There are two things a bank can do to supplement its organic growth efforts and efficiency improvements: engage in M&A activity and repurchase shares. The largest US banks have done lots of both. JPMorgan Chase (JPM), the largest US bank in terms of assets, has completed nine unassisted bank deals comprising over $100 billion in aggregate value since the beginning of 1989, and spent nearly $34 billion on share repurchases since the beginning of 2000. Wells Fargo (WFC), the largest US bank in terms of market cap ($182 billion, versus JPM's $160 billion), has completed 108 deals comprising nearly $76 billion in aggregate value and spent nearly $30 billion on share repurchases over the same time periods.
How good are these types of investments for shareholders?
Both with respect to M&A and buybacks, there is a simple definition of "good". If a bank can make an acquisition or repurchase shares at a price below intrinsic value, that's good for shareholders. How good is good? If a bank with a market cap of $1,000 can buy something worth $100 for a price of $90, it should, even though the gain of $10 will be modest in percentage terms (1%). The gain has to be big relative to market cap to be exciting, and that means the thing purchased has to be big and/or the gap between its price and intrinsic value needs to be large.
JPM shares closed at $42.09 yesterday. If you think fair value for JPM shares is $50 today, then if JPM executed a $10 billion share repurchase immediately, such repurchase would capture $1.88 billion of value. Divide this $1.88 billion by JPM's 3.8 billion shares outstanding and you get a per share gain of $0.49, or 1.2%. Big gap between price and value, big expenditure, modest per share gain. The same kind of arithmetic applies to M&A; large bank deals generally tout 2-3% EPS accretion for the buyer.
Some bank management teams will make a different argument about M&A and share buybacks. They will argue that both can improve a bank's growth trajectory, winning it a higher valuation multiple. If this is true, my above value calculations are too conservative. Is it true? First we need to define what level of baseline growth is possible.
A hypothetical bank with a 1.00% return on assets ("RoA") and 7.00% equity/assets ("E/A") delivers a return on equity of 14.3%. If the bank abstained from distributing earnings, equity would grow by 14.3% per year, and assets would too, assuming constant leverage and RoA. But no bank can grow at 14.3% over the long run without materially lowering its margins and/or taking on excessive risk. That's why banks pay dividends. While bank dividend payout ratios are currently depressed, in healthier economic times banks paid out about 37% of their earnings as dividends on average. If this hypothetical bank pays out 37% of its earnings as dividends, then the 14.3% growth figure would fall to 9.0%.
Few banks deliver even 9% growth over the long run. But on top of the 37% of earnings banks paid out as dividends, they paid out another 31% on average to repurchase shares. If the hypothetical bank pays out an additional 31% in the form of dividends, growth falls even further, to 4.6%. But if the bank instead uses those proceeds to repurchase shares, assets per share ("A-PS") would grow faster than 4.6%. How much faster? That depends on the buyback prices. If the bank repurchases shares at 1.0x book value per share ("BV-PS"), APS growth gets back to 9.0%. At 2.0x BV-PS, A-PS growth still rises, but only to 6.8%. 6.8% is much better than 4.6%, but still less than exciting.
So buybacks are great for growth only if they're executed at low valuation multiples, which the buybacks themselves are meant to cure? I estimate that shareholders of this hypothetical bank would be indifferent between share repurchases and higher dividends if the perpetual buybacks can be executed at 1.7x BV-PS. At a 1.5x BV-PS buyback multiple, shareholders are 10% better off in present value terms. And I'm using a 10% discount rate. Increase the discount rate to 12% and buybacks would have to occur below 1.3x BV-PS to create shareholder value.
Perpetual buybacks can't do wonders both for shareholder value and for growth.
Can M&A change a bank's growth trajectory? If a bank thinks it can grow by 6% organically over the long run, can M&A boost this growth rate even to 6.5%? To do so, M&A would have to increase Year 20 EPS by 10%. That's a tall order, requiring several large, properly-priced and executed deals. A lack of available targets is enough to derail such a plan.
There's an alternative way to answer these questions. Rather than poring through all the various inputs, look at the output. Since the end of 1989 JPM's and WFC's A-PS have grown by 3.3% and 10.0% respectively on an annually compounded basis. JPM's number is horrendous, but this is largely due to poor growth prior to JPM's $58 billion acquisition of Bank One Corporation in 2004 (2% compounded from 1989 to mid-2004, versus WFC's 10.4%). As if by magic, this deal jumpstarted JPM's growth. Since the deal closed, JPM's A-PS has grown at a respectable compounded rate of 8.6%, only slightly behind WFC's 9.6%.
So after a fifteen-year period of lackluster A-PS growth, JPM finally started hitting its stride. But did JPM achieve what it hoped it might? A June 2004 New York Times article contains an interesting quote from then soon-to-be JPM COO Jamie Dimon, offered at a meeting of senior JP Morgan and Bank One bankers just before the Bank One deal closed:
"If we do our jobs and get the $2.2 billion in cost saves, in five years if the stock is not $100, I will eat my hat."
Bon appetit. The five-year point was June 2009, now more than three years in the past, and the highest closing price JPM posted since Dimon made this statement was $53.20, which JPM hit in May 2007. JPM closed yesterday at $42.09. With that said, if JPM missed, it was, as golfers like to say, "a good miss". Many banks have achieved nowhere near the 8%+ A-PS growth that JPM and WFC have delivered since mid-2004. Some have delivered negative growth. And the biggest fans of financial engineering haven't done better than those who avoided it.
Bank stock investors need to keep all this in mind as the economy recovers and A-PS growth becomes more robust. It will be pleasing to assume that the growth spike is perpetual. It won't be, and valuing banks as if it is perpetual may prove to be costly. Furthermore, assuming that low A-PS growth banks (and I define "low" as anything below 6% long-term) have finally fixed their problems is probably dangerous.
There aren't enough Jamie Dimons to go around.