We believe that JPM offers the potential for ~100% total return over the next 18-24 months, with reasonable downside in a rational market.
The Three Little Pigs
In this fable, three pigs live in three different homes. The first pig made his home with straw, the second pig made his home with sticks, and the third pig made his home with bricks. There is a “big, bad wolf” that wants to eat the pigs, and tries to do so by blowing down their homes with his wind. He is successful in knocking down the home made of straw, and the home made of sticks, but when it comes to the home made of bricks, the wolf is no match.
JPM – The Brick House
We believe JPM is the equivalent to the house of bricks in the Little Pigs fable. The winds are coming, and many weaker houses will likely get knocked down, but we believe JPM will survive and thrive.
The strength of JPM is predicated upon its capital level, its earnings profile, and its operating prowess.
Regarding capital, JPM has Common Equity Tier 1 Capital (CET1) of 12.4%, which is very strong among financial institutions. Also, JPM has tangible book value (TBV) per share of $61, and has been accreting TBV at a rate of about $3-4 per year consistently over the past four years... JPM has a lot of capital to withstand a dislocation.
Regarding earnings power, JPM has one of the most impressive returns on its equity in all of banking. Their return on average tangible common equity (ROTCE) was nearly 20% in 2019. The simple math is that JPM reported nearly $11 of EPS in 2019 with average TBV of $58… TBV grew from $56 to $61 and JPM paid out dividends per share of nearly $4 per share… Another way to look at earnings is Pre Provision Operating Profit (PPOP)… This is effectively a measure of pre-tax and pre-provision profit. JPM has ~$16 of PPOP, which is very strong compared to the current stock price, and JPMs TBV... Any way you look at it, JPM has a lot of earnings power to offset a slowdown.
Regarding operating prowess, JPM has earned the reputation of being a great operating company. JPM navigated through the Great Recession and came out stronger from it. For those interested, “The House of Dimon” is a NYT best-selling book chronicling JPMs CEO, Jamie Dimon and how he led the company through that tumultuous time, but the numbers and the performance also speak for themselves. JPM gets a premium valuation for a reason, and in these uncertain times, we believe you want to own the companies with a proven history in dislocations.
The Big Bad Wolf
By now, this is not new news… There are several factors out there that are going to cause bank earnings to be strained. Coronavirus (and the fear surrounding it)…declining oil prices… interest rates going to zero… all of this very well could tip-off a recession in the US, and the potential is there for it to be swift, and for it to be severe.
Goldman Sachs recently wrote a very helpful report looking at the impact to the banking sector of a zero rate case, and a full on recession. Our view of their scenario analysis was that in that case, JPMs earnings could experience a 50% reduction in earnings. This is bad, but it is by no means a disaster. JPM will still be profitable, will still be accreting capital, and most importantly, the impact of these lost earnings will be temporary. Just as in the Great Recession, the surviving Financial Institutions will come out the other side stronger, with more opportunities, and eventually higher returns. As such, we believe the fear of a temporary dislocation and the risk of depressed earnings near-term is an opportunity, not a threat.
At ~$100 per share, JPM shares trade at the following valuation metrics
1-Price to TBV of ~1.6x
2-Price to PPOP of ~6x
3-Dividend yield of 3.6%
Price to TBV – JPM was recently trading at 2.2x TBV. In 2009, JPM troughed at ~1.3x TBV in the Great Recession. In a stress case scenario, were valuations go back to the Great Recession, and TBV doesn’t grow, the downside case could be ~$80 (20% down).
Price to PPOP – Large banks recently were trading at ~10x PPOP, and troughed at 5x PPOP in the 2008 crisis. At 6x, JPM is trading near trough valuation on this important metric, and trading back to trough levels again would indicate about 20% downside.
Dividend Yield – JPM pays an annual dividend of $3.60. This equates to a yield of ~3.6%. Obviously, this is very attractive in light of a 10 year treasury yield of <1%, and potentially going lower…
Our best guess is that JPMs earnings are depressed over the next few quarters, and that causes ROTCE to look poor in 2020. However we believe JPM still accretes capital, still pays the dividend, and that in the intermediate term, is back in a very strong place. Most importantly, we believe that a lot of this is already priced into the stock.
Even in a severe downside case, we think the risk here is to earnings, not capital, and that houses made of brick will endure through whatever winds may blow, and will be there to help rebuild the houses made of stick and straw.
We believe it would not be unrealistic to think that by year end 2021 (18-24 months), we could be seeing a stock that has over $15 in EPS power, where shareholders could see a total return of nearly 100%, including dividends.
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