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JP Morgan Chase’s (“JPM”) stock price has had a great run in 2019. Up 42% year-to-date, JPM now trades at 2.33x tangible book value per share (“TBVPS”). JPM has been repurchasing a ton of its own stock. In June, the Federal Reserve did not object to JPM’s plan to repurchase $29.4 billion of stock over the next 12 months. In Q3, JPM repurchased $6.7 billion of stock. However, at this valuation, the company is not enhancing shareholder value with its stock repurchases and should pause stock repurchases until there is a better opportunity to deploy capital.
Stock repurchases when the stock trades above book value hamper tangible book value growth. When a bank’s stock trades closer to tangible book value, and the bank has excess capital, it makes sense to use the excess capital to repurchase stock. The earnings per share of the bank increases due to the lower share count and book value is not affected by much. By repurchasing stock at 2x tangible book, earnings per share increase marginally, but tangible book value declines. After three years of higher earnings per share, the bank’s tangible book value recovers the initial dilution. Repurchasing shares at multiples of TBVPS above 2x pushes out the recovery of book value further both because the initial dilution is greater and the increase in earnings per share is reduced.
Financial stocks go through valuation cycles, and book value will matter in the next downturn. With JPM’s financial success over the past 10 years, investors and analysts are valuing the bank on a price-to-earnings basis, rather than, a price-to-TBVPS basis. But this will not always be the case. When we go through the next turbulent economic period, investors may once again consider JPM’s stock compared to its tangible book value. At that time, it will have been better not to dilute book value through stock repurchases at high multiples of tangible book. In fact, most of JPM’s competitors are valued by investors primarily on price-to-tangible book, such as Citigroup, Goldman Sachs, Credit Suisse, and Barclays.
The bank is better off retaining capital and deploying it when opportunities are more attractive. When a bank defers deploying excess capital into stock repurchases, the option to repurchase stock in the future still exists. If the stock were to decline, the bank could buy more shares back at a better valuation. Berkshire Hathaway does this by making their buyback dependent on the stock’s valuation. The Sandler Family at Golden West Financial were among the best at timing the repurchases of their own stock. They waited for the valuation to be attractive. Raymond James Financial’s management team has long had a 1.5x book value target for buying back their stock.
JPM’s alternatives to repurchasing stock are limited because they already invest as much as possible into organic growth, and their acquisitions are limited due to their existing market share of banking deposits. JPM’s best use for capital is to reinvest in its core business. However, JPM generates so much capital that it can only reinvest 30-50% of the new capital generated in its business. Normally, bank management would look to make acquisitions as the second best use of capital, but in 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act imposed a provision that limited banks from making acquisitions if after the combined entity’s market share of bank deposits was greater than 10% nationally. As of 2018, JPM’s market share of deposits stood at 10.35% (banks are allowed to grow organically above the 10% threshold). This law prevents JPM from acquiring any company that has deposits, so it can’t enter new markets like Philadelphia and Boston by acquiring a small competitor. It also prevents them from acquiring an online broker like E*Trade because E*Trade operates a bank and has deposits.
One potential avenue for JPM to pursue in M&A is purchasing loan portfolios from other banks. An example might be a credit card portfolio or a specialized lending platform. However, we have not seen JPM be aggressive in this area even though there has been ample opportunity for them. Examples of deals they passed on were the Costco and Wal-Mart credit card portfolios or the various lending portfolios of GE Capital that came to market as General Electric was exiting financial services.
The most realistic option for JPM’s excess capital is to retain it and wait for a better opportunity to deploy it. The opportunity that will likely come will either be a decline in JPM’s stock price or an improvement in JPM’s valuation because the earnings grow into the current stock valuation.
Another long-term opportunity for deploying excess capital could be if the 10% deposit caps are lifted. I believe that the current political climate for large banks makes this scenario unlikely, but if we had another time of financial stress, we could see a scenario where the deposit cap is lifted so large banks could acquire distressed banks. JPM acquired Bear Stearns and Washington Mutual in 2008. In late 2008, there was some speculation that the 10% deposit cap would be lifted in a scenario where additional institutions needed to be acquired.
Not everyone will agree that JPM should pause stock repurchases. Some may argue that excess capital could be trapped at the big banks. Another argument might be return on equity will decline if banks hold excess capital. Others may fret that pausing share repurchases is a poor signal to send to investors. And others may worry that excess capital retained by management will be wasted.
I believe a reasonable argument is the regulatory window is open for repurchases, so JPM should continue to use repurchases to get excess capital back to shareholders while the Fed is permissive. I would argue that the Federal Reserve has reached a steady state with the CCAR stress tests and with banks using repurchases to return excess capital. In fact, we have seen instances where the Fed has allowed banks to repurchase stock greater than 100% of their net income in an effort to manage down their capital ratios. I believe the current Fed policy regarding stock repurchases and managing down capital levels is a semi-permanent policy position. JPM management and shareholders should not worry about trapping capital if management paused buybacks because the stock price is too high.
Some investors may worry that Return on Equity (“ROE”) will decline if the company retains excess capital. Yes, this is the math. If the company retains equity that it can’t use in its business, then the ROE of the company will decline. Of course, the core ROE of the business remains unchanged. The company will just have excess capital. It could use the excess capital in the future. I believe stock market investors are adept at evaluating what a bank’s core ROE is and how much excess capital it holds.
Proponents of continued repurchases may argue that by pausing the stock repurchases, the company will be sending a bad signal to investors. After all, if the company thinks the stock is too expensive to buy, then why should investors buy the stock for themselves? This view assumes that all investors use the same framework for investments at the company. Some investors use momentum framework. Others look at earnings revisions. Because a company’s decision to repurchase stock is a semi-permanent one, they should use a long-term, value-based approach.
Others may argue that the company should return excess capital to shareholders so they can redeploy the funds into other businesses that need the capital. My view of this is the shareholders who would sell into a repurchase by the company can still sell into the current share price to redeploy their capital into other businesses. It doesn’t matter to them, nor do they know whether the company is buying their shares. The reason JPM’s stock price is so high is because shareholders don’t see other opportunities to redeploy their capital.
My opinion that JPM should pause their stock buybacks due to the stock’s high valuation is not controversial. It is basic corporate finance. I also believe that Jaime Dimon would agree with me. In fact, he’s made several public statements expressing a similar opinion.
“I would prefer to spend that money not buying back stock but doing [building bank branches.]… Growing our business is far better for the economy. Right now we don’t have a lot of choices. But over time I really would prefer not to buy back stock.”
“Stock buyback, in my opinion, is a very good thing to do when your stock is cheap… The highest and best use of our capital is reinvesting it and we are starting to do that now… This notion that you should buy back stock at three times tangible book value as a return of capital to shareholders is crazy.”
In his letter to shareholders in the 2018 Annual Report, Dimon talks about share buybacks at 1x tangible book versus 2x tangible book:
“In prior letters, I explained why buying back our stock at tangible book value per share was a no-brainer. Seven years ago, we offered an example of this: If we bought back a large block of stock at tangible book value, earnings and tangible book value per share would be substantially higher just four years later than without the buyback. While we prefer buying back our stock at tangible book value, we think it makes sense to do so even at or above two times tangible book value for reasons similar to those we’ve expressed in the past. If we buy back a big block of stock this year, we would expect (using analysts’ earnings estimates) earnings per share in five years to be 2%–3% higher and tangible book value to be virtually unchanged.”
the JPM’s stock valuation rises above 2x TBVPS, the earnings accretion declines
and the tangible book value recovery extends to future years. Current share repurchases reduce optionality
for future capital deployment if opportunities appear. With JPM trading at 2.33x TBVPS, management
should pause the share repurchases and hold onto the excess capital. I would not be surprised if management made
some commentary to this extent on their earnings conference call on January 14th.