Here's a chart that compares the profitability of our nation's 13 biggest commercial and universal banks to the valuation of their shares, measured by the price-to-book value ratio.
Is there anything that sticks out to you?
Two things immediately catch my eye. The first is that there's a unmistakable correlation between a bank's profitability and the valuation of its shares.
This makes sense when you consider that the more a bank earns, the more it'll be able to distribute to shareholders, buy back stock, and build up its book value, which, in turn, is the fundamental predicate of bank stock valuations.
The second thing isn't as intuitive. I'm referring to the one bank that seems to violate this rule: JPMorgan Chase (NYSE:JPM).
Even though JPMorgan Chase is one of the best-run and most profitable banks in the United States, its shares trade for a lower valuation than four of its less profitable peers -- namely, Fifth Third Financial, KeyCorp, BB&T, and M&T Bank.
What explains JPMorgan Chase's divergence?
It seems to me that it boils down to investors' perception of risk -- more specifically, to the $2.5 trillion bank's substantial trading operations.
JPMorgan Chase is exposed to more trading risk than any other U.S. bank. More than 15% of its assets, or $378 billion worth, are earmarked on its balance sheet for trading.
That's more in absolute terms than any other big bank, including Wall Street focused operations such as Goldman Sachs and Morgan Stanley, as The Wall Street Journal recently pointed out.
This matters because the heightened volatility associated with trading operations -- you needn't look any further than the fallout from Switzerland's decision earlier this year to unpeg its currency from the euro -- filters into a bank's earnings. And a bank's earnings, as the preceding chart shows, affects the valuation of its shares.
To the enterprising investor, this raises an important question: If JPMorgan Chase's shares seem to trade for a discount to its profitability in part because its earnings are exposed to more volatility on a quarter-to-quarter basis, isn't it an attractive long-term investment? That is, to investors who don't care about short-term volatility, doesn't this represent an opportunity to buy a highly profitable bank for a discount to what it would otherwise sell for?
I think it does. The key is that you must have the temperament to ignore short-term and largely irrelevant fluctuations in earnings. If you have that, this seems like a good candidate to add to your portfolio. If not, then you should probably stick to more conventional lenders along the lines of Wells Fargo and US Bancorp.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns and recommends Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.