Summary
This article analyzes the JPMorgan Chase stock under the framework of Buffett’s 10x Pretax Rule.
The results show that it presented an excellent opportunity and offered favorable odds for Buffett when he made his purchases.
At its current valuation, it is near fair valuation and offers favorable odds for double-digit return with long-term safety.
William Barton/iStock Editorial via Getty Images Thesis and Background
The thesis of this article is really simple. A stock with the quality of JPMorgan Chase ( JPM ), when traded near 10x pretax earnings, offers favorable odds for double-digit return according to what I call Buffett’s 10x Pretax Rule. The grandmaster himself had so many great successes with this rule. Many of his largest and best deals (including JPM) were made at entry prices near or below ~10x pretax earnings. JPM at this point is trading close to 10x FW pretax earnings. As such, you will see in the remainder of this article that an investment here is similar to owning an equity bond with about 10% yield and, at the same time, with a coupon payment that increases ~6% per year. JPM and Buffett: brief history
If you’re a devout Buffett cultist like this author, you must have noticed or heard that the grandmaster paid ~10x pretax earnings for many of his largest and best deals. The list is a really long one, ranging from Coca-Cola (NYSE: KO ), American Express (NYSE: AXP ), Wells Fargo (NYSE: WFC ), Walmart (NYSE: WMT ), Burlington Northern, and the more recent Apple (NASDAQ: AAPL ) and, of course, JPM as seen from the chart below. The results of all of these investments have turned out to be fantastic. Buffett himself also mentioned and discussed the 10x pretax multiple times in his shareholder meetings and Q&A sessions. An example quote is provided below (highlighting was added by me): Buffett: “Geico would be valued differently than Gen RE and other insurance businesses because it’s rational to assume a large underwriting profit and significant growth. You cannot say that about many insurance businesses. I would love to buy a new bunch of operating businesses with similar competitive positions to the ones we own now at nine to ten times pretax earnings. ” The following chart shows the price history of JPM and Buffett’s major purchases of it. Pretax earnings are also referred to as “EBT”, Earnings Before Taxes, in this article. In general, when the price was far above 10x EBT, it had been a good time to sell and vice versa. In particular, note that Buffett has PERSONALLY owned the stock in 2012 as shown below. And Berkshire Hathaway (NYSE: BRK.A )(NYSE: BRK.B ) added more than 35 million shares of JPM in the quarter ended September of 2018 according to the firm’s latest filing at the Securities and Exchange Commission also as shown below. At the peak of his holdings, his JPM position was worth more than $8B.
Overall, the market price generally tracked 10x EBT. The major exception was during 2012 and 2013, when the entire banking industry went through an abnormal earnings cycle due to the aftermath of the Eurozone debt crisis that started in 2011. As seen, during that period, JPM (together with the rest of the banking section) traded substantially below 10x EBT. This period of time offered a golden opportunity (and Buffett seized it).
The results also show that at its current valuation, JPM is at a perfect fair valuation. It is trading at 10.4x pretax rule now. And we will see next what such a valuation means. Source: Author based on Seeking Alpha data Warning and clarification
More details of what I call the 10x pretax rule can be found in my earlier writings such as this one on BTI . Here, before I go any further, a couple of clarifications and a strong warning are in order.
First, the master did not always pay 10x pretax himself. But there must be something fundamental to it given how many times he did it, the success he had with it, and how many times he mentioned it.
Second, why pretax earnings? Out of all the earnings metrics, EPS, operation income, free cash, dividend, etc., why do we favor the pretax earnings? There are at least two good reasons. After-tax earnings do not reflect business fundamentals. Taxes can change from time to time due to factors that have no relevance to business fundamentals, such as tax law changes and capital structure change. Plus […]
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