Banks Back in Vogue

12/22/2006 12:00 am EST

Focus:

Jon Markman

Editor, Trader's Advantage

Recently, stodgy banks have become trading behemoths, racking up earnings in non-traditional bank activities and attracting media disdain. Here, veteran adviser Jon Markman recommends an old-time banking pioneer that is going back to its roots, sort-of...

"Banks, once stalwart icons of conservatism and risk aversion, are letting it rip in today's advanced and liquid capital markets, trading almost anything, from mortgage derivatives to carbon emissions. Prudential analysts note that trading now generates 33% of revenues for large banks and brokerages, up from 26% three years ago.

"Banking powerhouse J.P. Morgan Chase (JPM NYSE) is a pioneer of this trend, driving performance over the past few years. When I introduced the company to subscribers in July, I observed that it was being derided as little more than a hedge fund in drag. JPM is making moves to shake that perception and behave more like a traditional banker.

"The company added 150 new retail locations last year, a pace that it is predicted to continue. JPM is also renovating and updating existing locations and initiating a marketing blitz to up its image with depositors. Company CEO Jamie Dimon views physical, brick-and-mortar branches as conduits to other businesses such as mortgages, commercial banking, wealth management, and credit cards. Moreover, the company is considering acquisitions in the Mid-Atlantic and West Coast areas.

"JPM's efforts should certainly help its all-important credit card segment, with 98 million cards in circulation. In 2004, it was the largest contributor to earnings, with a 27% share. It is estimated to be 19% this year, retail banking, 26%, and investment banking (which includes trading activity), 27%. To boost performance, JPM is looking to move further into the private-label and sub-prime segments, as it has with Circuit City and Kohl's.

"All of this helps build up the brand, expand the customer base, and allows cross-selling other services such as mortgages and car loans-classic retail banking activities- the services that will outperform when short-term rates start coming down next year. And look for JPM to further increase its trading activity in order to fund expansion. Now that the bank has managed to reduce trading volatility and stabilize returns, the hedge fund drag is still a good gig.

"JPM shares remain undervalued compared to peers, due to its narrower geographic and product footprint. But, like I said, efforts are well underway to grow both. I am looking for average annual earnings per share growth of 20% over the next few years as this plan is carried out. Throw a modest 13.5X multiple on my 2008 EPS estimate of $4.65, and you get a target of $58 for next year."

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