JPMorgan's Beef with the U.S. Government

Warren Buffett himself describes Jamie Dimon's letters to JPMorgan (JPM -1.25%) shareholders as a must-read for investors interested in the banking sector. Dimon didn't pull any punches in his most recent missive, calling the U.S. government to account and setting the record straight on the relationship between risk and size in the banking industry.

In addition, the Mailbag segment answers a question every investor asks eventually: When to sell? While The Motley Fool's default recommended holding period is theoretically "forever," that doesn't mean investors shouldn't reevaluate their holdings from time to time. Tune in for some overall guidelines on when and how to revisit your investment decisions, as well as a deeper dive on one specific example.

A full transcript follows the video.

Kristine Harjes: JPMorgan's got a beef with the government. This is Industry Focus.

[INTRO]

Hey everyone, welcome to Industry Focus financials. For The Motley Fool I'm Kristine Harjes, and I'm joined once again by our senior banking specialist, John Maxfield.

Hi John, it's great as always to have you on the show.

John Maxfield: Thank you very much, Kristine. It is a pleasure to be here.

Harjes: We've got a ton to cover today, but I have full faith that we can get to it all; kind of like I have full faith that I'll finish my taxes, even though I just started yesterday. Fortunately, that is not what we're going to be chatting about today!

Instead, we've got a letter to shareholders of JPMorgan to touch on, and we'll also be digging into the mailbag as well. Let's get to it!

Jamie Dimon, the big personality at the head of JPMorgan, released his letter to shareholders on Wednesday of last week.

We've talked on this show previously, about the Berkshire Hathaway (BRK.A -0.39%) (BRK.B -0.23%) annual letters and how they're must-reads, but I would also argue that curious investors should add Jamie Dimon's letters to their reading list as well.

There are tons of interesting topics that he talked about, from a potential Greek exit from the Eurozone to regulatory changes like an increased level of capital requirements ... let's just pick out a few of the most noteworthy takeaways.

John, you made a really good point to me earlier about the section of the letter that discusses the relationship between risk and size. Can you share that with our listeners?

Maxfield: Yes, absolutely.

Let me just add a quick thing about Jamie Dimon's notes. Jamie Dimon is one of the best bankers in this country. People can have qualms about JPMorgan and some of the things it's done, but there's no question that it is a preeminent financial institution, and that Jamie Dimon, the CEO and Chairman of the bank, is one of the best bankers in this country.

You don't have to take my and Kristine's word for it. Even Warren Buffett, who is a friend of Jamie Dimon's, has said that Jamie Dimon's annual letter to shareholders is a must-read. If you are even remotely interested in bank stocks, definitely take a look at this.

To get to the question, one of the things that Jamie Dimon touches on is this relationship between risk and size. This is interesting because, in the aftermath of the financial crisis, a lot of people think that larger banks are riskier than smaller banks, but the truth is actually just the opposite.

Jamie Dimon makes this point. He says in 1984 -- or the mid-1980s more generally -- there was an oil crisis as a result of some things that had happened in the '70s, and oil prices had tanked. That brought basically every bank in Texas that was focused on the energy industry down.

They all failed. The reason was that they were all too concentrated in one particular geographic segment, and in one particular industry.

This is something that I've seen in my own area. I grew up in an agricultural community in a valley. If you have a drought in a valley like that, all the agricultural banks, irrespective of how well they manage their expenses and their risk, are at threat of failing because of that.

That is a really good point that Jamie Dimon makes. He says, "Look, the bigger banks like JPMorgan, Bank of America (BAC -3.89%), Citigroup (C -2.49%), Wells Fargo (WFC -1.18%), we have businesses across the United States, across the world, in a variety of different industries. Whether there's a drought in a particular valley or an energy crisis in a particular region, those things may impact our results, but they will not take us down."

He's basically making the point that there is a relationship between size and risk, but it's not what most people think.

Harjes: Exactly. Earlier this week, you wrote a Fool.com article about JPMorgan's role in previous financial crises, and the aftermath that they're still dealing with today as a result of their actions during the most recent recession. Can you touch on this issue and the key takeaway?

Maxfield: Yes, absolutely. If you look back on JPMorgan's history, one of the things that we see is that, in almost every crisis since the Civil War, it has been a very important private sector partner of the United States government, in helping the financial system get through the crisis.

We've seen this during the panic of 1893. It led a syndicate of bankers that allowed the government to avoid devaluing the U.S. dollar. In 1907, it put together a syndicate of groups that saved a whole bunch of failing trust companies, one of the leading brokerage houses in New York. It helped New York City stave off insolvency, it rescued the New York Stock Exchange, and on and on and on and on and on.

What Jamie Dimon is saying is, "Look, when we did this in the most recent crisis at the behest of the U.S. government" -- it purchased Bear Stearns and Washington Mutual, and by doing so made sure that they didn't "fail" -- they were under the impression that when they purchased those two businesses that they would be indemnified for losses as a result of these businesses' previous actions.

But since then, JPMorgan has taken on something like $19 billion in legal liabilities associated with Bear Stearns and Washington Mutual. The point Jamie Dimon is making is, "Look, we came into this and we had an agreement."

It sounds to me like it was a verbal agreement, or some type of unstated understanding with Bear Stearns, but actually in writing with respect to Washington Mutual, that the government would be a good partner and make sure that JPMorgan wouldn't take on too many big losses in exchange for JPMorgan coming in and taking over these organizations.

But then the government -- other agencies of the government -- basically backed out on that and stuck JPMorgan with all these losses. Jamie Dimon is basically saying, "If you want us to continue playing this role where we're helping out the financial system in future crises, then you can't back out on agreements like this."

In fact, he went so far as to say -- let me pull up the quote right here -- "These are expensive lessons that I will not forget." It's a really important point, because you need that private sector response in the midst of crisis, and the government appears to have jeopardized that in the future.

Harjes: Yes, he's calling them out there, just laying it out that that kind of thing is not going to be beneficial for either side. He says very explicitly, "No, we would not do something like Bear Stearns again."

Maxfield: Yes. If you go back in time to that weekend that Bear Stearns was on the precipice of failure, had it failed, it could have potentially triggered the financial crisis in March of 2008 as opposed to in September 2008, when Lehman Brothers did in fact fail because they were not able to get a suitor -- namely Bank of America -- to purchase it and save it from doing so.

What caused the crisis was Lehman Brothers actually failing, and the reason it failed was because it couldn't find somebody to buy it.

When you think of a future crisis, certainly JPMorgan has a point that the government should stick to its word on these deals if it wants the private sector to play a role in these crises in the future.

Harjes: Dimon has plenty more to say, too, about the positioning of both JPMorgan and the banking industry as a whole, going forward and what the next financial crisis, or ones even after that, might look like. Definitely a good read, as we've mentioned, from an outstanding banker and CEO.

With that, let's move on to some of the mail that we received this week. We've got Mark from Syracuse, New York, who wrote in to us about Hartford Financial Services (HIG 0.43%), which he tells us that he's owned for two years, and he bought in at $24 per share.

Today, those shares are worth $42, which is a 75% gain for Mark, even without factoring in that these guys have been paying a dividend consistently, and raising that dividend too.

This was, at the time, a textbook buy. Hartford was down, and clearly it's been a great performer for Mark so far. His question was this: When does he sell? This is a great question, and it's one that we hear all the time.

Even though the Fool's favorite holding time is "forever," it's not always the case that you can buy and just hold everything. There are times when selling is a good decision. I'm going to lay out some considerations for our listeners, and then we can dig into Hartford specifically.

First and foremost, your focus when deciding whether to sell should be the precise reason that you bought in the first place. Let's not consider, at first, price movements since your initial buy, but talk just about reevaluating that initial buy decision when you're looking at whether to sell.

If your investing thesis remains intact and the stock looks like it's going to continue its great performance, there's no reason to sell. That's your forever holding period. That's the best case scenario.

The only time when maybe you might want to sell there could be if you've got your eye on an even better company, so you want to take money out of Company A to fund buying shares of Company B, if that looks more promising.

However, if something fundamental has changed in the business; management has gotten shaken up, competitive threats are building, profitability is waning, that could be a reason to reevaluate whether the stock is worthy of being in your portfolio.

It's important to stay humble here, too. Maybe nothing actually has changed in the business, but you made a mistake. You did a superficial glance at the business at first and you bought in, and then later you learned something about the business that you had initially overlooked, and now it doesn't look promising anymore.

A lot of us -- myself included; I'm guilty of this -- you don't want to sell that off and admit that you were wrong, but the best thing you could do is take that as a learning opportunity, and if you should get out, then get out.

Let's talk about price changing a little bit.

Say the stock has performed great since you bought in. You want, then, to make sure that you're looking at your valuation multiples. If all of a sudden it seems overpriced, that could be a good indicator that you might want to take some of the profits that you've gained from there.

Possibly what I'd do here is sell however many shares would be necessary to cover my cost of buying in initially, and then hold the rest. That kind of eliminates your downside, the way that I see it, and you still have a smaller holding so you can catch more upside.

Let's say on the other hand the stock is tanking. Again, you want to revisit that investing thesis. Is this a reaction to bad news that you didn't initially take into consideration, or is it part of a broader market downturn that has nothing to do with the underlying company?

Something that I've seen recommended on Fool.com that I think is super helpful is to write down why you buy every single stock that you purchase. Put it in words. What are your expectations? What would make you sell it? What's the general investing thesis for this company?

Then when it comes time to evaluate all of these things that I just mentioned, it will make that decision so much easier.

The last thing that you also want to keep in mind, that's worth mentioning: If you've held any stock for less than a year and you go to sell it, your gains are going to be taxed at your normal income tax rate, so there are tax implications to selling stocks, based on the timing.

However, if you hold out until after a year has gone by, then you're looking at a lower long-term capital gains tax. That's one more consideration that is definitely worth mentioning.

With all that in mind as a general framework, I'm going to let John take over and do a deeper dive on Hartford, which is the stock that our listener, Mark, had brought up for us to consider. John?

Maxfield: Just to add a general note to what Kristine said, what we know about successful investing for the individual investor is that if you buy good companies and you hold them for a long time, you're going to do really well.

As long as you think it's a good company, and it's continuing to do its thing, just continue holding it unless you need that money to do something else, or you see more attractive opportunities.

In Hartford's case in particular, let me make two comments. First, it is a turnaround story. If you look at its stock chart, it plummeted in the aftermath of the financial crisis.

That's not because all insurance companies plummeted in the aftermath of the financial crisis. Many insurance companies took a hit, but it was really because of imprudent risk management on Hartford's former management's part.

Now, this creates some interesting dynamics for investors because turnaround stories, if they get back up on the right track, provide a huge opportunity for short-term return as those stock prices recover, and that's what we've seen with Hartford.

To the listener's point, his stock is what? I think he said it was up 75%. That's nothing to shake a stick at, when you're looking at a two-year return on investment.

However, going forward the question is will Hartford be able to outperform both the insurance industry more generally, and the broader market like the S&P 500? I think that there are reasons to conclude that it won't.

If you read through Warren Buffett's letters to shareholders; Berkshire Hathaway is at its core an insurance conglomerate, and he says this. The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook.

You have hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In a business that's commodity-like, like this, only a very low-cost operator or someone operating in a protected and usually small niche can sustain high profitability levels.

If you look at Hartford in particular, its numbers just don't suggest that either it is a low-cost producer like, say a GEICO -- we all know their pitch; you spend 15 minutes, save 15% on car insurance. The reason GEICO is able to do that is because it doesn't operate through agents, so it doesn't have those commissions built into it, the expense base, so it operates really, really efficiently.

The second thing is that Hartford's insurance products, as best I can tell, are relatively vanilla insurance products -- life insurance, property & casualty, blah, blah, blah -- although I think maybe it sold off either the majority of life insurance or some of its primary life insurance businesses over the past two years.

But the point remains the same; it is not operating in a niche market, so if you're going to believe Warren Buffett's take on how to run a successful insurance operation, certainly going forward it looks like the odds are stacked against Hartford being able to do so.

By that I mean, being able to beat the broader market or the broader insurance industry, going forward.

Now, that doesn't mean necessarily that the listener should sell his Hartford stock. Because he got in at $24 and it's now at $42, and because insurance companies pay such generally generous dividends, he is going to be able to compound at a much faster rate, at his entry point.

The dividend right now is, I think, $0.18/share per quarter. If you put that over a year, that makes it $0.72/share. Then if you equate that to what he paid, that's a 3% dividend yield relative to a 1.7% dividend yield at today's price, so he's going to make more money on that stock, simply because of his entry point.

For that reason, I would say that unless he feels really concerned about Hartford's prospects going forward, and particularly about its ability to adroitly manage its credit risk and keep its expenses low, then I would probably hang onto it, unless he needs the money for something else.

Harjes: Right. Of course everybody's situation is unique, and we only had a little bit of information about Mark's holding in this. Mark, I hope that this was helpful for you, and anyone else holding Hartford, as you consider what the right move is for your individual situation.

Hopefully there are helpful takeaways there for the rest of you too, since investors across the board should have a strategy for selling and feel comfortable reanalyzing the stocks that you've made, and revisiting the initial purchase decision to decide what to do going forward.

Thanks so much, John, and thanks to everyone who emailed us this past week. Again, our email address is [email protected].

Really quick, before we wrap up, I just want to touch on ... it's earnings season, woohoo! John, it's going to be a really busy week in the financials industry this upcoming week. Tell us, who's reporting and what will you be watching the most closely?

Maxfield: Wells Fargo and JPMorgan reporting tomorrow morning. We have Bank of America going on Wednesday morning, and Citigroup going on Thursday. Earnings season, these are just temperature checks. These are not paradigm shifts.

We're just going to want to look at what the executives are saying, that their expenses are continuing to go down, that their revenue is holding relatively steady, then any color they have to provide on any of these outstanding legal issues that still haven't been resolved.

Other than that, so long as there isn't a huge catastrophe or anything like that, earnings season isn't that big a deal for investors.

Harjes: All right, then. Sounds good. I'm sure we'll be in touch next time if there is anything that was a big deal, that we want to highlight for you all. There will be plenty of Fool.com articles as well, giving you all the coverage you need in the meantime.

That's it for your financials Industry Focus. Have a great week, everyone!

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.