The Best Way to Invest in JPMorgan

By Bill Edson - July 26, 2012 | Tickers: BCS, HBC, JPM, WFC | 0 Comments

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In 2012 investors in financial companies should know that they are investing in black boxes that generate huge, sporadic losses. Firms like JPMorgan Chase (NYSE: JPM) and Barclays (NYSE: BCS) will seem stable for years only to report catastrophic losses or scandalous, regulation-challenging news. Investors have no chance of forecasting such events from financial statements. Though unpredictable in timing, severity, or details, such events should not come as a surprise to informed human beings with functioning memories.

Yet somehow the market is punishing JPMorgan and Barclays for "new" scandals that it should come to expect from these firms. There is no excuse for this implied naivety and the dramatic overreaction in stock prices.  In fact, the recent price drops in JPMorgan might be attractive buying opportunities for bank investors. These disparities in valuation can be used to construct a long/short portfolio to profit from converging valuation as these scandals become yesterday’s news.

Barclays’ Libor Scandal

Barclays, a multinational bank based in the UK, has been accused of altering the interest rate at which it borrows money from other banks.  This estimate has affected the LIBOR (London Interbank Offer Rate), which in turn informs the rates at which trillions of dollars are borrowed and lent, affecting everything from high-yield corporate debt to mortgages and student loans.

Evidence suggests that Barclays has been fixing the LIBOR since 2005, underreporting its LIBOR numbers in order to appear to have better credit quality and less risk.  The scandal narrative alleges that cooking the books was especially important for Barclays to save face during the financial crisis that started in September 2007.  Since then, the media has questioned Barclays’ reporting integrity multiple times in recent years. Regulatory bodies have at different times investigated Barclays’ financial conduct including the New York Fed, the British Bankers’ Association, the Financial Services Authority, the Commodity Futures Trading Commission, the New York Federal Reserve Bank, and the US Treasury.  It was not until June 27, 2012, however, that Barclays admitted to falsified reporting. Between different regulation authorities in the UK and the US, Barclays has been forced to pay £290m in fines.

Thus far, Barclays’ chief executive, chairman, and chief operating officer have resigned. Some of the higher-ups at Barclays who have retained their positions in the midst of this scandal have indicated that Barclays is not the only bank to have under-reported rates and that soon other falsified submissions from other banks will come to light.

Barclays has defended its actions by pointing out that because other banks were under-reporting at the time, and Barclays’ real numbers would have caused panic in a time when finances were unstable. Also, Barclays argues that because of its falsification, the lower LIBOR rate resulted in lower interest rates for the billions worth of pounds in loans taken out by businesses and homeowners. This reasoning, however, misses the fact that Barclays’ false reporting started before the crisis began.

JPMorgan’s Trading Loss Scandal

JPMorgan Chase made public that its bungled trading could cost more than $7 billion, a loss which its traders may have tried to hush up. Four investors from the company’s London office have been implicated and have left the bank, but are being fined heavily with amounts that would equal approximately two years' pay for each former employee.

The controversy over trades correlates to the bank’s decrease in market value. The gigantic loss felt by JPMorgan is largely due to Bruno Iksil, the “London Whale” so named because of his tendency to go big or go home on investments.  Iksil’s choice to put all his chips on US corporate bonds expecting a big payout cost JPMorgan $5.8 billion, three times the bank’s estimated risk.

Several organizations, including the SEC, the Justice Department, the Commodity Futures Trading Commission, and different Congressional committees are now investigating JPMorgan Chase. In addition, class action suits are being levied by public pension funds for causing these funds to sustain big trading losses. These cases rest on the fact that investors were given wrong information about the risk and financial condition of their investments.

Don’t Expect Lightning to Strike Twice

All this bad news is great at scaring investors, but it doesn’t make JPMorgan or Barclays more dangerous than other financial institutions going forward. It is impossible to predict the date or extent of the next scandal that will result from a financial company’s operations, but it is possible to expect such news to arise within these firms. Risk is uniformly the nature of this business: to push risk models and trading methods until losses must be made public. Banking peers cannot be distinguished as being more or less prone to release unexpected bad news. That’s right: unexpected bad news is not expected. Thus, there is no reason to price firms involved in yesterday’s scandals at considerably lower valuations than their peers.

Mispricing and Alpha Opportunities

Since we don’t know which bank will be the source of the next scandal, the best we can do is buy cheap. We can compare Barclays and JPMorgan to see which scandal, if any, has made for attractive valuations relative to peers:

The scandals have clearly dropped the valuations of JPMorgan and Barclays, making these stocks cheap on a relative basis. Among American banks, only Citigroup is cheaper than JPMorgan. Similarly, among banks in the United Kingdom only the Royal Bank of Scotland is cheaper (by the price-to-book ratio) than Barclays.

Investors who hope to generate alpha without net exposure to the financial services industry could buy shares of JPMorgan and Barclays while shorting shares of Wells Fargo (NYSE: WFC) and HSBC Holdings (NYSE: HBC). By valuation ratios Wells Fargo is about 50% more expensive than JPMorgan and HSBC is between 50% and 100% more expensive than Barclays. These long/short positions would profit as valuations of these firms converge to industry norms. Even investors who fear industry-wide swings in financials could be attracted to this hedged strategy, which is a play on valuation, not on the financial industry itself.

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