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JPMorgan Chase & Co. (JPM)

JPMorgan Chase (JPM) is one of the world's oldest banking institutions, tracing its roots back to 1799. Today it's the largest bank in the U.S., with over 5,100 branches, 16,000 ATMs, and $2.5 trillion in assets. This includes more than $900 billion in loans and $1.4 trillion in deposits, 27% of which are in non-interest bearing accounts.

JPMorgan operates in over 100 countries, although about 80% of revenues are generated in the U.S. 
Source: JPMorgan Investor Presentation
The bank has four major business segments: 

  • Consumer & Community Banking (45% of revenue and 39% of earnings): traditional consumer and small business banking services including: checking and savings accounts, small business loans, home mortgages, credit cards, auto loans, home equity loans, and personal loans.

  • Corporate & Investment Banking (33% of revenue and 44% of earnings): helps companies raise debt and equity capital, advises on corporate strategies (turnarounds, mergers & acquisitions), provides treasury services to the U.S. government (selling Treasury bonds), investment research, and prime brokerage services (clearing house of stock and bond markets). This segment also services as a fund custodian ($23.5 trillion under custody) for asset managers, insurance companies, and public and private investment funds.

  • Asset & Wealth Management (13% of revenue and 9% of earnings): provides wealth management services across various asset classes including: equities, fixed income, alternatives (hedge funds, private equity funds), and money market funds. This segment provides retirement services to large individual accounts, as well as trusts and estates. 

  • Commercial Banking (8% of revenue and 14% of earnings): provides lending, investment banking, and asset management services to corporations, municipalities, financial institutions, and nonprofit entities. It also finances commercial real estate development. 

Business Analysis

During the financial crisis large banks, long believed to be low-risk stocks, proved to be anything but. However, JPMorgan Chase, thanks to its far more conservative banking culture, largely avoided the subprime mortgage meltdown and managed to remain profitable. That's something that only one other major U.S. bank was able to do (Wells Fargo).

Today banking regulations have become far more stringent, thanks to the passage of the Dodd-Frank law and Basel 3 international banking accords. These regulations eliminated proprietary trading and significantly raised capital requirements on banks, effectively limiting how much leverage they could use to generate profits from their various businesses.

Despite these constraints, JPMorgan Chase has managed to return to record profitability. In fact, excluding the one-time $2.4 billion negative effect of tax reform (mostly due to repatriation taxes), JPMorgan finished 2017 as the most profitable major U.S. bank.
Source: JPMorgan Investor Presentation
And thanks to its ongoing cost-cutting efforts, its efficiency ratio (operating costs divided revenues) also fell to its lowest level in the company's history. The bank also benefited from rising interest rates, with its net interest margin (lending rates minus interest costs of capital) rising 20 basis points between Q4 2016 and Q4 2017. This allowed the bank, despite its massive size, to post strong double-digit EPS growth.

Going forawrd, JPMorgan is firing on all cylinders and has numerous growth catalysts that could lead to further earnings growth. 

For example, thanks to its ever-growing economies of scale, Morningstar estimates that over the next few years JPMorgan's efficiency ratio will decline further, and remain the lowest of any major U.S. bank.
In addition, management estimates that each 1% increase in long-term interest rates, will generate an additional $2 billion a year in net interest income.

Combined with the bank's falling operating costs, these higher net yields on loans mean JPMorgan's earnings per share could continue rising at a high-single digit rate for at least the next few years. 

Shareholders should benefit from this given that management has made returning profits to shareholders a key priority. For example, in 2017 the bank paid out 98% of net profits in the form of buybacks and dividends (including a 13% dividend hike).

The key to JPMorgan's long-term success will be whether or not it can continue maintaining a very conservative corporate culture and safe balance sheet across such a large and complex mix of businesses. 

Thus far the bank has been able to effectively leverage its complexity to the benefit of shareholders. For example, JPMorgan is the number one credit card issuer in America, and its retail banking services are used by about half of all U.S. households.

The bank has also been steadily gaining market share in small business loans in recent years, and now has about four million such accounts.
Source: JPMorgan Investor Presentation
JPMorgan is also the leading global generator of investment banking fees and has the largest fixed-income, commodities, and currency trading operations in the world.

The bank is also the third-largest asset custodian with $23.5 trillion held for various governments and financial institutions around the globe. And its wealth management businesses oversees $3.1 trillion in assets.

All of which means that JPMorgan enjoys meaningful advantages in an otherwise highly competitive industry. By offering its customers, both consumer, small business, and corporate, a one-stop shop for all their financial needs, JPMorgan is better able to create higher switching costs and sell additional products to existing customers. This is why JPMorgan is able to generate far more non-interest fees than most other banks, further helping to diversify its income stream.

However, as the financial crisis showed, no matter how profitable a bank's operations are in the short-term, high profits are meaningless if the bank's balance sheet is a dangerous mix of potentially explosive toxic assets that can bankrupt the institution during an economic downturn.

Fortunately, JPMorgan's CEO Jamie Dimon has proven to be one of the most conservative bankers in the world, instilling a relatively disciplined low-risk culture at the company. For example, the Federal Reserve sets a minimum common equity tier 1, or CET1, ratio for large Global Strategically Important Banks, or GSIBs (too big to fail), of JPMorgan's size at 9.5%.

CET1 is the ratio of a bank's retained earnings and common equity over its risk-adjusted assets. This ratio is set to a level that the Fed estimates would keep the bank solvent even during a worse global economic downturn than what happened in 2008-2009.

JPMorgan's CET1 fully adjusted to the strongest Basel 3 2019 standards (the gold standard in capital requirements) finished the year at 12.7%. Management plans to always maintain the company's CET1 in a range of 11% to 12%, indicating a dedication to what it calls its "fortress balance sheet."

Among U.S. mega banks, JPMorgan is arguably one of the best in the market. Its strong competitive advantages across all its major business lines, combined with one of the safest balance sheets in the industry and its very low cost structure, mean impressive earnings and dividend growth is likely to continue. Importantly, this growth comes with relatively less risk compared to JPMorgan's peers during the next economic slowdown.

Key Risks

While JPMorgan Chase is arguably the highest quality big bank in America, there are still many risks that might make it unsuitable for some investors.

For one thing, like all global banks, JPMorgan's finances are incredibly complex, effectively making it a "black box" that might hide some nasty surprises which may not become evident for years.

Another thing to consider is that the very large size of the bank could also work against it in the future. For one thing, the Federal Reserve, which regulates all U.S. banks, isn't likely to allow it to grow through acquisitions as it has in the past. 

This is because JPMorgan is in the top tier of GSIBs, meaning that it has extra regulatory scrutiny compared to smaller rivals. As a result, it faces higher capital requirements which effectively put a cap on how high its profitability can get.

Then there's the issue that JPMorgan's impressive growth over the last few years, such as its double-digit deposit growth, has begun to slow. That's simply a result of becoming so large that it becomes harder to move the needle in regards to further growth.

For example, between 2013 and 2017, deposits grew on average 13% a year. However, in 2017 that rate dropped to 9%, and in 2018 management expects deposits to increase just 6% to 7% a year.

More importantly, while JPMorgan is expected to benefit from rising interest rates, the pace of the benefit is also expected to slow. For instance, in 2018 net interest revenue is expected to grow 8%, but then just 3% a year over the medium-term.

That's because up until now JPMorgan's costs of capital (such as interest paid to depositors) has been growing much slower than the rates on its loans. However, in the future increasing market competition means that rising rates will mean that its borrowing costs will finally start rising, potentially resulting in a slowdown in its net interest margin spread. 

And we can't forget that one of the biggest reasons for JPMorgan's strong earnings growth in the past few years has been a long and steady economic expansion. For example, the bank's most profitable segment (global investment banking) is prone to wild swings in fortune based on the fickle nature of equity and bond markets around the world.

At the end of the day, all global banks' earnings are volatile and highly exposed to the underlying health of the U.S. and global economy. Eventually a recession will cause JPMorgan's earnings to fall significantly as new loan demand declines, defaults rise, and dealmaking slows.

While bank stocks would likely underperform in such an environment, their long-term earnings power shouldn't be affected. Importantly, banks are also much better capitalized than they have ever been as a result of new regulations. Here is what Buffett said about banks in a 2013 interview:

“The banks will not get this country in trouble, I guarantee it. The capital ratios are huge, the excesses on the asset side have been largely cleared out. Our banking system is in the best shape in recent memory.”

Finally, it's worth mentioning that the Federal Reserve has to approve each year's capital returns via its annual Comprehensive Capital Analysis and Review, or CCAR. This means that JPMorgan's annual dividend increases need to gain regulatory approval after each year's stress test.

Over time, these tests have been getting more stringent and the Fed has indicated that it wants banks to pay out around 30% of earnings as dividends. This is to give them a wider safety cushion during the next economic downturn, so that bank failures and hopefully dividend cuts can be avoided.

However, even factoring in the benefits of tax reform, JPMorgan's 2017 payout ratio came in at about 28%. This means that going forward, the dividend is only likely to grow during good economic times, and only as fast as earnings per share. 

In other words, investors are not likely to see the kind of double-digit dividend increases of the past few years. And what increases they see are likely to be volatile, with payouts likely frozen during times of economic distress.

Closing Thoughts on JPMorgan Chase

JPMorgan is arguably the highest quality large bank in America. The company's highly conservative banking culture means that despite its massive size and complexity, it was able to work through the financial crisis largely unscathed and remained profitable the entire time. 

Management is also very impressive. Jamie Dimon has created a corporate culture that balances fast growth in attractive global markets with a strong underwriting discipline and a focus on maintaining one of the safest balance sheets of any major bank in the world. 

Combined with its massive economies of scale and large base of low-cost deposits, JPMorgan has been able to continue winning market share and cutting costs to become the most profitable big bank in America. In addition, the bank's cash return policies have proven very friendly to shareholders, resulting in strong dividend growth. 

That being said, banking is a highly complex and cyclical industry, one that isn't for everyone. And thanks to the Fed's payout ratio cap, no major bank is likely to be able to offer the kind of generous dividend growth over time that many investors want. 

While JPMorgan offers one of the fastest-growing and safest payouts among its major peers, more conservative investors might still want to consider whether or not they really need to own any major banks at all.  

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