XLF is OK, but JPMorgan Chase is much better (NYSE:JPM)

JoeDunckley

Thesis

As detailed in our previous article,

We use a top-down investment approach. We use a market dashboard to first take a view from 30,000 feet. We then decide where to look further – which sector, growth stocks, value stocks, bonds or precious metals, et al.

With this approach, the thesis of this article is twofold: the financial sector is the 3rd currently the most attractive sector of the market, and JPMorgan Chase (NYSE:JPM) is even more attractive among financial stocks. More precisely,

  • The financial sector, represented by the Financial Select Sector SPDR Fund (NYSEARCA:XLF), is currently the 3rd most attractive market sector based on our sector scorecard (and you can download it here). Its dividend yield is above the top quartile (23% percentile deducted from its 0.77 dividend yield score) in a decade. And its yield spread over risk-free rates is also ranked in the top 3 among all sectors, as you can see. Other sectors with higher dividend yields and higher yield spread Z-scores are small caps and energy.
  • In this context, the second graph shows that JPM is even more attractive than the financial sector on average. JPM offers superior profitability (over 50% as measured by ROE), better growth (over 31% as measured by dividend increases over the past 5 years), and better consistency and lower volatility, as we will see later. Don’t worry about JPM’s slightly higher price-to-sales ratio (2.66 vs. 2.38). JPM’s net profit margin is so much higher that its price-to-sales ratio is actually lower once the margin is adjusted. Still, JPM is on sale at around 24% discount to XLF in terms of PE multiples.
  • Especially when we use dividends as a proxy for owners’ return, JPM is currently yielding 3.5%, about 1.44% above XLF’s 2.06% return. Such a spread is close to the thickest level in the past decade, signaling an attractive entry opportunity for JPM.

Note that we used a similar approach in a previous article comparing T. Rowe Price (TROW) Vs. XLF. The main differences in this article are also twofold. First, when this article was published in April 2022, the financial sector was not as attractive as it is now compared to other sectors. Second, JPM and TROW are also different. JPM and TROW under different price levels and trade outlook in April. And JPM’s business model as an integrated bank is different from TROW’s as an asset management company.

Also note that all data comes from either Yahoo Finance or Seeking Alpha after the market close on July 8. Given the high volatilities these days, these numbers may have changed when you read this article.

We will then expand on the above points immediately below.

Market Sector Dashboard

Source: author

JPM vs. XLF

Source: author

XLF and JPM – basic information

XLF is a popular financial sector fund that needs no introduction. At the time of this writing, he holds a total of 70 in the financial sector, as you can see in the following table. JPM is the second largest holding company, accounting for over 9.5% of total assets.

Given JPM’s large allocation to the fund, it’s no surprise that the price actions of the fund and the stock are highly correlated, as you can see in the second chart below. Although JPM provided much better performance than XLF. Since the fund’s inception in 2000, XLF has generated an annual return of 4.2% CAGR, while JPM has generated over 6.7%. Such a performance, cumulated over the year, led to a big difference in total return. And as you can also see, JPM has tracked or outperformed the overall market most of the time. But XLF has always lagged the overall market after the financial crisis.

A closer look also reveals that JPM actually suffered lower price volatility in terms of worst performance of the year and maximum drawdowns. XLF suffered the worst performance of the year of almost 55% and an agonizing maximum decline of 78% (which will require a 350% rally to break even). In contrast, JPM’s worst performance of the year and maximum declines were “only” around 30% and 65% (which still requires a 185% rally to break even).

To me, that’s a sign of the strength of JPM (or the nature of XLF diworsification). Adding a bunch of extra inventory into XLF actually increases risk at the worst times, when you need security the most.

XLF ETF Top 10 Holdings

Looking for Alpha

Growth of the XLF ETF portfolio

Source: www.portfoliovisualizer.com

JPM’s Superior Profitability

The following chart shows JPM’s profitability in terms of ROE (return on equity). ROE is presented here based on annual financial data provided by Seeking Alpha. As can be seen, JPM’s ROE averages around 12.49%, very close to XLF’s ROE of 12.4%. Note, however, the improving trajectory of JPM’s ROE. It has gone from the level of around 10% over the years to the current level of 19.01%, which is not only significantly higher than its historical average, but also higher than XLF by around 50%.

Return on Equity JPM

Looking for Alpha

Looking ahead, I expect JPM’s industry superiority to expand further for two considerations:

  1. Its state-of-the-art scale and integrated business model. It’s probably the best-run integrated bank, with well-diversified revenue streams, as you can see in the next chart. Its Consumer & Community Banking segment generates the most revenue, around 40% of total revenue, followed by Corporate & Investment Bank (around 18% of total revenue), then by Asset & Wealth Management (around 7.4% of total revenues). Deposits and investment assets have shown healthy growth, and stabilization or recovery in the mortgage, credit card and auto categories may create further growth.
  2. The bank benefits from a fortress balance sheet. He maintains the credit measures of the fortress. As a result, it is well positioned to expand its business, weather future economic uncertainties, and increase shareholder value through dividend increases and share buybacks.

Admittedly, JPM faces volatile and challenging environments ahead (more on this in the risk section). But everyone in the financial sector is too. And I think JPM is in a better position than the average industry to navigate uncertainties with its cutting-edge scale and diverse revenue streams.

JPM Revenue Exposure

Edge Merrill

Dividends as a measure of owners’ income

Now let’s move on to valuation. As mentioned at the beginning, despite its superior profitability and scale, JPM is actually significantly undervalued compared to XLF. Its 10.11x PE is about 24% lower than XLF’s 13.2x PE.

Another effective way to gauge their valuations is their dividend yield, as dividends provide a reliable measure of owners’ income, as detailed in our previous article. JPM currently yields 3.5% and XLF 2.06%, so JPM offers a yield spread of 1.44% above XLF.

The following chart puts the 1.44% yield differential in historical perspective by showing the yield differential between JPM and XLF over the past decade. As can be seen, the spread is positive most of the time because JPM has always paid a higher dividend yield than XLF in the past, on average around 0.75%. Additionally, you can see that the spread is limited and treatable most of the time. The spread was between about 0.25% and 1.25% most of the time. Such a tradable YS suggests that when the spread is near or above 1.25%, JPM is significantly undervalued relative to XLF.

You can see the screaming buy signal for JPM in 2013 when the yield spread jumped above the 1.25% level. And now we see a similar signal with the yield spread reaching 1.44%.

Automatically generated chart description

Author

This next chart shows that their relative performance is positively correlated with their yield spread. It shows the 1-year total return (including price appreciation and dividends – both regular and special) of JPM minus that of XLF when purchased at different yield spreads. You can see there is a clear positive trend and the Pearson correlation coefficient is 0.37. Again, the current yield spread of 1.44% is close to the thickest level of the historical spectrum in a decade, as shown.

ROI JPM vs. XLF

Author

Summary and risks

We follow a top-down approach: first we get the big picture, then we look at attractive sectors for specific investment ideas. Our sector dashboard shows that the financial sector represented by XLF is now the 3rd most attractive sector. And its flagship stock, JPM, is an even more attractive buy due to its above-industry-average profitability and discounted valuation.

Finally, we would like to highlight the risks, both to our general approach and also specific to JPM. As detailed in our previous article,

  • The yield spread measures the RELATIVE risk premium and does not guarantee a positive ABSOLUTE return. It is a reliable method to accumulate more securities given in terms of SHARES, but not in dollars. Absolute return is determined by both the number of stocks you own (which the yield spread can help) and their prices (which the yield spread cannot predict).
  • Finally, dividend yields do not always reflect the activities fundamentals due to several factors such as tax laws, political climate, stock index composition, etc. Therefore, we do not directly use the yield spread in our investment or asset allocation decisions. In practice, we first adjust the above corrections and then use the adjusted yield spread in our investment decision. But the data and approach shown here is the first place we check.

Specific to JPM, it faces several macroeconomic uncertainties, including the Russia/Ukraine situation as well as Fed hike expectations. The following Q&A during its April earnings report (abbreviated and underlined by me) illustrates these uncertainties quite accurately:

Questions from John McDonald of Autonomous Research: I was wondering about the net interest income outlook… evidently, rate expectations have risen since then. Could you give us some color on the kind of assumptions that underlie the outlook for non-market net interest income?

Answers provided by Jeremy Barnum, JPM CFO: Good question. And yeah look obviously given what’s happened in terms of Fed hike expectations and what’s in question at the front of the curve we would be actually expect the $53+ billion access portion to be larger than it was at Credit Suisse. So to assess that, probably a few million dollars.

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