estimate on JPM of around $60 per share.  In fairness to Morningstar they could be right — JPMorgan could be worth north of $60. However, sometimes in life we luck out. We have a positive outcome but for all the wrong reasons.

For example, consider someone who buys shares in a hot stock on a friends tip. The shares in the company  proceed to double the following week. After cashing out, the buyer experienced a positive outcome, but for the wrong reasons. If Morningstar is right about JPMorgan, I think it would be a case of bad process - good outcome.

I question whether JPM has a fortress balance sheet. More than that, I question how anyone can make a sound argument that they understand the risks involved with JPM’s loan and derivative exposures.

In the section of Morningstar’s report entitled ‘risk’ they offer:

[JPM] could suffer additional mark-to-market losses on securities held at its investment bank including $16 billion in legacy leveraged loans and related commitments, $12 billion in commercial mortgage-backed securities, $20 billion in prime and Alt-A mortgage-related securities, and $1.9 billion of subprime mortgage exposures.

It’s odd that Morningstar uses the words mark-to-market and fails to mention any permanent losses that might be incurred. A couple of billion here and a couple of billion there and sooner or later you might be talking some real money.

However, what concerns us about JPMorgan has nothing to do with their loans but rather one of their opaque profit centers know as derivatives.

Morningstar admits, "[that] it is difficult to quantify the risk surrounding J.P. Morgan’s $77 trillion notional derivatives exposure.” Further elaborating on the subject they go on to say “it is nearly impossible to get a grasp on the real underlying risk this exposure creates.”

If Morningstar doesn’t understand the risk involved with an investment, how on earth can they determine a fair value?

Last week we penned an article on financial risk. In the article we detailed a fundamental concept: sometimes what matters most is not the probability of loss, but what matters more is the consequences of that loss.

As an independent financial advice shop, I expect it would be easy for them to say “we’re dropping coverage because we no longer understand the risks associated with an investment in JPMorgan”. Perhaps  Morningstar has lost their independence. If you can’t measure risk, how can you value it?

Disclosure: We have a Morningstar membership (but likely won’t renew when it comes due as we feel the quality and logic of their analysis is starting to suffer).

Comments

[Ishortyou:]

Not to mention that a big bulk of fraudulent loans wraps were done by Bear Sterns, so a lot of people are going to be knocking on JPM doors for refunds.

2008 Aug 24 08:06 AM

[Bobster:]

This article discusses a report whose content is not immediately available to the reader and in a sense exemplifies the very thing they are accusing Morningstar of - in regards to JPM coverage. What I take greater issue with is the sanctimonious tone and the very last comment "Disclosure"...where they say they are "dropping their Morninstar membership". Something is amiss here and with that type of grandstanding I think it not only has to do with Morninstar but some additional agenda perhaps that is not being clearly spelled out to the reader.

2008 Aug 24 10:20 AM

[tjschoenlein:]

Where is it written that Morningstar is going to get it right 100% on the 2000+ stocks they cover? Those folks pour over the balance sheets and give their best shot at what they think the stock is worth. For me, I accept that and do some serious homework before buying any stock out there.
Generally speaking, I am very satisfied with the quality of their work.

2008 Aug 24 11:32 PM

[J. B. Wulff:]

The current difficulty in the financial world stems from the initial failure of the ratings gurus to correctly rate the risk of "new" investment vehicles. This situation has only been touched on briefly so far. Until confidence in the financial system is restored in the collective mind of the investing public - now a world wide entity - we will not begin to see the proverbial light at the end of the tunnel. JPM is doing its best to stand as an anchor for the financial system as its namesake founder did a century ago. This is one of those "If not here, where? If not now, when?" moments. (In the interest of accuracy, I have owned JPM for many years. I recently increased my investment. I am 66 years old, retired, and far from independently wealthy.)

2008 Aug 25 12:01 AM

[nyka:]

Based on the tone of this "I'm dumping Morningstar" piece, I stand with Bobster that this guy has other issues with big M totally unrelated to JPM.

2008 Aug 25 02:09 PM