Banking and finance (XLF) comprises some strange business. In some ways they are the opposite of biotech (IBB), on which I comment from time to time. In biotech, a powerhouse such as Amgen (AMGN) works for 10-20 years to develop a product, which may never be commercialized. If it does reach the market, it may be a huge success such as denosumab (Prolia/XGEVA), a dud such as Repatha (so far), or a product with an unanticipated black box warning such as Evenity. In the prototype of finance, banking, a company can begin doing business promptly. It can gather up insured deposits and begin making loans. Almost no waiting! But then it may have to wait years to find out if the loans were really good ones. That's one reason to be careful investing in the banking sector.
we run hundreds of stress tests internally each month, some of which are far more severe than the Federal Reserve's (the Fed) annual stress test... we should have strong earnings after making investments for the future - which may reduce earnings in the short run.
we are rigorous about proper accounting and disclosure, [but] sometimes accounting can distort the actual economics of a business
conservative accounting is better
earnings guidance can be very damaging... The real damage to an organization comes from the cumulative corrosiveness of trying to "make" its numbers.
I interpret all this to mean that without exactly saying so, Mr. Dimon is implying that dollar for dollar of stated EPS, JPM's earnings are of well above-average quality, and therefore that it should have a premium P/E. But it does not. Now that JPM has come out with its Q1 financial results, we can begin to assess whether my bullish JPM article from last July, when it was in the $104-105 range, is looking sensible. Other related materials from Q1 include the press release and a detailed supplement. I have also listened to the conference call, but a transcript is not yet available.
Q1 - upside surprises
JPM has many moving parts. No one metric is determinative. On the basic numbers, we have positives:
- EPS $2.65 (consensus $2.35)
- managed revenues (a non-GAAP number) $29.9 B (consensus $28.4 B).
Beating on revenues this much is huge, especially given softness in Markets & Investor Services (see slide 5 of the financial results). The upside to consensus comes primarily from Consumer and Community Banking, with net income of $4.0 B, up 19% yoy, with revenue up 9% yoy and expanding margins.
On the conference call, CFO Marianne Lake reported that consumer satisfaction with Chase bank is high and continuing to improve. Active mobile accounts rose 11% yoy to 34.4 million - a statistic I find impressive.
This growth was achieved with improved (lower) overhead ratios, down 2 points to 56% using GAAP and down 1 point to 55% on a managed (non-GAAP) basis.
Ms. Lake was not especially perturbed by the flat yield curve up to 5 years. She pointed out there are some benefits to lower long-term rates, that today's flat yield curve may not predict tomorrow's yield curve, and made other points.
There is much more in Jamie Dimon's shareholder letter and in the various releases from Friday, as well as the Q1 10-K. Please familiarize yourself with them if thinking of investing in JPM.
My focus is on the quality of earnings, and likely dividend increases.
JPM as a free cash flow champion
I would like to reiterate and update comments I made in my July 3, 2018, article on JPM, which included the following points:
... JPM deserves a higher relative multiple and probably a higher absolute multiple, as well.
One of the disparities I have observed in the market this year is that superior companies within an industry have frequently traded at the same P/E as laggards... JPM strikes me as fitting into this paradigm. I think it is too cheap to other universal banks and too cheap to the S&P 500 (SPY).
With greater than an 8% capital return yield and about a 9% forward earnings yield on 12-month forward projected EPS close to $9.50 through 6/30/19, JPM may appeal to both dividend and GARP (growth at a reasonable price) investors.
All those points remain valid in my view today, and leaves me largely positioned in large-cap, high-quality names. Your guess is as good as mine as to JPM's forward earnings through March 2020. I will guess $10.20. With JPM at $111.50 mid-day Friday as I write this, it once again remains around 11X my guess for a forward P/E, or the same 9% earnings yield.
I would expect a substantial dividend increase for Q3, following the Fed's review of JPM, as well as a large buyback. With junk bond yields dropping, another potential 8% cash-on-cash capital return program, likely again tilted toward buybacks, strikes me as attractive. Again, what's important is not the capital return per se, it is that the bank is investing heavily today for future growth, and is still able to do that while generating copious distributable profits.
Liking other banks
Empirically, yield curve flattening due to Fed tightening that does not lead to a recession can be very good for banks. Many or most banks surged after the 1994 Fed tightening gave way to robust growth. The key I look for is whether loans are going bad. Throughout the banking system today, I do not see that. At least one questioner on the JPM conference call tried to see if JPM would admit that some bump-up in non-performing loans meant anything. I remember Ms. Lake saying there was no "there" there, that NPLs were at low levels, and that JPM was continuously upgrading and lowering credit quality throughout its vast portfolio, and that credit quality remained, on balance, strong.
I am hopeful this is true throughout the US banking system. On a valuation and contrarian technical basis, I recently took profits on some bonds and went long some super-regional banks, such as U.S. Bancorp (USB) and the merging pair of BB&T (BBT) and SunTrust (STI). I also added to East West Bancorp, Inc. (EWBC), which tends to trade with the state of the US-China trade dispute rather than macro US business and financial conditions.
As always, risks on lending institutions, and companies such as JPM that are tied to the merger and acquisition business, are significant in many ways. The weather can look clear, and darken suddenly. Friday's optimism may not be so well-founded, and risks can come from other parts of the world. If you are new to investing, please understand the basics of how banks earn their money and what core risks they take. These top-down risks typically include borrowing short term from depositors and lending longer term, with loans outstanding far outstripping equity.
JPM's revenues were up 5% yoy in Q1. The latest GDP data showed a 5.2% yoy growth in Q4. With Q1 expected to have slowed, it appears to me that JPM has met my threshold of matching, or perhaps slightly exceeding, GDP growth in the first quarter of this year. With its efficiency ratio improving, and with diluted shares outstanding down 5% yoy, EPS has grown nicely. JPM has been volatile, but as of Friday, it has provided about an 8% total return in the 9 months since I first went long the stock last July. This is about 6 points better than XLF and much better than a major regional bank ETF (KRE). My conclusion is simple: JPM is performing very well operationally, and has momentum in its core business of consumer and commercial banking. Lots of domestic and some international growth opportunities exist, and in banking (and business in general), strength begets strength. Thus I remain long JPM.
I see no reason why its record EPS will not be followed by record share prices.
Several regional banks may have been unduly depressed by the yield curve flattening as well as the apparent growth slowdown. Sometimes the laggards, such as the names mentioned above, rebound fast and outperform a sector leader such as JPM.
Risks in financial stocks are significant, however.
Thanks for reading and sharing any comments you wish to contribute.
Submitted Friday early afternoon.
Disclosure: I am/we are long JPM,BBT,STI,USB,EWBC,SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.