I was reading through the J.P. Morgan (JPM) 2014 Annual Report and Jamie Dimon’s letter to shareholders was rather interesting. I ended up highlighting a bunch of things and wrote a bunch of notes along the columns. JPM has seen solid tangible book value and diluted earnings per share growth over the past 10 years but haven’t seen much movement in the stock price – Dimon thinks he knows why. An interesting fact was how JPM went through the 2008 financial crisis – the answer may shock you. I warn you right now though, this is a long and arduous post – more for my own interest than you, the reader. If you don’t have the slightest interest in reading snippets from the JPM annual report, I suggest you read no further as it will probably just bore you to tears. With that said: here are some random musings from the JPM 2014 Annual Report.
You can read the full annual report here.The letter starts with a little introduction and sampling of the bank’s performance.
Seven years ago, the world was shaken by the global financial crisis… We have endured an unprecedented economic, political and social storm — the impact of which will continue to be felt for years and possibly decades to come. What is most striking to me, in spite of all the turmoil, is that our company became safer and stronger.
In 2014, J.P. Morgan recorded $21.8 billion in net income on revenue of $97.9 billion. That’s a 22.3% net profit margin.
The following 2 graphs on diluted earnings per share growth and tangible book value per share interesting:
The 10 year compound annual growth rate for diluted earnings per share was 13.3% – tangible book value saw 11.3% growth. That’s with one of the worst recessions since the Great Depression thrown in there – an economic crisis that centred around the financial sector. I was blown away by this.
I think there must be some sort of bias affecting people’s thinking on the financial sector. Something along the lines of “since 2008 was a financial crisis where lots of big banks went bankrupt or received big government bailouts, the sector as a whole must be rotten and risky.” I must admit I was subliminally affected by this sort of first level thinking bias.
I. Outstanding Franchise
Since 2000, compared to the S&P 500, tangible book value growth has outpaced the index by 7.4%. Total stock return has outpaced the index by 2.2%.
While growth in tangible book value and diluted earnings per share have outpaced the S&P 500 since 2000, the stock price hasn’t really reflected this performance:
However, our stock performance has not been particularly good in the last five years. While the business franchise has become stronger, I believe that legal and regulatory costs and future uncertainty regarding legal and regulatory costs have hurt our company and the value of our stock and have led to a price/earnings ratio lower than some of our competitors. We are determined to limit (we can never completely eliminate them) our legal costs over time, and as we do, we expect that the strength and quality of the underlying business will shine through.
Not only does Dimon believe JPM is safer and stronger than ever, he believes that the bank is one of the biggest winners in the evolution of the financial sector:
If you think back 10, 20 or 30 years ago, my predecessors and I struggled to try to build a great company, which we hoped would emerge as an endgame winner. The ultimate outcome was unclear – and many competitors did not survive (this is true for most large- scale consolidating industries). Even for those of us that did, it was quite a struggle. Today, it is clear that our company is an endgame winner – both in the United States and glob- ally – which is invaluable in any industry. And while we have had some difficult times since the financial crisis, the power of the franchise has shone through. We also know that future success is not guaranteed – only consistently good management over a long period of time can ensure long-term success in any business. But we certainly are in a very good place.
Dimon goes on to highlight JPM’s margins and returns vs the best-in-class peers in the industry.
Not only has JPM shown strong growth since 2000, they are right up there with their best in class peers.
A good company should be able to earn competitive margins over an extended period of time regardless of economic conditions while investing and without taking excessive risk. Any company can improve earnings in the short run by taking on additional risk or cutting back on investments. Any company can grow rapidly if it takes on too much risk – but that usually is the kind of growth one comes to regret. Our margins have been quite good, even as we have been investing for the long run. These investment expenses lower our short-term returns, but they are “good” expenses.
JPM certainly has performed regardless of economic conditions.
The chart below shows earnings, the capital we returned to shareholders through dividends and stock buybacks, our returns on tangible common equity and our high quality liquid assets (HQLA). High quality liquid assets essentially are deposits held at the Federal Reserve and central banks, agency mortgage-backed securities and Treasuries, and they are the component of our balance sheet that has grown most dramatically. Only HQLA count for liquid assets under banking regulators’ definition of liquidity – and we currently have more than is required by the regulators. The chart below also shows that even after dramatically increasing capital and liquidity, both of which reduce returns on capital, we were able to earn an adequate return on tangible common equity, grow our capital base as needed and still return capital to shareholders.
Dimon lists the following as JPM’s moat:
We believe that we have well-fortified moats in the form of economies of scale, brand, expertise, tech- nology and operations, and – importantly – competitive advantages created by our ability to cross sell… we have performed fairly consistently in good times and in bad. Even in 2008, the worst year in perhaps 75 years for financial companies, we earned 6% return on common tangible equity – not great but not bad, all things considered. Additionally, we have embedded strengths that are hard to replicate – the knowledge and cohesiveness of our people, our long-standing client relationships, our technology and product capabilities, our fortress balance sheet and our global presence in more than 100 countries.
What exactly does JPM do?
We are an operating company providing financial services to consumers, companies and communities… we provide you with essential financial products, services and advice. We have a broad product offering and some distinct capabilities, which, combined, create a mix of businesses that works well for each of our client segments.
In Dimon’s opinion, the US financial system is still the best in the world:
America’s financial system is still the best the world has ever seen — it is large and diverse — and it serves the best economy the world has ever seen, which also is large and diverse… it includes not just banks but asset managers, private equity, venture capital, individual and corporate investors, non-bank financial companies, and public and private markets. In fact, in the United States, banks are a much smaller part of the financial system and the economy than in most other countries. And there is a great need for the services of all banks, from large global banks to smaller regional and community banks.
What gives JPM a competitive advantage over smaller, regional banks?
Our large global Corporate & Investment Bank does things that regional and community banks simply cannot do. We offer unique capabili- ties to large corporations, large investors and governments, including federal institutions, states and cities. For example, we provide extensive credit lines or raise capital for these clients, often in multiple jurisdictions and in multiple currencies. We essentially manage the checking accounts for these large insti- tutions, often in many different countries. On the average day, JPMorgan Chase moves approximately $6 trillion for these types of institutions. On the average day, we raise or lend $6 billion for these institutions. On the average day, we buy or sell approximately $800 billion of securities to serve investors and issuers.
Thoughts on the level of confusion on what banks do:
There are understandable questions about the role that large financial institutions play. Some of these questions make people nervous, in part because they do not understand the larger picture… People also should ask themselves one basic question: Why do banks offer these services? The fact is, almost everything we do is because clients want and need our various and sometimes complex services.
II. A Long Term Focus
On risk and stress tests:
We are fanatics about stress testing and risk management. It is in our best interest to protect this company – for the sake of our shareholders, clients, employees and communities… We run hundreds of stress tests a week, across our global credit and trading operations, to ensure our ability to withstand and survive many bad scenarios. These scenarios include events like what happened in 2008… Our stress tests include analyzing extremely bad outcomes relating to the Eurozone, Russia and the Middle East… We stress test frequently virtually every country and all credit, market and interest rate exposures; and we analyze not only the primary effects but the secondary and tertiary consequences. And we stress test for extreme moves – like the one you recently saw around oil prices. Rest assured, we extensively manage our risks.
The stress tests seem to focus around on the worst case scenarios playing out in the Eurozone/Greece, Russia, and the Middle East/ISIS.
Apparently this was the only geopolitical crisis after the Korean War that derailed global financial markets:
Also regarding geopolitical crises, one of our firm’s great thinkers, Michael Cembalest, reviewed all of the major geopolitical crises going back to the Korean War, which included multiple crises involving the Soviet Union and countries in the Middle East, among others. Only one of these events derailed global financial markets: the 1973 war in the Middle East that resulted in an oil embargo, caused oil prices to quadruple and put much of the world into recession.
These are the requirements of new regulations by the Federal Reserves Comprehensive Capital Analysis and Review (CCAR) stress test that JPM has to be able to pass:
The stress test is good for our industry in that it clearly demonstrates the ability of each and every bank to be properly capitalized, even after an extremely difficult environment. Specifically, the test is a nine-quarter scenario where unemployment suddenly goes to 10.1%, home prices drop 25%, equities plummet approximately 60%, credit losses skyrocket and market-making loses a lot of money (like in the Lehman Brothers crisis).
These are Dimon’s assumptions on what he believes the Fed makes when conducting stress tests:
To make sure the test is severe enough, the Fed essentially built into every bank’s results some of the insufficient and poor decisions that some banks made during the crisis. While I don’t explicitly know, I believe that the Fed makes the following assumptions:
- The stress test essentially assumes that certain models don’t work properly, particularly in credit (this clearly happened with mortgages in 2009).
- The stress test assumes all of the negatives of market moves but none of the positives.
- The stress test assumes that all banks’ risk- weighted assets would grow fairly signifi- cantly. (The Fed wants to make sure that
a bank can continue to lend into a crisis and still pass the test.) This could clearly happen to any one bank though it couldn’t happen to all banks at the same time.
- The stress test does not allow a reduction for stock buybacks and dividends. Again, many banks did not do this until late in the last crisis.
I believe the Fed is appropriately conservatively measuring the above-mentioned aspects and wants to make sure that each and every bank has adequate capital in a crisis without having to rely on good management decisions, perfect models and rapid responses.
These stress tests seem very stringent and Dimon says:
We believe that we would perform far better under the Fed’s stress scenario than the Fed’s stress test implies.
However, he does take issue with the way the Fed envisioned the stress scenarios:
Let me be perfectly clear – I support the Fed’s stress test, and we at JPMorgan Chase think that it is important that the Fed stress test each bank the way it does. But it also is important for our share- holders to understand the difference between the Fed’s stress test and what we think actually would happen. Here are a few examples of where we are fairly sure we would do better than the stress test would imply:
- We would be far more aggressive on cutting expenses, particularly compensation, than the stress test allows.
- We would quickly cut our dividend and stock buyback programs to conserve capital…
- We would not let our balance sheet grow quickly. And if we made an acquisition, we would make sure we were properly capitalized for it… There is no way we would make an acquisition that would leave us in a precarious capital position.
- And last, our trading losses would unlikely be $20 billion as the stress test shows. The stress test assumes that dramatic market moves all take place on one day and that there is very little recovery. In the real world, prices drop over time, and the volatility of prices causes bid/ask spreads to widen – which helps market makers.
Finally, and this should give our shareholders a strong measure of comfort: During the actual financial crisis of 2008 and 2009, we never lost money in any quarter.
I found that last line very interesting. Again, affected by bias towards the financial sector after the 2008-2009 financial crisis, I just assumed all big banks lost lots of money.
While there always will be cycles, we need to keep our eye on the important things, too — the outlook for long-term growth is excellent. The needs of countries, companies, investor clients and individuals will continue to grow over time.
The following graph is used to support the above statement:
JPM believes super low interest rate environment is temporary:
A very good current example of how we view investing and long-term decision making is how we are dealing with the squeeze on our net interest margins (NIM) due to extremely low interest rates. The best example of this is in our consumer business, where NIM has gone from 2.95% to 2.20% (from 2009 to 2014). This spread reduction has reduced our net interest income by $2.5 billion, from $10 billion to $7.5 billion – or if you look at it per account, from $240 to $180. Since we strongly believe this is a temporary phenomenon and we did not want to take more risk to increase our NIM (which we easily could have done), we continued to open new accounts.
Thoughts on P/E ratios, stock prices, and JPM’s stock:
Our long-term view means that we do not manage to temporary P/E ratios — the tail should not wag the dog. Price/earnings (P/E) ratios, like stock prices, are temporary and volatile and should not be used to run and build a business. We have built one great franchise, our way, which has been quite successful for some time. As long as the business being built is a real franchise and can stand the test of time, one should not overreact to Mr. Market… While the stock market over a long period of time is the ultimate judge of performance, it is not a particularly good judge over a short period of time… Because of our conservative accounting, tangible book value is a very good measure of the growth of the value of our company. In fact, when Mr. Market gets very moody and depressed, we think it might be a good time to buy back stock.
Dimon believes the reason the stock price of JPM has been depressed is because of the uncertainty hanging above higher legal costs and regulatory costs since the financial crisis:
While we acknowledge that our P/E ratio is lower than many of our competitors’ ratio, one must ask why. I believe our stock price has been hurt by higher legal and regulatory costs and continues to be depressed due to future uncertainty regarding both.
He does own up to some of the costly mistakes JPM made during the financial crisis:
I should point out that while we certainly have made our share of costly mistakes, a large portion of our legal expense over the last few years has come from issues that we acquired with Bear Stearns and WaMu. These problems were far in excess of our expectations. Virtually 70% of all our mortgage legal costs, which have been extraordinary (they now total close to $19 billion), resulted from those two acquisi- tions. In the Bear Stearns case, we did not anticipate that we would have to pay the penalties we ultimately were required to pay. And in the WaMu case, we thought we had robust indemnities from the Federal Deposit Insurance Corporation and the WaMu receiv- ership, but as part of our negotiations with the Department of Justice that led to our big mortgage settlement, we had to give those up. In case you were wondering: No, we would not do something like Bear Stearns again.
Believes uncertainty surrounding legal and regulatory costs should start coming down in the near future
The good news is that our legal costs are coming down and, we hope, will normalize by 2016. Uncertainty remains around regulatory require- ments, though we believe this will diminish over time, too. That uncertainty is particularly acute around the extra capital that JPMorgan Chase will have to hold because of the new Global Systemically Important Bank (G-SIB) rules, the ultimate impact of the Volcker Rule, total loss-absorbing capacity, CCAR and Recovery & Resolution. And it’s because of that uncertainty that a majority of the time I spend with analysts and investors these days is devoted to regulation… Given that much uncertainty, which is greater for JPMorgan Chase than for most other banks, it is understandable that people would pay less for our earnings than they otherwise might pay. Having said all this, the contours of all of the new regulations have emerged, and we believe that regulatory uncertainty will diminish over time. And, we hope, so will the drag on our P/E ratio… our ultimate goal is to think like a long- term investor – build great franchises, strengthen moats and have good through- the-cycle financial results.
III. Fortress Controls
Only a few things caught my eye in this section. Regarding simplifying the business, on the list of things they are improving on to simplify the business, “ceased originating student loans” was an interesting bullet point on page 21. Makes me wonder what they truly think about the growing student loan debt issue in America.
On adaptation to all the new regulations:
While uncertainty remains, the contours to the new rules are largely known, and we have made enormous progress adapting to them.
On the new Global Systemically Important Bank (G-SIB) rules:
G-SIB is not a simple calculation. It requires thousands of calculations, and it does not look at just assets – it looks at products, services, assets, type of client (i.e., international and financial or corporate) and collateral type, among others in order to determine capital levels… G-SIB is not a direct measure of risk. The G-SIB calculations show that JPMorgan Chase is the most Global Systemically Important Bank, and, therefore, we have to hold more capital than any other bank in the world…
Optimism on the financial sector:
There is no question that, today, the global banking system is safer and stronger – possibly more so than it has ever been. That is not to say that the changes do not create a whole range of challenges, complexities and new risks (which we will talk about in the next section). But at the end of the day, the system will be safer and more stable than ever.
IV. Future is Bright
Talk about big data and leveraging this data through intelligent solutions made me think of IBM – wonder if IBM provides any data solutions for JPM?
We continue to leverage the data generated across JPMorgan Chase, as well as data that we purchase to create intel- ligent solutions that support our internal activities and allow us to provide value and insights to our clients. For example, we are monitoring our credit card and treasury services transactions to catch fraudulent activities before they impact our clients, we are helping our clients mitigate costs by optimizing the collateral they post in support of derivatives contracts, and we are highlighting insights to our merchant acquiring and co-brand partners.
There will be more competition coming for the financial sector from abroad, especially from China:
Large banks outside the United States are coming. In terms of profitability, the top two Chinese banks are almost twice our size. Thirty years ago, Industrial and Commercial Bank of China operated in only a handful of countries, but it now has branches or subsidiaries in more than 50 countries. It has a huge home market and a strategic reason to follow the large, rapidly growing global Chinese multinationals overseas. It may take 10 years, but we’d be foolish to discount their ambition and resources. We’re also seeing world-class banks emerge and grow in places like India and Brazil, and Japanese and Cana- dian banks are coming on strong, too. Many of these banks are supported in their expan- sionary efforts by their government and will not need to live by some of the same rules that we in the United States must adhere to, including capital requirements. We welcome the competition, but we are worried that an uneven playing field may hamper us many years from now.
Also some talk about Silicon Valley and competitors in the payments area:
There are hundreds of startups with a lot of brains and money working on various alternatives to tradi- tional banking… They are very good at reducing the “pain points”… You all have read about Bitcoin, merchants building their own networks, PayPal and PayPal look-alikes. Payments are a critical business for us – and we are quite good at it. But there is much for us to learn in terms of real-time systems, better encryption tech- niques, and reduction of costs and “pain points” for customers.
Dimon is confident that JPM will enter the next crisis with a banking system that is stronger than ever:
Each individual bank is safer than before, and the banking sector overall is stronger and sounder because, among other things:
- Capital levels are far higher today… In the last six years, it’s back to high numbers not seen since the late 1930s.
- Highly liquid assets held by banks probably are much higher than ever before.
- Many exotic and complex products are gone.
- Many standardized derivatives are moving to clearinghouses.
- Both consumer and commercial loans are underwritten to better standards.
- Transparency to investors is far higher.
- Boards and regulators are far more engaged.
Thoughts on the October 2014 volatility in treasury markets:
Recent activity in the Treasury markets and the currency markets is a warning shot across the bow. Treasury markets were quite turbulent in the spring and summer of 2013, when the Fed hinted that it soon would slow its asset purchases. Then on one day, October 15, 2014, Treasury securities moved 40 basis points, statistically 7 to 8 standard deviations – an unprecedented move – an event that is supposed to happen only once in every 3 billion years or so (the Treasury market has only been around for 200 years or so – of course, this should make you question statistics to begin with). Some currencies recently have had similar large moves. Importantly, Treasuries and major country currencies are considered the most standardized and liquid financial instruments in the world. The good news is that almost no one was significantly hurt by this, which does show good resilience in the system. But this happened in what we still would consider a fairly benign environment. If it were to happen in a stressed environment, it could have far worse consequences.
There will always be crisis – it never is different this time:
Some things never change — there will be another crisis, and its impact will be felt by the financial markets. The trigger to the next crisis will not be the same as the trigger to the last one – but there will be another crisis. Triggering events could be geopolitical (the 1973 Middle East crisis), a recession where the Fed rapidly increases interest rates (the 1980-1982 recession), a commodities price collapse (oil in the late 1980s), the commercial real estate crisis (in the early 1990s), the Asian crisis (in 1997), so-called “bubbles” (the 2000 Internet bubble and the 2008 mortgage/housing bubble), etc. While the past crises had different roots (you could spend a lot of time arguing the degree to which geopolitical, economic or purely financial factors caused each crisis), they generally had a strong effect across the financial markets.
The commonalities of how crises play out in the financial markets:
While crises look different, the anatomy of how they play out does have common threads. When a crisis starts, investors try to protect themselves. First, they sell the assets they believe are at the root of the problem. Second, they generally look to put more of their money in safe havens, commonly selling riskier assets like credit and equities and buying safer assets by putting deposits in strong banks, buying Treasuries or purchasing very safe money market funds. Often at one point in a crisis, investors can sell only less risky assets if they need to raise cash because, virtually, there may be no market for the riskier ones. These investors include individuals, corporations, mutual funds, pension plans, hedge funds – pretty much everyone – each individually doing the right thing for themselves but, collectively, creating the market disruption that we’ve witnessed before. This is the “run-on-the-market” phenomenon that you saw in the last crisis.
In a crisis, everyone rushes into Treasuries:
In a crisis, everyone rushes into Treasuries to protect themselves. In the last crisis, many investors sold risky assets and added more than $2 trillion to their ownership of Treasuries (by buying Treasuries or government money market funds). This will be even more true in the next crisis. But it seems to us that there is a greatly reduced supply of Treasuries to go around – in effect, there may be a shortage of all forms of good collateral. Currently, $13 trillion of Treasuries are outstanding, but, according to our estimates, less than half of this amount is effectively free to be sold. Approximately $6 trillion is accounted for by foreign exchange reserve holdings for foreign countries that have a strong desire to hold Treasuries in order to manage their currencies.
There will be limits on what healthy banks can do during the next crisis:
In the last crisis, some healthy banks used their investment portfolios to buy and hold securities or loans. In the next crisis, banks will not be able to do that because buying most types of securities or loans would increase their Risk Weighted Assets and reduce their liquidity… In the last crisis, banks underwrote (for other banks) $110 billion of stock issuance through rights offerings. Banks might be reluctant to do this again because it utilizes precious capital and requires more liquidity.
The next crisis might see even more volatility because of new bank regulations and the scarcity of Treasuries, which could lead to very dramatic declines and price movements:
The markets in general could be more volatile — this could lead to a more rapid reduction of valuations. The items mentioned above (low inventory, reluctance to extend credit, etc.) make it more likely that a crisis will cause more volatile market movements with a rapid declinein valuations even in what are very liquid markets. It will be harder for banks either as lenders or market-makers to “stand against the tide.”
V. Strong Culture
Some points on compensation that were interesting:
Compensation has been consistent and fair and is awarded with proper pay-for-performance. We do not have change-of-control agreements, special executive retirement plans, golden parachutes, or things like special severance packages for senior executives. We do not pay bonuses for completing a merger, which we regard as part of the job. We virtually have no private “deals” or multi-year contracts for senior management.
They believe their senior managements should have significant skin in the game:
We still believe deeply in share ownership. We would like all our senior managers to have a large portion of their net worth in the company… We want your management team to be good stewards of your capital and to treat it as they would their own.
JPM still has defined benefit pension plans, which I find surprising because it seems like a lot of the companies I have read about have phased out DB pensions:
We still have a defined benefit pension plan for most of our employees that provides a fixed income upon retirement.
Final thoughts on building and maintaining a strong culture at JPM:
We need to develop the right culture and avoid creating a culture of finger-pointing. We need to analyze our mistakes because that is the only way we can fix them and consis- tently improve. But we cannot allow this to devolve into crippling bureaucratic activity or create a culture of backstabbing and blame. We need to develop a safe environment where people can raise issues and admit and analyze mistakes without fear of retribution. We must treat people properly and respectfully – even if we have to make tough decisions.
A very Munger-esque would ask about the type of people you want to be in business with:
I now ask questions that I did not ask when I was a younger manager: “Would I want to work for these managers?” “Would I want my children to work for these managers?” My answer would not always have been yes, but now it is.
Well… that was incredibly long. I don’t know what it was about this shareholder’s letter, but it made me reflect on it in ways that not many shareholder letters do. I thought Dimon’s thoughts and insights were interesting. I found the performance of JPM, especially tangible book value and diluted earnings per share growth very fascinating – especially since JPM had to endure through the financial crisis. And one of the most important take aways has been spotting my own bias that made me think that the financial sector as a whole was a bad place to invest because of the association of the entire sector to the negatives of the 2008-2009 financial crisis.