JPMorgan vs. Moody's Showdown

A few weeks ago, Industry Focus: Financials host Gaby Lapera shared one of her New Year's resolutions: to buy five new stocks, one from each sector of Industry Focus. This week, she's consulting the guests of every show to get two of their favorite picks from the sectors they've spent so much time researching.

In today's Financials episode, Fool contributors Jordan Wathen and John Maxfield pit big bank JPMorgan Chase (JPM 0.43%) against ratings company Moody's (MCO 0.85%). Find out what's so appealing about each company for the long term, how the Trump administration's likely deregulation of the banking industry will affect both companies, and much more.

A full transcript follows the video.

This podcast was recorded on Feb. 6, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, recorded today, on Monday, Feb. 6, 2017. My name is Gaby Lapera, and joining me on Skype is John Maxfield, our banking expert, and Jordan Wathen, our financials specialist, is joining us on the phone. Hey, guys!

Jordan Wathen: Hey, Gaby!

John Maxfield: Hey, how's it going, Gaby?!

Lapera: [laughs] Good! Listeners, just so you know, none of us can see each other, so we might accidentally talk over each other a little bit. But I still think it's going to be great, because this is the start of a very special theme week on Industry Focus. You may remember that one of my New Year's resolutions was to buy five stocks, one in each sector from Industry Focus. We decided to do it on air so you all can follow along with my trials and tribulations, and maybe learn a little bit about how to buy a stock. This is how it's going to work: I'm going to go on all the Industry Focus shows this week. Two people, in this case, John and Jordan, will present their favorite stocks, stocks that they would think about buying, or maybe already own. I'll ask a few questions, and then next week, on the Financials show, I'll talk about which stocks I have decided to buy. I know there are some listeners who hate the Financials show. I'm really sorry if you're one of them. You're probably not listening to this one, but I'm going to be on all the shows this week. [laughs] 

Anyway, that being said, it is time for disclaimers. I had to clear all of this with our legal team, and they would like me to make a couple of things very clear before we start, both for transparency on our parts and to make sure that everything stays up to code. So, listeners who have emailed me, this one will be familiar: What you hear on the show today is not personal advice for me or for you. We cannot give personal advice, because otherwise we would be in big trouble with a couple of regulators, and they're scary. You will also notice that no one is going to say anything like, "You'll like this stock because I know that you, Gaby, get really bad motion sickness, and this company makes the best anti-emetic on the market!" [laughs] That's a little joke about my nausea. The stocks we're going to talk about are just the ones that the analysts like. Maybe they're right for you, maybe they're not. You shouldn't buy or sell based solely on what you hear on this show.

Second, we have trading restrictions at The Motley Fool. I'm going to read them word for word so I don't mess them up. Here we go. The Motley Fool has a disclosure policy. You must publicly disclose if a contributor has an interest in any of the stocks mentioned. Additionally, Fool employees work under trading restrictions. The restrictions require that employees must hold any stock that they own for at least 10 days. We cannot write about a stock in the period of two market days before to two market days after purchasing or selling a stock. Which means that I cannot buy any of these stocks for at least two days until after this show, and I haven't bought any of the stock prior to the show, which you all know because I don't own any. Also, we are required to notify our compliance department any time we buy or sell a stock. 

OK! [laughs] We have that all out of the way! I was starting to feel like one of those voices on those drug ads that are like, "Listed side effects include ... " So, here we go, we're ready to go. Here's the deal. Each of you will get a max of five minutes to talk about your stocks. You don't have to do the whole five minutes if you don't want to -- that's a long time to talk. After that, we'll do a question and answer section. You are allowed to ask each other questions. Just say who you are before you ask question, or say the other person's name, because I've noticed that people have a really hard time telling people's voices apart. At the very end, I want each of you to wrap up with one thing a beginning investor should keep in mind when researching and purchasing a stock. OK! We have all the front matter out of the way. I have a coin here. We'll flip to see who goes first. Jordan, do you want to call it?

Wathen: I'll call tails.

Lapera: OK. It is heads, so John, you get to go first.

Maxfield: All right, Gaby. Let me take you through my whole thought process here from soup to nuts. As an investor, one of the things that you always want to keep in mind is that the greatest tool at your disposal, in terms of maximizing your returns, is compounding returns. In order for compounding returns to work, you have to give an investment time. But there are different types of investments that compound returns better than others. And banks, it just so happens, are probably the best of all the types of investments when it comes to compounding returns. Now, why is that? The reason is because it gives you a really clean shot at compounding. Because, when a bank makes money, let's say a bank has $100 million in capital, and let's say it makes $20 million a year on that capital. Well, a portion of that capital is just going to be reinvested right back into the bank. And when it's reinvested right back into the bank, it's reinvested into loans, which then generate interest. So, as you put that money back in, you're not investing it back into manufacturing operations or anything like that. You're reinvesting it into another investment that is an investment in money. So, it's a really clean shot at maximizing your compounding returns. 

When you think about it, when you look at, say, Warren Buffett's portfolio, and Warren Buffett, he's the best investor...maybe ever? I don't know if there's anybody that I have ever come across that's beating his returns over such a long period of time. And when you look at the portfolio that he has accumulated for Berkshire Hathaway, about a third of that consists of bank stocks, and that's the reason. He talks about compounding returns and how powerful that is for investors. So, that's why, I think, being in the banking sector is a great place for investors to be. 

But here's the thing: Banks are incredibly fragile institutions. The reason they are so fragile is two things. First, they use an enormous amount of leverage. As a general rule, for every $1 worth of capital, a bank will borrow about $10 worth of debt. But the second part of that is that that isn't just ordinary debt. It's not like a term loan like a mortgage. If you could have 30-year mortgage, the bank can't call you tomorrow and be like, "Look, Gaby, you have to repay that money right now." You just have to repay that money over time, and you're done with it at the end of that 30 year period. Well, banks borrow, to a large extent, what is called callable debt. Callable debt means that the people that are lending that money to the bank can call that money and require the bank to pay it at a moment's notice. And why is so much bank debt callable? Because so much bank debt consists of deposits. So, let's say you have a checking account. All the money in a checking account is no more than a loan to a bank. But because you can pull that money out of the checking account at any particular time, that makes it callable. 

So, why is that a problem? That is a problem because when banks get into trouble, and their depositors hear about the fact that they are in trouble, they can then go and pull all of their money out of their accounts en masse, and that is what you call a bank run. And when you have a bank run, that obligates a bank to quickly sell its assets. And when you have to quickly sell your assets, you have to generally take large haircuts on them, so, you have to sell them for less than they're worth. And when you sell assets for less than they're worth, you're taking a loss. To circle back around, because banks are so leveraged, having $10 worth of assets for every $1 of capital, it doesn't take an enormous amount of haircut on those asset sales to wipe out all of your capital and render you insolvent.

And this issue about the fragility of banks is particularly important right now. If you look at what's going on in the market, there is an enormous amount of volatility going on, because nobody knows what's going on on the policy front, and there's always the possibility that there will be some other sort of crisis in the future. So what you have to do is, you have to pick banks very carefully. And right now, what you want to do is, you want to be thinking in the context of both offense and defense. You don't want to just pick the safest bank, because the safest bank isn't going to provide the best return. And you don't just want to pick the most profitable bank, because the most profitable bank might not be very safe. So, you want both offense and defense. And when I'm thinking about banks that are really good to play offense and defense with, I'm thinking about banks like U.S. Bancorp, Wells Fargo, and JPMorgan Chase. Let's throw Wells Fargo out, because Wells Fargo has had all those problems. They're switching up their operations. That's going to reduce the profitability going forward. We'll throw that one out. U.S. Bancorp is an incredibly important bank. It's a great bank stock, it's very profitable, one of the most profitable big bank stocks in the market. But the problem with U.S. Bancorp is that because it's such a good thing, its shares trade at a very high valuation. 

So, that leaves us with JPMorgan Chase, which trades at a reasonable valuation, is very respectably profitable, and will continue to be more and more profitable as time goes on and interest rates go up. But at the same time, it's incredibly well managed. Jamie Dimon, its CEO, is one of this generation's, if not the generation's greatest bankers. And there are a number of different reasons, we can talk about that. But, he is very well attuned to risk in the banking industry. With a stock like JPMorgan Chase, not only does it give you that upside, but it also gives you protection from the downside. 

To wrap this all up into a nice package, if you want to invest, you want to look for opportunities to maximize compounding returns. Banks are a great way to do that, but you want to pick them carefully. You want to pick ones, right now, where you can play both offense and defense. I think JPMorgan Chase is one.

Lapera: OK. Thank you very much, John! We turn to you, Jordan.

Wathen: That was an awesome pitch, John. The stock I wanted to pitch is Moody's. What makes Moody's interesting to me is that I truly believe it has one of the most impressive moats around the business, and it would be very hard to knock off what they have done. Buffett actually once said that even though he owned the stock at the time, he said, "I don't even know where they're located, I just know that the business model is extraordinary." What Moody's does is, there are actually two businesses inside of it. There's the ratings business, which basically provides corporate debt ratings. Then, there's Moody's Analytics, which is a software platform. The ratings business is its bread and butter. It generates about 80% of operating income. And I think it's what makes the business model so great.

When you look at the ratings industry, there's really only three major players. There's S&P, Standard & Poor's, there's Moody's, and there's Fitch. And of those, S&P and Moody's control about 80% of this market. The reason why they control so much of it is because back in the day, 40 years ago in 1975, the SEC created a designation called the Nationally Recognized Statistical Ratings Organization. And what this did was it said, "These are the ratings agencies that we trust." And it really only gave this designation to about six companies. And over time, they merged together to form the big three that we have today. In 2007, the SEC actually opened this market back up and they said, "We'll take new applications." And a bunch of companies applied. And now, today, there are about 10 companies that provide ratings which are basically accepted by the regulatory regime. 

One of the reasons it's so hard to break into this business is that even though there are 10 companies now, you still have three that control the main part of it. The reason why it's so hard to break in is mostly because of habit. Let's say you're, for instance, Wal-Mart. And you've always issued debt that was rated by S&P. If you go out and issue a new security and get it rated by Moody's, people are going to wonder why you're shopping around for a better rating. Why did you change the company that's rating your debt securities. On the investors' side, people understand what a rating means. When I open up an insurance company's books, I can look at it and see, "They've invested in AA paper, or B paper," and I know what kind of risks come with that. So, even though you can criticize the ratings agencies for how they performed during the housing crisis, we know that, over time, a AA performs better than an A, which performs better than a BB. So, if I open the books on an insurance company and I see that it is heavily invested in securities that the big three have rated investment-grade, then I know that, on average, the risks are quite low. If, however, I open up the books and I see that the insurance company invested in bonds that were rated by Uncle Bob's Rating Agency, I'm probably not too excited about what I have found, right? It's not really worth it for a company to invest in securities, or issue securities, that have a lower quality stamp on them.

Then, finally, I think one of the big issues, especially today, is that the bond indices really rely on these ratings. S&P, Moody's, Fitch, they are basically the basis for which index a bond issue falls into. And it really doesn't matter who it is. If it's a Bloomberg index or a Barclays index, if it's a junk index or an investment-grade index, basically, they all say, "This is the reason why the bond will go in." If it's an investment-grade or junk rating or whatever from S&P, Moody's, or Fitch, there's really just three players. 

So, let's get to how Moody's makes money, and how, generally, the ratings business works. If you want to issue debt, you have to pay the credit rating agencies to issue it. I used Wal-Mart as an example earlier, and I'll just continue with that. Let's say Wal-Mart wants to issue a bond to finance something, inventory or whatever. Obviously, the ratings agencies collect a fee from Wal-Mart to do it. The reason why you pay for a ratings agency to rate your debt as a company is, the amount that you pay for the rating will save you much more when you get the rating. In general, an investment-grade rated company might pay five or six basis points in a fee to get the rating on a bond. But, it will save them, over time, about 30 basis points in interest every single year for as long as that bond exists. In effect, what the ratings agencies are is just a toll road to bond issuance. If you want to issue a bond, you have to pay, basically, the tolls that sit on the road to collect a fee. That's why I think Moody's is probably one of the greatest businesses out there. And at 20 times earnings, roughly, I think it's starting to become, potentially, a very good investment for the long haul.

Lapera: OK. Thank you very much, Jordan and John! I have a couple of questions for both of you, but I'm going to start with John. JPMorgan Chase is a bank. What kind of bank is it? Because, there are a lot of different types of banks, right?

Maxfield: That's a great question. JPMorgan Chase is what's called a universal bank. And what a universal bank is, it's a combination of a commercial banking operation, which is just your standard bank, they make loans, they take deposits. Then, on the other side of their operation is an investment bank. Investment banks operate Wall Street operations. They take companies public, they have trading operations where they're buying and selling securities to institutional clients. They're advising companies on mergers and acquisitions and things like that. The reason it's such a good question, actually, Gaby, is that universal banks have a different set of risks that they expose investors to, and those risks primarily come through trading operations. Because, we learned with JPMorgan Chase in particular in 2014, they had something like a $6 billion trading loss. These things can materialize very quickly. But the Dodd-Frank Act put in this thing called the Volcker rule, and what the Volcker rule does is it limits how much proprietary trading a large bank can do. It limits it to what's called market-making.

So, as opposed to just going out and making proprietary bets with your own capital, what it limits you to is just, basically, facilitating the purchase and sale of fixed-income securities and other types of securities for institutional investors. That really reduces that trading risk. But, the benefit of a universal bank like JPMorgan Chase is that, because it has both commercial banking operations and investment banking operations, and because those operations operate on slightly different cycles, it kind of gives you a natural hedge for when the market is going up and down. Because some investment banking operations will do really well when the business cycle goes down, whereas commercial banking operations might not do as well in that time period. So, it flattens out your return over a long period of time.

Lapera: OK. I do have another question for you. You mentioned some of the risks that are involved with investing in a bank like JPMorgan Chase. One of my big things with banks is being able to look at their 10-Qs or 10-Ks, and being able to understand what's going on. JPMorgan Chase is generally not a bank where that's easy. What are some of the things that you look for that are signaling to you that they're doing well and will do well in the future? 

Maxfield: There are three main things I think we should look at. Let me give you a shortcut, though, before getting into those. Actually, let me just give you a shortcut on picking bank stocks, as opposed to getting into the details. JPMorgan Chase, if you look at their 10-K, it's something like 250 pages. And it is really complicated. And I think that's what you're getting at, right?

Lapera: Yeah.

Maxfield: I have lived in the banking world, now, for almost six years. That's all I do and it's all I think about. And even for somebody like me, this is a very complicated thing. So one of the shortcuts that you can take is just go and look at the portfolio of bank stocks that Warren Buffett has accumulated. He has basically done the research on these. Now, if you go and look at that portfolio, you're not going to see JPMorgan Chase, and you're going to be like, "That doesn't make any sense, John." But, there are some other back stories behind it. First of all, while Berkshire does not own JPMorgan Chase, Warren Buffett himself does. And Warren Buffett holds Jamie Dimon, the CEO of JPMorgan Chase, in incredibly high regard. On top of that, even though Berkshire Hathaway's second-largest holding in that portfolio, and one of its most profitable over the last couple decades, is Wells Fargo, he doesn't have representation on that board. But, one of Dimon's chief lieutenants just joined the board of JPMorgan Chase. And you can rest assured that that was done with Warren Buffett's approval. And he would not allow that to happen if he did not believe that, No. 1, Jamie Dimon was an incredible CEO, and No. 2, that JPMorgan Chase was an incredible bank.

Lapera: Fair enough. That's really funny, about Warren Buffett and JPMorgan. Jordan, Moody's. Not a company that I actually thought you were going to pick, so I was interested to hear that you had gone for Moody's. What are some of the growth prospects for Moody's? What can we expect to see from them in the future?

Wathen: That's an interesting question, especially now. I think that's one of the reasons why the valuation is almost in line with the average company -- a lot of people are afraid that rising interest rates will lead to an environment where companies just aren't issuing as much debt, that it's not as attractive to issue, and maybe some of the junk-rated companies of today won't be so willing -- not just the pay higher rates in the future, but, there won't be such an appetite for yield. And actually, one of the reasons I like it is because I'm glad that people are afraid of that. I think, over time, what you will see is that banks play less of a role in financing companies, and what happens is that more money comes from the capital market, so more money comes from the bond market, and bond fund managers, and things of that sort, which would be very good for Moody's over time. So, I actually think one of the biggest growth prospects is the banks sticking to more of their plain vanilla bread and butter loans, and then the markets picking up everything else.

Lapera: Interesting. A question for both of you -- we've seen, so far, in the last two weeks or so, that deregulation has been the name of the game for the Trump administration. John and I will eventually do a show on that. [laughs] Get excited, John is just hearing about this now, but I'm sure he anticipated it. So, how do you think that is going to play for both of these companies? John, do you want to go first?

Maxfield: As a general rule, deregulation will be good for JPMorgan Chase and most other banks. The extent to which it will be good will depend on the extent to which they deregulate. We just do not know, at this point, whether the regulations they have in mind and are going to be able to get through Congress are just going to be minor variations on a theme, or a wholesale repudiation of Dodd-Frank. If you look at what bank stocks have done since the presidential election in November, one would be excused for concluding that the market believes it will be a wholesale repudiation as opposed to a minor variation on a theme. So, the risk there is that it will, in fact, be a minor variation on a theme, and the multiples will have to adjust. But even if that is the case, JPMorgan Chase is still trading for a reasonable valuation. JPMorgan Chase is still an incredibly good bank to own. And if you own it over 30 years, I'm telling you, you'll look back in 30 years from now and you will thank yourself for making that decision.

Lapera: I have a quick follow-up for John. It has been the case in the past that when deregulation occurs, banks end up doing something slightly riskier because you tend to be coming off of a period of economic stability. Does JPMorgan Chase have that record of being a smart, conservative underwriter to back up any potential headiness from deregulation? Giddiness, I suppose?

Maxfield: If you look back 100 years in the banking industry, and you look at what happened in the Great Depression, which is when a large swath of our nation's banks failed. They put in new regulations. However, even had they not put in new regulations, there was a multi-decade period after the Great Depression that they call in the banking industry the Great Moderation. And what happened during the Great Moderation was, all of these CEOs of these banks who lived through the Great Depression were just terrified of the possibility of taking on too much risk. So, what they did in that scenario was they elevated the risk managers above their revenue generators. And it is my belief that even if there is deregulation, if they tailor back on the Dodd-Frank act, the risk managers in these banks still have an enormous amount of power relative to the revenue generators. So, I do not believe that over the next generation -- and nobody can predict the future. But it is my reading on the history of banking that we have a good generation, 10, 20, 30 years even, where the CEOs of these banks will remember the financial crisis and act accordingly.

When you think about JPMorgan Chase in particular, and I'll be really quick on this, if you look at all the banks in the United States that survived the financial crisis, there is no bank that foresaw the financial crisis as early as JPMorgan Chase did. And the reason they foresaw it so early is because Jamie Dimon -- and I know I've said his name a gazillion times -- is such a good risk manager, and has his finger on the pulse of how the credits cycle works. And I believe that even when he retires, whoever his successor is will be trained by him and will adopt those same characteristics.

Lapera: OK. Jordan, your turn. Deregulation, Moody's, what do you think?

Wathen: I can actually be pretty quick with this one. With Moody's, one of its most profitable segments is structured products, which are all the fancy three-letter words that blew up and probably concern a lot of people today. That's where it makes some of its biggest margins. So, to the extent that rules relax in that area, that'd be a huge win for Moody's, especially, over time. I think, actually, deregulation would work in its favor. To basically the same degree, I'm saying, with John, I think deregulation in general is probably good for financial companies as a whole.

Lapera: Cool. Do you guys have any questions for each other?

Maxfield: Jordan, why are you so awesome?

Lapera: [laughs] Oh my gosh! So, when we were planning this show, it was like listening to Canadian parliamentarians talk to each other. They were like, "Well, the fine gentleman from Alberta has a great point," and the other one was like, "Well, thank you very much, kind sir from Victoria!" The whole thing, I was like, "You're not going to give the listeners the bloodlust they want!" That's fine, I would rather you guys get along with each other. Jordan, any questions for John?

Wathen: No. I just have to say, John makes this whole thing look easy. So I appreciate that question from him. [laughs] 

Maxfield: Let me bring up one point to close this out. You had said you wanted us to talk about our advice to beginning investors, one piece of advice. And let me give my really quick, short piece of advice. The way you win in investing is you leverage time. If you're trying to trade in and out of the market because you think you have some advantage doing that, you're going to find out that you are sorely mistaken, because hedge funds have so much data and so much information that they are going to win on trading. But hedge funds have to generate returns on a yearly basis, whereas you, as the individual investor, do not have to do that. You can take advantage of compounding returns over 10, 20, 30 years, and that is where the real money is at. So, focus on picking good companies that are going to last a long time, and you're going to do really well over a long period as an investor.

Lapera: Awesome. And what about you, Jordan, one piece of advice for beginning investors?

Wathen: I'm actually going to follow up on that. I think that's probably the best advice ever -- the key to investing is that it takes time. If you go back to 2010, and you were someone who thought that you should buy bank stocks because interest rates were going to go up, like everyone else did, you were wrong for six years, six years running. Then 2016, rates go up, and suddenly that thesis plays out, and actually bank stocks outperform pretty much every other sector over that period. So, for five years, you look stupid, to look like a genius in the sixth year. So, one of those things, I just completely agree with John, the most important thing you can do as an individual investor is to just be able to buy a stock and ignore it, just hang on to it. I think everyone does better by holding a little bit longer.

Lapera: Thank you, both of you. That was a very enlightening and substantial discussion. You guys will hear my decision next week. Austin, JPMorgan Chase or Moody's?

Austin Morgan: I'm not totally sure. They both sound pretty solid. Good luck on deciding.

Lapera: [laughs] Thank you very much. It sounds like you guys did a very good job of convincing us of both. Contact us at [email protected], or by tweeting us @MFIndustryFocus. The internship is closed, everyone who applied, (claps) I applaud you. I'm very excited about meeting one of you. Thank you, Austin, for producing today's show, and thank you to you all for joining us. Everyone, have a great week, and I'll see you tomorrow!