By
I have had an experience.
Last week, I reported on the seemingly stellar earnings of J.P. Morgan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %>, wondering why in darnation the stock was collapsing. My conclusion was that "the stock market is whacky."
I still believe the stock market is whacky; but this had little to do with J.P. Morgan's selloff.
One of the marvelous gifts of Fooldom is the information exchange available as people in our community offer unique perspectives on stock market happenings. Together we inform, educate, and amuse. In this cooperative vein, I was educated by a wonderfully Foolish new friend, James Abbot of SNL Securities. Here is an excerpt from his note to me.
"I cover JPM as part of my job at SNL Securities, and noticed your article on its earnings, and thought I'd shed some light. This is an article our newswriter put together. He was headed down the same path you did until I pointed out to him the sale of an interest (a very large $$ amount) in a foreign bank and the highly questionable (that's the politically correct way for an analyst to wonder about earnings management) practice for a bank/thrift to reverse its provision for loan losses. (If you're unfamiliar with this practice, or how much Arthur Leavitt, chairman of the SEC, hates it, ask SunTrust Bankcorp. what the SEC required of them a couple of years ago.)
"I hope this helps you understand why JPM actually missed estimates and the market has reflected that. Also, with the sale of the interest in the foreign bank, the revenue stream from that institution no longer exists, and therefore the Net Present Value (NPV) of the company -- reflected in the stock price -- would necessarily decline unless JPM shows it has found another project to invest the sale proceeds which has a higher NPV."
Here are the relevant excerpts from the report to which he referred, which was prepared by SNL's Paul Davis:
"The fourth quarter for J.P. Morgan & Co. obliterated consensus estimates. However, the bank would have missed analysts' estimates had it not reported a loan-loss provision reversal and the sale of its interest in a foreign bank during the period.
"The bank showed an exceptionally strong fourth quarter, earning $509.0M, or $2.63 per share, compared with $89.0M, or 42 cents per share, in the year-ago period. The total surpassed the consensus estimate of $2.01 per share.
"Approximately $1.00 of J.P. Morgan's fourth quarter EPS could be attributed to $25.0M from a loan-loss reversal provision and $140.0M from the sale of an investment in Bank of the Philippine Islands, based on the bank's 164.8 million shares outstanding as of Dec. 31. Subtracting those gains, fourth quarter EPS would have been $1.63, missing the consensus by approximately 38 cents."
Aha! Even though J.P. Morgan's revenues were up 46% from the year-ago period, and up 31% from 1998; even though investment banking revenues were up 17% from the year-ago period, and up 19% from 1998; even though revenue from equities doubled from a year ago, there was some information in the annual report that lead analysts to question just how wonderful all those numbers really were.
First, in industries other than banking, the sale of a huge stock holding is not counted as "real" earnings. It's like selling your house. You might have some extra cash for a while, but you'll most likely have to reinvest in another house soon, and it does nothing for your income next year. Perhaps because J.P. Morgan is an investment bank and this was technically the sale of a security on which they routinely make a profit, the sale wasn't flagged as a one-time charge like it would have been had they sold a wholly owned subsidiary. But apparently the more astute analysts considered it more like the sale of a subsidiary than a stock trade. Also, as Mr. Abbot points out, there's now a hole in the future revenue stream. The earnings from the bank that was sold will need to be replaced. Perhaps J.P. Morgan has an investment in mind that will do that, but uncertainty is never good for stock prices.
The "reversal of loan-loss provisions" is also something that raises concerns. Banks always set aside cash from earnings to cover loan defaults. Basically they have to guess at how much they will need. When economic times improve, as they have, the bank may find that it has set aside too much cash. Normally a bank will fix that problem by simply reducing or eliminating the loan provision set aside for a few quarters until things are back in balance. In this case, however, J.P. Morgan didn't just forgo setting aside money for bad loans, they reversed some of their past bad loan provisions -- adding the money back into the money earned from interest this year. In effect, they shifted income from last year to this year.
There may be very good reasons to have reversed those loan-loss provisions (and the annual report does mention that their "impaired" loans ledger is looking much better these days), but it raises eyebrows. Especially when the money came out of a year when the stock was in free fall anyway and was added to a year where it was important to show a strong recovery.
I am grateful for friends like Mr. Abbott who constructively point out my mistakes... er, experiences. This highlights why a mechanical strategy like the Foolish Four is such a great investment tool. As a Foolish Four investor, it isn't necessary to scour earnings reports and look between the lines. Nope. All one needs to do is purchase the Foolish Four stocks and hold them for a year and a day. Or, like J.P. Morgan, sometimes two years and a day.
However, it behooves us to become as educated as possible, especially if we want to begin purchasing individual stocks for our portfolios. If you want to become a better analyst, visit our Valuations area and brush up on your skills. See ya there!