I admit, this post is noise. For a little experiment I made a list of everything I read online today (including  non-investing related reading).

• ATS Automation annual report. (We mentioned the company in passing back in November.)
• An analyst cuts his view on the the auto parts sector.
• The Government is asking for more information on the Waste Management big for Republic Services. (Republic has said the $37 bid substantially undervalues the company.)
• Sears Canada seems to be doing well. (Sears Holdings reports tomorrow. Is it just me or are newspapers using analyst reports as news now? where did investigative journalism go?)
• I’m a huge NFL fan, so i found this story amusing. ($100 if you knock the football out of his hands and $500 if you bring it to the running backs meeting.)
• CEMEX 2Q Results. They certainly appear to be paying back the Rinker debt quickly. I like how they break out “expansion capital expenditures from Maintenance cap-ex, I wish every company did that.)
• Icahn is always worth reading. The post, on proxy contests, resonates with us given our investment in Steak n Shake and our attempt at iActivism.
• What is a Hobson’s choice?
• I love reading the WSJ Law Blog.  Today they point out a reference to an episode of Sienfield in a legal opinion!
• Consolidation in HVAC? Does this mean good things for KSW? (Thank you Jeff.)
• First Industrial, an old Buffett pick, signed a new warehouse lease.
• The surprising way wind turbines kill bats. (Hint: it’s not what you probably think.)
• What if the best way to conquer obesity is to have fat injected into your stomach?
• Margin pressures for restaurant companies.
• Cut costs like Avon, not home depot.
• Large US corporations might start using international accounting rules as soon as next year.
• 42% of corporations now offer a telecommuting option to some employees.
• Mr. Market’s overreaction on JTX is good news for investors in the company.
• The beginnings of an operational advantage for NASDAQ?
• A very short bankruptcy.
• Interesting. I wonder where Tom Brady would have ranked when he was 3rd on the depth chart?
• 10Q Detective did a post on O’Charley’s. (We put out an Intrinsic Value report on CHUX a while back. The market hasn’t agreed with us yet. Meanwhile the company is retiring shares at a pretty fast clip.)

If you like this post let me know, and i’ll do more of them. If not, it’ll be the last one I promise!

I think the picture says it all.

The numbers above seem to indicate that Sardar was right when he stated, “In my view, our poor performance is not the result of poor economic conditions. Much of our operating shortfall, I believe, is the result of our own lack of execution.”

It is hard to imagine something more difficult than trying to determine the intrinsic value of a bank right now.  The combination of complexity and a tendency towards subterfuge make understanding the risks involved near impossible.

Morningstar, a company that provides independent advice to the average Joe on equities and mutual funds, appears to have taken a liking to JPMorgan.  Warren Buffett clearly thinks highly of their CEO.

It appears that Morningstar blindly regurgitates JPMorgan’s unchallenged assumption that they have a “fortress” balance sheet. The investment advice company argues that this strength makes JPM a good investment. The logic is simple enough – if a company has a fortress balance sheet then they are likely able to grow intrinsic value in tough economic environments such as this one.

Morningstar places a “fair value” estimate on JPM of around $60 per share.  In fairness to Morningstar they could be right — JPMorgan could be worth north of $60. However, sometimes in life we luck out. We have a positive outcome but for all the wrong reasons.

For example, consider someone who buys shares in a hot stock on a friends tip. The shares in the company  proceed to double the following week. After cashing out, the buyer experienced a positive outcome, but for the wrong reasons. If Morningstar is right about JPMorgan, I think it would be a case of bad process - good outcome.

I question whether JPM has a fortress balance sheet. More than that, I question how anyone can make a sound argument that they understand the risks involved with JPM’s loan and derivative exposures.

In the section of Morningstar’s report entitled ‘risk’ they offer:

“[JPM] could suffer additional mark-to-market losses on securities held at its investment bank including $16 billion in legacy leveraged loans and related commitments, $12 billion in commercial mortgage-backed securities, $20 billion in prime and Alt-A mortgage-related securities, and $1.9 billion of subprime mortgage exposures.”

It’s odd that Morningstar uses the words mark-to-market and fails to mention any permanent losses that might be incurred. A couple of billion here and a couple of billion there and sooner or later you might be talking some real money.

However, what concerns us about JPMorgan has nothing to do with their loans but rather one of their opaque profit centers know as derivatives.

Morningstar admits, “[that] it is difficult to quantify the risk surrounding J.P. Morgan’s $77 trillion notional derivatives exposure.” Further elaborating on the subject they go on to say “it is nearly impossible to get a grasp on the real underlying risk this exposure creates.”

If Morningstar doesn’t understand the risk involved with an investment, how on earth can they determine a fair value?

Last week NoiseFreeInvesting penned an article on financial risk. In the article we detailed a fundamental concept: sometimes what matters most is not the probability of loss, but what matters more is the consequences of that loss.

As an independent financial advice shop, I expect it would be easy for them to say “we’re dropping coverage because we no longer understand the risks associated with an investment in JPMorgan”. Perhaps  Morningstar has lost their independence. If you can’t measure risk, how can you value it?

We have a Morningstar membership (but likely won’t renew when it comes due as we feel the quality and logic of their analysis is starting to suffer).

Three interesting articles from the New York Times today.

It is simply impossible, Pastorek has come to believe, for a traditional school system, run from the top down by a central administrator, to educate large numbers of poor children to high levels of achievement. “The command-and-control structure can produce marginal improvements,” he told me when we met last month at a coffeehouse on Magazine Street. “But what’s clear to me is that it can only get you so far. If you create a system where initiative and creativity is valued and rewarded, then you’ll get change from the bottom up. If you create a system where people are told what to do and how to do it, then you will get change from the top down. We’ve been doing top-down for many years in Louisiana. And all we have is islands of excellence amidst a sea of mediocrity and failure.” Full Article.

On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. Full Article.

In Ahead of the Curve Mr. Broughton goes beyond the regurgitation of classroom notes on management techniques to offer a sociological critique of the school’s stated mission “to educate leaders who make a difference in the world.”

“Business schools no longer produce just business leaders,” Mr. Broughton says. “M.B.A.’s determine the lives many of us will lead, the hours we work, the vacations we get, the culture we consume, the health care we receive, and the education provided to our children.”

“Sometimes, what matters is not so much how low the odds are that circumstances would turn quite negative, what matters more is what the consequences would be if that happens”  Jean Marie Eveillard

Financial bulls (Pzena, Miller, etc.) and bears (Romick, Tilson, etc.) make compelling cases. One side argues that financials are a coiled spring ready to explode. The other argues that the spring is broken.

In a recent quarterly report Pzena wrote:

A new fear has permeated conventional investment thinking: the massive leveraging-up of the recent past has gone too far and its unwinding will permanently hobble the global financial system. This view sees Bear Stearns as just one casualty in a gathering wave that has already claimed many U.S. subprime mortgage originators along with several non-U.S. financial institutions and will cause countless others to fail. And it sees the earnings power of those that survive as being permanently impaired.

The obvious question then is, which scenario is more logical: the extreme outlook described above, given the long period of easy credit extended to unqualified individuals? Or the scenario of a typical credit cycle that will work its way out as other post- excess crises have, and without impairing the long-term ROEs of the survivors? We believe the latter.

Steven Romick of First Pacific Advisors offers some alternative insight.

I’m more concerned about what I don’t see. Why is it that we are not being told about or seeing another bidder for Bear Stearns other than JPMorganChase? Might JPMorganChase be playing defense so as to protect its $91.7 trillion dollar derivative exposure (according to September 2007 Office of the Comptroller of the Currency data) that is supported by just $123 billion of equity? How much counter party exposure did JPMorganChase have to Bear Stearns?

…

Within the greater derivatives market, there is a segment, referred to as credit default swaps (CDS), which has grown from $900 billion in 2001, to $45.5 trillion in 2007.

…

In our opinion, a new financial system is in the process of being created. This is the beginning of a new era. Some may refer to it as Pre-Bear Stearns and Post-Bear Stearns. It is inconceivable to us that the Fed can place its balance sheet at greater risk without having some type of regulatory authority over those financial institutions that now have access to its liquidity services. In essence, new and increased levels of regulations are a likely outcome from this series of events

…
(In a recent Value Investor Insight Interview he added)

We believe in reversion to the mean, so it can make a lot of sense to invest in a distressed sector when you find good businesses whose public shares trade inexpensively relative to their earnings in a more normal environment. But that strategy lately has helped lead many excellent investors to put capital to work too early in financials. Our basic feeling is that margins and returns on capital generated by financial institutions in the decade through 2006 were unrealistically high. Normal profitability and valuation multiples are not going to be what they were during that time, given more regulatory oversight, less leverage (and thus capital to lend), higher funding costs, stricter underwriting standards, less demand and less esoteric and excessively profitable products. (emphasis added)

Can history be a guide?

During the great depression, which was the last credit bust witnessed in the west, the price to book of the financials fell from 2x to 0.5x. The following chart from James Montier shows that during the great depression the book value of financial stocks halved. Thus far in this financial crisis we are down a mere 6%.

Before investing - we have some simple questions for readers to ask themselves.

Can you measure the risk of the financials? Do you understand the derivative exposures? It seems almost a certainty that regulatory changes will be coming ( increased capital ratio requirements, perhaps costly oversight, etc) - how will these affect profitability? Perhaps more important in today’s operating environment - do you trust the person running the company?

I can’t answer those questions with very many financial companies. There are, however, some interesting financial companies to keep in mind as this mess plays out.

In a recent note to shareholders Mark Sellers said this of Fairfax Financial:

“The company’s intrinsic value goes up when the market falls. The great thing about this situation is that it isn’t priced into the stock, so we get a free put option on the market and an undervalued stock at the same time.”

Berkshire Hathaway, of course, is very well positioned for this environment and so are some of their financial holdings. It’s not a coincidence that the two banks Berkshire has been buying recently are relatively unscathed by the financial mess. More than just protecting existing wealth - they are both capitalizing on this environment to grow intrinsic value.

A lot of people put JPMorgan up there with WFC and USB. I think this is largely because all three banks have tier one capital ratio’s over 8%. At a time when most banks are struggling these three - with plenty of liquidity to opportunistically expand - stand out. However, not all banks are created equally.

I love Jamie Dimon - he’s the guy that wrote the best shareholder letter ever. I think he’s one of the smartest, honest, and capable people around. That doesn’t mean I’ll invest in JPM right now. I doubt even they understand the large, complex, derivatives book embedded in their reports. I don’t understand their risks and if i can’t measure their risks - I can’t ensure that I have a margin of safety. (JPM does a lot of things right - perhaps i’ll leave that for another post.)

If Buffett’s prediction that derivatives are the ‘financial weapons of mass destruction’ comes true - JPM is not a company you’d want to own. If Buffett’s wrong - or JPM really does understand their derivative book, we could see a massive upside to shares from these prices.

As the opening quote to this post highlights: expected value matters more than simple probability. The probability of something going wrong in the JPM derivatives book might be low, however, the expected value of that problem could destroy the company.

You only learn who has been swimming naked when the tide goes out — and what we are witnessing at some of our largest financial institutions is an ugly sight. Warren Buffett

For the most part we prefer to sit on the sidelines and watch. As Yogi Berra said “You can observe a lot just by watching.” With that in mind, we’ll be keeping a close eye on Buffett.