JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon began his most recent letter to shareholders on a triumphant note. He proudly reported a record $21.3 billion in net income for 2012, which he said marked the third consecutive year of record profits.
Dimon also pointed to the solid performance of the company's stock over the past eight-and-a-half years, and said that the company is optimistic about the future.
Despite this commendable performance by JPMorgan, we strongly believe that investors should pass on buying its stock. As an investment, the possible upside in shares of JPMorgan does not outweigh the potentially considerable, though unknowable, downside risk.
With the vast amount of news that's printed about the banking giant on a daily basis, it's helpful to stop and really think about JPMorgan from the perspective of how we approach the purchase of any new investment. First of all, we look for a great business that is growing and sustainable. Next, we like to check to see if the company is delivering value for all of its stakeholders. Obviously, a close look at the valuation is also very important. And finally, we ask ourselves if the company's management is effective and trustworthy.
Let's lay the facts out on the table and see how JPMorgan holds up in those key areas.
JPMorgan is primarily a large, traditional bank attached to a massive corporate and investment bank. Traditional banking is a cyclical, but decent business. It's very competitive, of course, but companies can muster reasonable levels of profitability through leverage and cross-selling different products to loyal customers. The corporate and investment banking business can be extremely profitable, though it's also quite competitive and cyclical. Careful risk management is crucial to survival.
Compared with the other banks traded on U.S. exchanges, JPMorgan has average profitability that becomes larger if you take into account leverage; superior growth rates (zero) that resulted from avoiding the worst of the financial crisis; and a somewhat weaker balance sheet:
One caveat worth noting: A good chunk of JPMorgan's profits probably results from its lenders' perception that the bank remains too-big-to-fail. Economist Deniz Anginer calculated that such funding advantages saved JPMorgan $16.27 billion from 2009 through 2011. That amount comes out to 24% of the bank's total pre-tax profits during those years.
But overall, JPMorgan does have a moderately profitable business that stacks up reasonably well against its competitors, and certainly better than fellow megabanks Bank of America (NYSE:BAC) and Citigroup (NYSE:C).
As the financial crisis demonstrated, however, banks that fail to manage risk can post record profits for years before suddenly collapsing. And like its Wall Street peers, JPMorgan faces considerable risks. Its most recent 10-K devotes more than 12,000 words to a dizzying array of risk factors such as regulatory risk, market risk, credit risk, liquidity risk, legal risk, and operational risk. Recently, The New York Times reported that the bank is being investigated by at least eight federal agencies in addition to investigations by federal prosecutors and the FBI.
How well does JPMorgan serve its stakeholders?
We believe that you can't predict how successful a company will be solely by looking at its profit model and historical bottom line. Over the long run, corporate performance is also driven by how well a company satisfies its key stakeholders. If a company cheats its customers, they'll shop elsewhere. If it mistreats employees, they'll be less effective in their jobs or find another employer. If a company creates enormous problems for society, society ultimately won't tolerate it anymore.
According to the website Glassdoor, employees actually give JPMorgan pretty good marks all around. On the compensation front, JPMorgan's investment banking employees took home an average of $217,000 in 2012, and managing directors and top traders can make several million in a year.
It's not quite so clear that the company is serving its customers and society well. Some of the evidence is pretty troubling, in fact. One analyst noted that JPMorgan has paid well over $8.5 billion in regulatory and legal settlements since 2009 to settle accusations spanning multiple lines of business. A few of the charges included:
- "Egregious" violations of sanctions against Cuba, Iran, Sudan, and the Former Liberian Regime of Charles Taylor.
- MF-Global-like failures to segregate customer funds, over and over, again.
- Misleading investors in synthetic and residential mortgage-backed securities.
- Overcharging and wrongfully foreclosing on soldiers.
- High-pressure and deceptive auto-finance sales tactics.
- Abusive processing of checks to maximize overdraft payments.
- Mis-investing client pension funds.
- Illegally boosting credit card payments.
- Bribing officials in Jefferson County, Alabama in a sewer bond deal that bankrupted the county.
- Bid-rigging 93 municipal bond deals in 31 states, and paying its lobbyists with proceeds from municipal bond offerings.
- Derivatives sales fraud in Italy (found guilty).
The bank is also under investigation for allegedly manipulating energy markets and hiding evidence that it did so, working with other banks to manipulate global interest rates, and failing to sound the alarm on Bernie Madoff's Ponzi scheme, among other things.
In summary, we'd say the company delivers significant value for its management and employees. It's debatable, to say the least, how well it's serving its customers and society at a large. And despite management's myopic focus on today's bottom line, it's our view that the value long-term investors in this business are receiving isn't sufficient to the risks they are taking.
So what's the company worth?
We'll cut to the chase here: We don't think it's possible to derive a meaningful valuation for JPMorgan's stock or its assets in general.
And we're not the only ones. According to Jesse Eisinger and Frank Partnoy, a recent survey found that "more than half of institutional investors did not trust how banks measure the riskiness of their assets." And 60% of hedge fund managers gave our big banks unsatisfactory marks when it came to the trustworthiness of their "risk weightings." Eisinger and Partnoy write of one CEO who "regularly hears from investors that banks are "uninvestable."
During the financial crisis, banks wrote down hundreds of billions of dollars in ordinary mortgage assets. But major trading institutions like Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), and JPMorgan work with assets that are notoriously difficult to value. And JPMorgan is the largest derivatives dealer in the world, with $69 trillion in notional value, nearly all of which are traded over the counter instead of on a transparent exchange.
In early 2012, as JPMorgan's so-called "London Whale" trades began to unravel toward at least $6.2 billion in losses, traders began employing dubious valuation practices to cover their tracks. The bank conducted an internal investigation that discovered the "aggressive" pricing, but determined it to be "consistent with industry practices" and "acceptable under bank policy" -- good enough, in other words, for the bank's official quarterly earnings filing. JPMorgan didn't consider the books to be mismarked for several more months, until after they found out traders had been disparaging their own valuation with descriptions like "idiotic."
As the Senate Permanent Subcommittee on Investigations put it, "That the Controller concluded that the SCP's [Synthetic Credit Portfolio] losses could legitimately be reported at anywhere between $719 million and $1.2 billion at the end of March exposes the imprecise, malleable, and potentially biased nature of the credit derivative valuation process."
No outside investor can truly understand this bank. We think you're kidding yourself if you believe you can peruse its financial statements and come away with an informed, clear view of the riskiness of its assets.
As an investor in JPMorgan, you are ultimately relying on the ability and trustworthiness of the company's management to deliver solid gains, while preventing the whole enterprise from blowing up. This is faith-based investing.
Is JPMorgan's management worthy of such extraordinary faith?
So, assuming we're not already dissuaded from investing in such a company, the question we now have to ask is: Can we trust the leadership team at JPMorgan?
When Warren Buffett looks for an investment, he insists that the people operating it are "honest and competent." The recent JPMorgan Whale Trade debacle as outlined by the Senate Permanent Subcommittee on Investigations raises some reasonable doubt about those two attributes. Take a look at the following table we put together based on the report by the Senate Permanent Subcommittee on Investigations:
Public Disclosure on the JPMorgan Whale Trade
Ultimately, the Subcommittee concluded that "derivative trading and financial results were misrepresented to investors, regulators, policymakers, and the taxpaying public, who, when banks lose big, may be required to finance multi-billion-dollar bailouts."
Now, if this were an isolated incident, we might be tempted to write it off (so to speak) as an unfortunate mistake. Dimon has taken responsibility for the fiasco, and has promised that he will fix the problems that led to the trading losses. He also said recently of the trading debacle, "Businesses make mistakes, they learn from it and get better." For the most part, we couldn't agree more.
The problem, of course, is that there have been far too many breakdowns in internal controls and risk management of late at JPMorgan. When the litigation section of your quarterly filings is almost 9,000 words and even your CEO talks of regulatory orders requiring improved performance in multiple areas (with more to come), then there's a worrying pattern that needs to be properly evaluated and fixed. At a certain point, it's only natural to ask, how many investigations are too many?
Just say no
Ultimately, JPMorgan operates a pretty profitable business that could be considerably safer and more sustainable, if the company possessed much better internal controls and risk management. What is particularly worrying for us is that there's been scant evidence of improvement in those areas despite past promises.
The company has a mixed track record of taking care of all its stakeholders (other than management and employees). It's basically impossible to value. And it's not obvious to us why JPMorgan's management team would deserve the extraordinary level of trust such an inscrutable investment would require.
Why should we invest in a black box of unknown but potentially enormous risk when there are dozens, if not hundreds, of more attractive publicly traded, large-cap companies out there? We strongly believe this one is a pass.
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