In a panicked market, good news is ignored and all of the focus tends to be on the bad. On Tuesday, J.P. Morgan held its investor day meeting. In the meeting, the company announced that it was going to add another $500MM to energy-related loan-loss reserves. This followed a $67MM provision in Q4, which at the time brought total oil and gas loss reserves to $815MM, on a portfolio with a book value of $44 billion. In addition, the bank said it could potentially add another $1.5 billion to reserves should oil hang around $25 per barrel over the next 18 months. Keep in mind that JPM had 2015 net income of $24.4 billion of $6.00 per share. Additions to loan-loss reserves are pretax and so even if JPM added $2 billion over the next year, that would only equate to a 5-6% hit to earnings. The company is overly capitalized with a CET1 ratio of 11.6%, which was up 140 basis points year over year, despite returning $11 billion to shareholders. Keep in mind that the tens of billions of dollars in legal settlements that have haunted the banks are now mostly a thing of the past. Those losses were far greater than the potential fallout from low commodity prices, meanwhile lower gas prices are enormously constructive for consumers. In the same presentation, JPM announced that they were optimistic about nearly all of their business lines and planned to report record profits once again this year, of up to $30 billion. The stock dropped 4.5% yesterday. Fundamentals and prices have diverged to nonsensical levels. Below is a slide outlining JPM’s energy exposure.
Firm Overview – February 23, 2016
Here you can see that despite the low interest rate environment that we have been in, JPM has been consistently growing its tangible book value per share. The stock has swung from time to time of course, but the trajectory of the business remains strong. This is important to keep in mind because stock prices fluctuate far more than actual business values.
Here is the slide that in my opinion is most important. JPM and most of the other big banks’ are already above the regulatory minimum capital ratios. This allows the companies to return capital to shareholders via stock buybacks and dividends. With the stocks so cheap, buybacks are the preferred way to return capital as it increases the per share intrinsic value of the companies. Even with strong buyback and dividend growth, these banks will still be increasing their capital ratios. Ultimately, in a few years, this would create a situation in which these companies are likely to be returning 100% or greater of net income to shareholders. Citigroup’s CET1 ratio is actually 12%, so it is higher than JPM’s. Citigroup earned $5.35 per share in 2015 and has more efficiency gain potential than JPM, which would imply considerable earnings growth potential. The valuation is also far cheaper than JPM’s, as Citigroup trades at about 63% of tangible book value. In a few years, Citigroup would likely need to be returning over 100% of net income to shareholders due to the extreme levels of over-capitalization that the company would have. If income was the same as 2015, the dividend yield on Citigroup stock would be 14%, with growth potential beyond that.
It is these fundamental differences between price and value that give me confidence that we will see a very strong rebound in financials. There is no logical explanation for tens of billions in losses on the market capitalization of the companies. With their increased capital ratios, enhanced liquidity, and enormous earnings potential, financials can absorb losses even greater than what occurred in 2008. This is nothing like 2008, but the market in the short-term is voting with its feet. Fear rules the day. I don’t know when sentiment will change but I have very little doubt that a year from now and especially over the longer-term, things will look much brighter. These prices cannot be justified for long and as more facts come to light, the outcome will become that much more likely.