My neck hurts.
Why? Because I've been trying to watch the Dow Jones Industrial Average (DJINDICES:^DJI) this week, and my head keeps whipping up and then way back down. It feels like I've been rear-ended at high speed.
These kinds of weeks happen in the markets -- the Dow will rise or fall more than 1% a dozen or more times every single year. But this time is different. This time the jarring head movements have knocked some sense into me.
Right now, JPMorgan Chase is the best value of any bank, and perhaps any stock, on the Dow
It's time for investors to stop worrying about JPMorgan Chase's (NYSE:JPM) derivative book, its London Whale fiasco, higher capital requirements, and "too big to fail." It's time to recognize what the bank truly is: a well-oiled profit machine that is extremely undervalued.
The story is all about profits, capital, and return on equity. Let's break it down.
The last five years have been tumultuous for banks (to say the least). Legal fees, reserves, and settlements have skewed the true earning ability of these companies. What matters for the long term is their core earnings power.
CEO Jamie Dimon accounted for this when presenting the bank's results in his annual shareholder letter. Excluding legal expenses, gains from asset sales, and reserve releases, JPMorgan Chase earned $23 billion last year.
You will likely see headlines describing a "down year" for JPMorgan or how profits declined. Ignore them. These are sensationalist and ignore the real earning power of the company. Don't buy or sell a stock because of last year's results. Buy or sell based on the future, based on that core earnings potential I mentioned above.
JPMorgan achieved this result despite interest rates being at historically low levels. In general, banks make more money when interest rates are high (with the caveat that they can get squeezed when rates are moving). According to Dimon, if rates were normalized at historical levels, the bank would have earned an additional $6 billion!
Again, think long term. Rates will eventually normalize. JPMorgan will eventually see that $6 billion bump to earnings, even if it takes several years to materialize.
This $23 billion translates to adjusted earnings of $5.94 per share. At the time of this writing, JPMorgan was trading at $55.65. Based on this, the market is valuing JPMorgan at a hilariously low 9.37 price to earnings ratio.
Forget the derivatives. Forget the London Whale. Forget Dodd-Frank. Forget "too big to fail." JPMorgan Chase is dirt cheap.
Not only that, but the bank still sits on its famous fortress balance sheet.
A lot has been said about the impact to bank returns from increased capital requirements primarily driven by the Basel III accords. The process began a few years ago and will continue for five or so more, but the bottom line is that banks are being forced to deleverage via increased capital.
The theory is that with more capital available to absorb losses, the banks will be less likely to require a bailout in the event of another mega shock to the financial system.
Think about it like this: two people have the same net worth (all their assets minus all their debts). One person has four times the debt as the other. Which is more likely to file bankcrupty?
The person with more debt relative to his or her net worth. It doesn't matter if that net worth is $10 or $10 billion. The more net worth you have with less debt, the less likely it is that you will have to file for bankruptcy. It's more or less the same concept here for banks.
JPMorgan has been a leader among banks in raising capital to meet the new requirements.
In 2007, using the new Basel III requirements, JPMorgan had a capital ratio of 5%. Today that number is 11.3%. Using the older, Basel I accounting guidelines, JPMorgan's capital base increased from 7% in 2007 to 11.8% in 2013.
It could easily be argued that no bank managed through the financial crisis and Great Recession better than JPMorgan (Wells Fargo certainly gives it a run for its money). The crisis hit hard in 2008 when JPMorgan had 4.7% Basel III capital and 7% Basel I capital.
The fact of the matter is that JPMorgan has more than doubled the strength of its balance sheet by Basel III standards and nearly doubled it by Basel I standards since the worst economic shock since the Great Depression.
If a crisis hit tomorrow, JPMorgan is more prepared than ever.
Return on equity
Perhaps the most impressive takeaway from JPMorgan's 2013 fiscal year is its return on equity. Conventional wisdom is that if banks are forced to hold more capital, then return on equity will be lower. It's just simple division. The same profits divided by more equity equals a lower percentage.
JPMorgan has proven the conventional wisdom wrong. The bank has been able to maintain a 15% return on equity each year from 2011 through 2013 (using the adjusted earnings from above for 2013).
And that is while the bank has been aggressively increasing capital. Conventional wisdom be damned.
Dimon speaks directly to this in the letter. He noted that conventional wisdom is that returns will suffer, all things being equal. But he added:
But all things are not equal. Clients, markets, and businesses adjust to changing economic circumstances. Our company has already taken action that gives us some confidence that we will be able to maintain decent returns in spite of what a static analysis would show. ... Some banks will continue to earn better-than-average ROEs. Not all companies are created equal.
What kinds of things? Dimon said JPMorgan has already begun these tactics and more:
- Run off unprofitable products
- Product repricing
- Product redesign
- Client selection and reoptimization
Dimon goes into great detail in his letter; it is absolutely worth a read for any investor in any industry. You can check it out here.
The case for JPMorgan is pretty simple. The bank is ridiculously profitable today and it's true earning ability is even greater in the future. The bank still has a fortress balance sheet, and it is stronger today than it ever has been. Return on equity is impressive even in the face of raised capital standards and a historically low interest rate environment.
And the bank trades at less than 10 time earnings. Summing it all up in four words: "high quality, dirt cheap." Or, if you prefer, "buy low, sell high."