Letter to Shareholders: JPMorgan & Chase Co

Sources of knowledge… and where to start

Knowledge accumulates, it snowballs. The following quote from the Snowball: Warren Buffett and the Business of Life gives us some insight into this.

“The snowball just happens if you’re in the right kind of snow, and that’s what happened with me. I don’t just mean compounding money either. It’s in terms of understanding the world and what kind of friends you accumulate. You get to select over time, and you’ve got to be the kind of person that the snow wants to attach itself to. You’ve got to be your own wet snow, in effect. You’d better be picking up snow as you go along, because you’re not going to be getting back up to the top of the hill again. That’s the way life works.”

An important part in investing is reading a lot, about investing of course, but also about as many other areas as possible that in the end helps make investment decisions as good as possible.

With this in mind, it then becomes crucial to find new sources of great reading. One way to accomplish this is to read a lot, then read some more and along the way look out for references to follow up on.

In his 2011 letter to shareholders Warren Buffett discussed the issue of share repurchases and recommended, a source of good reading, JPMorgan Chase & Co’s (JPM) Jamie Dimon and his annual letter to shareholders.

“We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)”

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So, with a new shareholder letter out from Jamie Dimon, released as part of JPMorgan Chase & Co’s 2013 annual report (including shareholder letter), I felt it was time to make some use of Warren’s recommendation once again. Check out the shareholder letter here (excluding the rest of the annual report).

Business operations in 2013 – a summary

Let’s start out with a brief look at the financial highlights to get a sense of what the business looks like, at least during fiscal year 2013 and 2012. For a five-year summary of consolidated financials, go to page 62 in the annual report.

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A good sign in this disclosure is that there are no changes to net income due to one-time events. There obviously was some things here which is mentioned later earlier in the letter.

“What a year. Despite tremendous challenges, your company earned $17.9 billion in net income on revenue of $96.6 billion in 2013. Our financial results reflected strong underlying performance across our four main businesses — unfortunately marred by significant legal settlements largely related to mortgages. These legal expenses cost the company $8.6 billion after-tax. Excluding these expenses and some one-time positive benefits from reserve reductions (which we never have considered true earnings) and one-time gains on the sale of assets, your company earned about $23 billion.”

I especially appreciate the words “which we never have considered true earnings.” As a reader of shareholder letters (and also other kinds of financial reporting) honesty in what is reported by management is always of utmost importance. In other words, this is a good sign but too much emphasis should not be wasted, a sound skepticism always has to be maintained when reading financial reports. Because otherwise the end could be much more close than it seems to be – here in the sense of death of money, i.e. a permanent loss of capital.

Diluted earnings per share fell to $4.35, a decline of 16.3%, compared to $5.20 in 2012. During the same time tangible book value per share increased by 5.3%, from $38.75 to $40.81. Cash dividend per share during 2013 amounted too $1.44 compared to $1.20 in prior year, an increase of 20%.

From earnings power and tangible book value to intrinsic value

During 2005-2013 compounded annual growth rates was as follows:

  • Earnings ($ in millions): 9.9% (2005: $8,483; 2013: $17,923)
  • Diluted Earnings per Share: 8.0% (2005: $2.35; 2013: $4.35)
  • Tangible Book Value per Share: 12% (2005: $16.45; 2013: $40.81)

The same metrics compared to prior year shows the following growth (decline) rates:

  • Earnings ($ in millions): -15.8% (2013: $17,923; 2012: $21,284)
  • Diluted Earnings per Share: -16.3% (2013: $4.35; 2012: $5.20)
  • Tangible Book Value per Share: +5.3% 2013: $40.81; 2012: $38.75)

Dimon also touches upon the measure of value in one sentence when discussing the growth in tangible book value as follows.

“One of the tables also shows the growth in tangible book value per share, which we believe is a conservative measure of value. You can see that it has grown far more than the S&P 500 in both time periods.”

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Earnings has been a bit bumpy but look at the consistent growth in tangible book value per share during the period 2005-2013.

A quick and dirty estimate of intrinsic value

Benjamin Graham stated that “the ideal form of common-stock analysis leads to a valuation of the issue which can be compared with the current price to determine whether or not the security is an attractive purchase. This valuation, in turn, would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate capitalization factor.”

As stated by Dimon a conservative measure of value, that is intrinsic value, is tangible book value per share of $40.81. An This conservative estimate of intrinsic value is suitably of the business.

Warren gave some insight in his latest letter to shareholder how he thinks about analyzing and buying stocks. He goes on to say that “When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects.”

Let’s take the average diluted earnings per share for three different periods and calculate some different estimates of intrinsic value at different earnings multipliers. The table below shows these calculations.

I intentionally left out the current price per share to make it possible for anybody to make their own calculations of business intrinsic value without being anchored to what the market says at the moment.

Remember, never look at the market price in the first step. The first step is always to get to know the business fundamentals and the playing field it’s in, and then ask yourself if this is a business that lends itself to valuation. But what if it isn’t? Move on. Maybe this is due to the business itself or the fact that you yourself, a this moment, haven’t got the knowledge required to make a proper analysis. In the end this will protect you from permanent loss of capital.

As Warren advised in his latest shareholder letter “Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.”

I’m not saying that I should invest in a company like JPM either. The above calculations is just, as I stated, a quick and dirty exercise and a first step to see if the intrinsic value value seems favorable compared to the current market price. To make an investment, I would do a lot more reading and in-dept analysis than the one carried out above.

Financials are risky in the sense that it can be really hard to know if there are anything hiding in the balance sheet that could make the future a less prominent place to be. When I look at financials, I always want great management that is able, honest and trustworthy with reasonable paychecks and bonuses where incentives are aligned with shareholders  interest, conservative lending practices and allowance for loan losses, and reasonable growth rate (i.e. not too high) in line with the general growth in the economy.

Bad news

So, back to Dimon’s shareholder letter again. A great shareholder letter should emphasize anything bad that has happened and in a clear and understandable way describe the issues, how they are taken care of and  also any impacts arising in the coming future that is uncertain at the time of writing.

The bad news in the shareholder letter is explained by Dimon as follows.

“The bad news was bad. The most painful, difficult and nerve-wracking experience that I have ever dealt with professionally was trying to resolve the legal issues we had this past year with multiple government agencies and regulators as we tried to get many large and risky legal issues behind us, including the Chief Investment Office (CIO) situation (that happened in 2012) and mortgage-related matters (that happened primarily in 2005-2008, a significant portion of which occurred at heritage Bear Stearns and Washington Mutual (WaMu)).

There is much to say and a lot to be learned in analyzing what happened, but I am not going to do so in this letter — more distance and perspective are required. Suffice it to say, we thought the best option, perhaps the only sensible option — for our company, our clients and our shareholders — was to acknowledge our issues and settle as much as we could all at once, albeit at a high price. This allowed us to focus on what we are here for: serving our clients and communities around the world.”

The company’s business operations in 2013 is expressed  “…as A Tale of Two Cities: “It was the best of times, it was the worst of times.” We came through it scarred but strengthened — steadfast in our commitment to do the best we can.”

Competitive advantage

After a discussion abut leverage and comparison with regulatory requirements (see letter for this part – important but I won’t get into it at the moment), Dimon goes on to talk some about JPM’s competitive advantage.

Here are som of th main points which also give some insight into any advantages enjoyed by JPM:

  • “Our scale and breadth create large cross-sell opportunities and strong competitive advantage. Each of our four major businesses operates at good economies of scale and gets significant additional advantages from the other businesses. We believe this is one of the key reasons we have maintained good financial performance.”
  • “In total, we believe that the combination of our businesses accounts for $15 billion of additional revenue, which helps drive both profits and customer satisfaction. Each of our businesses would be worse off but for the other three.”
  • “Our capabilities are extraordinary and are difficult to replicate — we can bring huge resources to bear for the benefit of our company and our clients Our scale creates huge cost efficiencies and enables significant resources to be brought to bear for the benefit of our company.”
  • “In total, we believe that expense synergies across the company save us approximately $3 billion a year.”
  • “The markets in which we operate cover 5.6 billion people who speak 100+ languages and use close to 50 currencies. It would be difficult to replicate the size, capabilities and knowledgeable staff of our businesses globally.We can help our clients when and where they need it.”

So any competitive advantages enjoyed by JPM seem to come from economies of scale and cost efficiencies, customer switching costs (probably increases with cross-selling of products). Also handling all regulatory requirements takes a lot of effort and investment in the business, as pointed out by Dimon in his walkthrough in the letter of regulatory changes and risks faced by the business in this area.

Other topics discussed

I really enjoyed reading the letter. It’s easy to follow and I like the way in which it’s written.

Some topics that are brought up in the letter, except the ones discussed above, are:

  • Regulatory environment – Impact from regulatory changes and how the company responds it.
  • Business simplification – Exiting certain products and businesses. Dimon states that “As we adapt to all the new rules, we will deliberately maintain our franchises even at the expense of sub-optimal profits. Since we don’t know what the impact of all the new rules will be, we don’t want to guess or make major changes in strategy in anticipation of these new rules. If some of the changes cause disappointing profits in the short term, so be it. We are fairly convinced that we will be able to adjust and earn fair profits in the long run.”
  • Investments in organic growth – Driving future long-term profits.
  • Expense management – Expect to continue drive down expenses as a percentage of revenue.
  • Business risks –  Cybersecurity is a critical priority to the company, geopolitical risk, uncertainty in doing business and sensitivity to risk in general, among others described in the letter.
  • Long-term growth – Looks excellent as to Dimon and expected to come from GDP growth, infrastructure investments to be able to keep pace with GDP growth, growth of large companies, urbanization and population growth, growth in financial assets of consumers and businesses.
  • FED and the impact of tapering“We cannot predict the future, and it is rational to have a healthy fear of new and untested policies. However, we think it will be helpful to put some of these issues in perspective, too.” See shareholder letter for this part.
  • Interest rates“Rising interest rates (all things being equal) will be a big plus for your company.” resulting in higher net-interest margin.
  • New things coming – Better client data management leading to deeper penetration. Increasing segmentation and focus on more refined market segments. JPMorgan Chase Institute. Big Data. ChaseNet. Payments about which Dimon states that “While this topic does keep us up at night due to the talent and innovation of the competition that would love to make us obsolete, we should point out that JPMorgan Chase is one of the biggest payment companies in the world (across credit cards, merchant payments, global wire transfers, etc.). We are even one of the biggest mobile payment companies. So in this space, there is both risk and opportunity. We have some good ideas and action plans so stay tuned!” European capital markets.” 

I must say that I agree with old Warren (who thought anything else…) about recommending Dimon’s shareholder letter. It’s well worth a read. Just because you read it you don’t have to do a write-up this long. Actually it got a lot longer than I expected when I sat down and started to write it. But anyways, now it’s done and all of you out there, feel free to share your insight and knowledge by leaving a comment.

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