The BuyChart of the Day: JP Morgan's Risk

Several banks reported earnings today, including JP Morgan. JPM has been rated high in The Bankcaster since we launched the tool last month. And as of posting this, its latest quarterly numbers have not yet percolated through our systems.

JPM’s overall Rationality Score is pretty high because it’s Safety Score is high, which means that it’s a low-risk stock. The Bankcaster tells us that if we buy and hold JPM for about 5 years, the potential loss, if the bet turns out to be a mistake, is quite palatable. Here’s the Potential Loss chart from the Bankcaster:

How does it figure that? This is the Bankcaster’s way of quantifying Thesis Risk, which we’ve learned over time (and with some painful losses) is the real risk. What if we buy JPM based on its (highly believable) NIIcast* (see note below) and the bet doesn’t pan out? What’s the damage if our thesis turns out to be very wrong?

To estimate that damage, the Bankcaster considers the following variables:

1. JPM’s historical revenue growth
2. Wall Street expectations of future Net Interest Income growth (if available)
3. Its NIIcast*.

That results in a “Downcast” – our estimate of JP Morgan’s revenue growth in a pessimistic scenario.

The Bankcaster explains all this in detail. But the key message is this: Focus on Thesis Risk, not statistical risk measures like volatility. More on this below.

*NII stands for Net Interest Income. NIIcast, therefore stands for Net-Interest-Income-cast. This is our best estimate of “revenue growth we need to believe to – rationally – expect our desired return”. This estimate is a back-solved number based on a few (rational) assumptions about cash flow items and trading multiples that are congruent with past trends for this particular company/stock. We start with our desired return, and then back-solve towards the Net Interest Income we need to believe to consider buying the stock. More details in the Appendix.

NII or Net Interest Income is the best measure of a bank’s revenue. The term is confusing because it has the word “income” in it. But it’s a measure of revenue – it represents the revenue generated from its base business of “borrowing at lower interest rates and lending at higher interest rates”. Interest Revenue minus Interest Expenses (cost of borrowing) is Net Interest Income. Most banks have a second source of revenue - Fees - but that is not the base business. In back solving to the NIIcast, we made some reasonable assumptions about growth in the bank’s fee business. 

Underrated Stock Insight: What’s your Thesis Risk?

At university, we were taught that Risk = Volatility. Wall Street also runs on that assumption, more or less (there are statistical variants, but they remain…statistical). Over time, through experience, I learned that “Risk = Volatility” is simply not true. In fact, it’s practically useless to manage risk, unless you’re a short-term trader who needs to liquidate positions every single day or week.

Apart from some painful losses, my self-imposed study of the greatest minds of investing (before I launched The Buylyst) helped shape my thinking about Risk. And long story short, these great minds all agree that:

1. The concept of Risk in long-term equity investing has been hijacked by economists and statisticians with “physics envy”.
2. The best definition of Risk is: Permanent Loss of Capital. This isn’t easy to measure (although we’ve done a pretty good job in our tools). Volatility is just temporary loss, and it’s not even a loss unless you sell. In fact, it presents opportunities to buy more.
3. Permanent Loss comes from “not knowing what you’re doing…”, which is mostly about not knowing about the underlying business behind the stock.

By the way, all this self-study is documented in the Mental Models page. The Risk Mental Model was one of the first ones to be assembled. And it formed the basis of the Safety Score in the Buycaster, Bankcaster, and Fundcaster. The Safety Score is one-half the Rationality Score.

Here are the top 5 quotes on Risk that changed the game for me:

1. “I’m sure ‘risk’ is—first and foremost—the likelihood of losing money.” – Howard Marks in The Most Important Thing
2. Buffett thinks the whole idea that price volatility is a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty,” he says. “If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing." – Robert Hagstrom, author of The Warren Buffett Way
3. “If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.”  - Warren Buffett, Berkshire Hathaway Shareholder Letters
4. “Beta and Modern Portfolio Theory and the like – none of it makes any sense to me…how can professors spread this? I’ve been waiting for this craziness to end for decades. It’s been dented and it’s still out there.” – Charlie Munger in Poor Charlie’s Almanack.
5. “The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.” – Howard Marks in The Most Important Thing