Regional banks have had a strong rally in July. The Fund benefited from the rally. The tame Consumer Price Index report on July 11th sparked the rally. Then, the assassination attempt on Trump and Biden’s withdrawal from the Presidential race improved the prospects for a Republican Administration. Investors continued to buy Regional Banks with the prospect of a more favorable regulatory environment for banks. Regional banks have also benefitted from investors rotating out of large stocks into small-cap stocks.

 

Prior to the July rally, the negative positioning by other investors in Regional Banks had been extreme. The short interest in the S&P Regional Bank ETF (“KRE”) has been very high. In mid-June, the KRE had 50 million shares outstanding and 50 million shares short for a 100% Short Interest ratio.  We believe some momentum-based and thematic investors were using the KRE as a large short position. When regional banks started to rally on the tame inflation report, these investors aggressively covered their short positions and drove the KRE higher. By mid-July, the shares outstanding of the KRE increased to 54 million and the short interest declined to 40 million, so the short interest declined to 74%. By July 26th, the shares outstanding of the KRE increased to 63 million shares. We still think regional banks are cheap compared to their history, we think the coming interest rate cuts will drive earnings higher, and we think credit is manageable. So, it will be interesting to see if the investors who had been shorting banks come back to short the regional banks again or move on to other opportunities. The extreme negative positioning in Regional Banks is not as extreme as it was in late June.

 

Growth Banks Within Regional Banks

 

In our Q1 Letter, we shared our investment thesis on Regional Banks. At the end of our investment discussion, we briefly mentioned three specific opportunities we saw within Regional Banks: Puerto Rican Banks, Growth Banks, and Small Banks with Unique Stories. In this section, we are going to expand on the opportunity we see within Growth Banks. During July, the stock prices of Regional Banks rallied strongly due to softer inflation, prospects of a more favorable regulatory environment, and better-than-expected earnings reports. Even as Regional Banks have rallied 20%, we still see potential in Growth Banks relative to other Regional Banks.

 

Growth Banks are a core theme in the Fund. When we think about the distribution of mid-sized publicly traded banks, some are well-run, some are not well-run, some grow by acquisition, and some grow through organic growth. There is a group of banks that grow through organic growth and have high returns on capital. They can reinvest that capital into faster organic loan growth relative to their peers. There are seven or eight banks with these characteristics, including Western Alliance, Pinnacle, and Axos. These banks grow faster than the rest of the industry. They have historically traded at a premium to the rest of the industry. The regional banking industry usually trades at 12x earnings, while Growth Banks historically trade at 15x earnings.

 

Currently, these Growth Banks trade along with the rest of the industry at 10x earnings, a discount to where regional banks have traded in recent history. We believe we will realize an excess return as the industry returns to its normal valuation range and as the Growth Banks regain their premium valuations.

 

We think these banks are conservatively run by management teams who are thoughtful and motivated. These banks are more diversified than the banks that failed last year. Some investors are avoiding Growth Banks. These investors believe you should not own the fastest-growing banks if we are heading into a recession. We may or may not be heading into a recession. Other investors are staying away from these fast growers due to credit concerns. We are comfortable owning these fast-growing banks because we think their credit quality will be no worse than peers through the cycle. Regional Bank stock prices are beginning to mean-revert to their historical range. We believe Growth Banks are going to regain their premium valuation. While we wait for these things to happen, the Growth Banks will grow faster than other banks in the industry.

 

Our view on credit quality at banks is not as pessimistic as some other investors. We think office towers in major markets like New York, Chicago, and San Francisco will struggle for a while as old leases run off and companies do not renew their leases for the same amount of space. However, most of those credits are not on Regional Banks’ balance sheets. Most of the loans on large office towers in gateway cities are held in Commercial Mortgage-Backed Securities (“CMBS”), Collateralized Loan Obligations (“CLO”), or on the balance sheets of large banks, especially European and Asian banks. Credit quality is something that we watch closely, but we do not see it as a problem. The bank management teams we talk with are very transparent about their exposures and the portions of their loan books that are concerning. They also have begun to break out their real estate exposure by sector. Right now, we are comfortable with credit quality.

 

Why does this opportunity with Growth Banks exist? One reason is investors’ general apprehension about banks and non-bank lenders who grow quickly. Historically, fast-growing lenders have grown because they have loose underwriting criteria or they offer credit structures that are too favorable to the borrowers (e.g., large real estate loans without recourse or personal guarantees). Another reason investors may be shying away from Growth Banks in the current market is recent history. The three large bank failures last year were banks that would have been considered Growth Banks. Another reason to doubt Growth Banks is the current deposit funding environment makes deposit growth difficult and expensive. Some investors are fearful of a step-up in expenses, higher capital requirements, and higher liquidity requirements.

 

Growth Banks compound tangible book value per share at faster rates than other banks. They are not ballooning assets to make their balance sheets bigger. Instead, they are compounding their equity capital at a faster rate than peers. Many of the management teams at the Growth Banks publicly talk about their history of growing tangible book value. Usually, they have higher returns because they operate more efficiently than peers. The operational efficiency may come from a branch-lite operating strategy. Or, it may come because management works to cut out bureaucracy from the bank. Since banks need capital to grow their loan portfolios, Growth Banks with higher returns can reinvest into loan growth.

 

Here’s some data on how smaller, faster-growing banks can compound tangible book value faster than large regional banks. This graph shows the growth of tangible book value over the last ten years of a group of Growth Banks versus the large regional banks.

The opportunity we see in 2024 is atypical as Growth Banks currently trade at lower valuations than Large Regional Banks. Growth Banks trade at 10.2x 2025 Consensus Earnings per Share (“EPS”) estimates versus the Large Regional Banks at 11.0x 2025 EPS estimates. These Growth Banks trade at a discount despite faster book value growth than the large regional banks.

Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Derek Pilecki!

Derek is currently the portfolio manager of Gator Capital, a Financials sector long/short fund he launched in July 2008. Since inception, Gator Capital has returned ~1,900% compared to ~485% for the S&P 500 and ~260% for the S&P 1500 Financials index. Before launching Gator Capital, Derek was an analyst at Goldman Sachs and Clover Capital. Derek was previously featured on Idea Brunch in November 2021.  

To continue reading the article, click here.

 

Andres Sandate: 00:02

Welcome everybody to another edition of the Asset Backed podcast. I’m your host, Andrei Sundate. I am excited to bring back a former client and, and also, an expert in financials, Derek Pilecki, the founder, CEO, and portfolio manager of Gator Capital Management based in Tampa, Florida, is my guest today on Asset Backed. Welcome, Derek, to the Asset Backed podcast.

Derek Pilecki: 00:30

Thanks, Andres. Great to see you.

Andres Sandate: 00:33

Yeah. It’s great to see you. It was good to catch up offline. I’m glad to hear that, the kids are going gangbusters like mine. Today is the official start of summer for me here in Atlanta.

Andres Sandate: 00:43

So, hopefully, nobody will jump up here, with a surprise and interrupt our show. But, I’m I’m glad to hear that that you and the family are doing well, and, I can’t wait to hear, you know, more about what’s going on at Gator. Before we, talk about financials and and I know we’re gonna spend a lot of time today talking about banks and what’s going on, in, you know, the boardrooms at banks with, respect to the interest rate environment. Tell us a little bit about your backstory.

Derek Pilecki: 01:10

Yeah. So, I mean, I I’ve been running my firm for 16 years. It’ll be 16 years next month. And, you know, prior to starting my firm, I worked at Fannie Mae, the the big mortgage giant, you know, the hated mortgage giant.

Andres Sandate: 01:24

Yeah.

Derek Pilecki: 01:24

You know, back in the nineties, it was one of the smart companies. I worked in their mortgage portfolio doing interest rate risk analysis. And so it was a great first job in finance. You know, they’re long mortgage backed securities and CMOs and short agency debt, including a ton of structured notes. And so I got to learn about almost every type of fixed income instrument.

Derek Pilecki: 01:46

And so that was great. And I went back to business school to make the transition to equity research and came out covering financial companies, worked for a couple small value oriented investment firms, and then was recruited to GSAM and work for their growth team. So I covered financials for Goldman’s growth team for 5 years before launching my fund.

Andres Sandate: 02:05

Yeah. And, you know, financials for many people, who are not in the financial world day in, day out, like like you and I, it’s, like, you know, complicated. Why is it so complicated? So many acronyms. I wanna ask you some fundamental basic questions about what attracted you to financials with the complexity and with a lot of, you know, a lot of the things that attract people to the investment industry and asset management.

Andres Sandate: 02:34

But then within that, financials could be even more complex. You just talked about agency, CMOs, etcetera, working at Fannie Mae and understanding all the fixed income products and strategies. What what what is it about, financials, that got you excited, you know, if you go all the way back to, you know, your days right out of Duke?

Derek Pilecki: 02:53

Yeah. I mean, I I am just attracted to the the business models within financials. I think there’s a variety of business models. You know, a capital markets firm versus an asset manager, an insurance company, banks, they all have different business models, different income statements, and I just find it’s find it fascinating. You know, growing up, my dad would work for the Federal Reserve.

Derek Pilecki: 03:14

He was a bank examiner for the Philly Fed, and they put him through law school. We moved to DC, and he worked as an attorney for the board of governors of the Federal Reserve. And so, you know, the dinner table conversation was always kinda around banking. So it was kind of a natural thing for me to, you know, not be scared away from banks. Right?

Derek Pilecki: 03:30

You know, we talked about bank regulation and bank mergers. And and I remember when I was in college, we went through the SNL crisis. And by that time, he was in private practice and just the some of the stories of the of what was going on with banks and what made a good banker, you know, just really attracted me to the industry.

Andres Sandate: 03:49

Yeah. So sort of like being being the coach’s, son or daughter. Right? You just sort of grow up around the game and and you you you sort of are exposed to it. And and I I can completely think back to that first time we met in Nashville, Tennessee, at an industry event, and, you know, you stood up and talked about your strategy.

Andres Sandate: 04:10

And at the time, I was coming out of working, in banking myself, at SunTrust and Regions for 4 or 5 years and was starting in the industry. And I thought that’s somebody that I need to go meet and talk to. And then lo and behold, we worked together for a few years, and, I’m just excited to have you back, on the show or on the show to talk about this 15 plus year run you’ve had with your firm, Gator Capital Management. But but, you know, more selfishly with the asset backed podcast, I’d love to ask you, you know, about just the health of the overall financial sector. And I know banks is not the only thing that you do at your firm in terms of of research, but it certainly has has had, you know, bigger parts of the portfolio over time.

Andres Sandate: 04:54

So let’s start there. Let’s let’s talk about, let’s talk about banks, because it is, you know, top of the news channel, makes the headlines. But there’s 2 narratives. Yeah. There’s 2 narratives.

Andres Sandate: 05:08

There’s there’s the main street narrative of bad office loans and, you know, credit risk, and then there’s maybe a second narrative that isn’t often talked about. What is often missed when people think about banks?

Derek Pilecki: 05:22

Yeah. I mean, I think banks are still recovering from the regional bank crisis of last year. Right? I mean, we we just had this huge shock to the system of, the the 3 big bank failures in last March. And what we’re still dealing with is the interest rate risk that these banks still have.

Derek Pilecki: 05:38

That, you know, there’s they made a ton of fixed rate loans and bought a ton of low coupon securities during the 2021, 22 time frame, and those those loans and securities are sticking on the books for a long time. You know, we all know talk about people with low coupon mortgages. You know, they’re not gonna leave their house. They’re not gonna prepay that mortgage. Then you you have a 3% mortgage.

Derek Pilecki: 06:02

You’re not gonna leave your house. So the banks are stuck. A lot of banks are stuck holding that paper. And so I really think that, you know, when people talk about you know, bank stock investors are most focused on interest rate risk right now because we’re all concerned about credit risk. Right?

Derek Pilecki: 06:18

I mean, it’s topical. It’s obvious. We hear about the the office buildings that are vacant and that are going to foreclosure auction for 83% discount to the previous sale. That’s all happening. Right?

Derek Pilecki: 06:31

So a lot of those buildings are in commercial mortgage backed securities or owned by foreign or, you know, lent against by foreign banks. The the credit metrics for the regional banks aren’t that bad right now. Like, they they’ve improved their disclosure. They show us what their office loans look like, what their multifamily loans look like. It’s not a huge problem currently.

Derek Pilecki: 06:55

It could become a problem later this year or next year. I think the the central issue right now is interest rate risk. There’s a bunch of banks that have too many mortgage backed securities, too many fixed rate loans. And with the competitive deposit environment, they’re really getting squeezed. And they’re just sitting there waiting for these loans and securities mature, and it’s gonna take a long time.

Derek Pilecki: 07:16

And so I think that’s the real issue when we we look at these net interest margins that have compressed, how long will it take to rebound? I think it’s gonna be a while. So I think that’s the thing that, you know, investors generalist investors aren’t really as focused on or compared to the credit risk.

Andres Sandate: 07:34

Yeah. So when when you when you talk about a a bank investor versus, maybe just a general equity investor,

Derek Pilecki: 07:40

If you

Andres Sandate: 07:41

look at the bank sector, you talked about how there is a really competitive environment for deposits, and that net interest margin is compressed. And so where are banks that you are looking at and saying there’s a constructive, set of activities happening at these institutions versus maybe another subset. What are you seeing? What are the things that, I I don’t wanna call them growth banks, but more attractive from the standpoint of, their balance sheet, their fundamentals.

Derek Pilecki: 08:12

Yeah. I mean, I think there are some bankers who wisely did not load up their balance sheet with mortgage backed securities during the pandemic. So right during the pandemic, there was huge deposit flows. You know, quantitative easing just flooded the system with liquidity. The bank saw a huge deposit growth, like way above trend deposit growth.

Derek Pilecki: 08:32

And it was a question of what did the bankers do with all that excess liquidity. A lot of them just invested in mortgage rec securities like Silicon Valley. But, you know, other solid banks did too. Like Glacier Bancorp in in Montana, great franchise. They saw a flood of liquidity, and they bought mortgage backed securities.

Derek Pilecki: 08:51

They’re not the only bank like that. There’s a lot of banks who just took that exit excess liquidity and invested it out the yield curve. And but there are some bankers who didn’t do that. And those bankers who didn’t do it are in the catbird’s seat. There’s the spreads of widened on loans.

Derek Pilecki: 09:08

They can can continue to grow at these wider spreads at these higher rates, and they can continue growing. And so it’s a small subset of these banks that you wisely sub sidestep the the low interest rates, and now they’re in a very good position to continue lending. What they need is a little bit more loan growth or loan demand. You know, loan growth demand is really down because obviously, real estate investors aren’t buying new buildings now or new properties because the the numbers don’t pencil with high interest rates. But there are there is some loan demand out there.

Derek Pilecki: 09:43

And these these bankers who sub side stepped low interest rates are able to take advantage of it.

Andres Sandate: 09:48

Yeah. I there’s a lot of, themes that I wanna sort of talk about. 1 one, selfishly because of the show, the asset backed show, you know, we are, we are constantly, trying to sort of understand this narrative around the growing asset backed finance market. Right? It should be everything from student loans, aircraft loans, all the way to mortgages and auto.

Andres Sandate: 10:10

And, and I wanna talk about, that. But before we do that, I wanna ask you back back to banks for a second. When when you look back at the career you’ve had of of looking at banks and and getting to know bank management teams and understanding, you know, the the characteristics and the qualities as a as a you know, I don’t wanna say you’re a value investor, but certainly trained at Chicago and trained at some of these organizations, that you that you, that you came up in. When you look at banks and you say, okay. Finding loan growth, competing for deposits, what are some of the different levers?

Andres Sandate: 10:52

Because when you look at 5, 6000 banks, how many do we have in the US? It is such a different just playing field than, say, Europe, right, where there just aren’t as many banks. And I always ask the question to bank investors, do we have too many banks? But but what are the levers that these management teams can pull in this type of an environment? And as a growth invest you know, as an investor that’s looking for for growth and looking for those sort of proverbial diamonds in the rough, what are the what are the things in those management teams that really stand out?

Derek Pilecki: 11:29

Yeah. I mean, I would say one thing that really stands out is, like, not being distracted. Right? So organic growth is the most valuable growth the bank can have. So and the way you get organic growth is from your existing teams making more loans, hiring, bankers, you know, you can steal bankers from the the bigger the bigger banks or, you know, some of these failed institutions had great client facing bankers.

Derek Pilecki: 11:55

You hire them. And if you’re not distracted, you can make those additions to the team. Where you get distracted is if you have problems in credit, or if you do an m and a transaction. So m and a, although it seems pretty attractive, like, put 2 banks together, cut out a bunch of costs, returns go up, it’s a huge management distraction for a 2 year time frame. And then you can’t really grow organically while you’re in that integration period.

Derek Pilecki: 12:20

And so you’re internally focused, you’re not externally focused. So, you know, I think that’s why when you see deals, even though the accretion on deals is very seems very high, the the stocks don’t react because I think investors just are like, that management team is gonna be distracted for the next 2 years. Like and we you know, it’s gonna be hard to to value the bank. And so I think that distraction, you know, avoiding the the companies that are going through m and a that are potentially distracted is is one thing to to look for.

Andres Sandate: 12:51

Yeah. Let’s let’s, I wanna ask you about, about CRE as well. I know that the popular narrative is, yes, post COVID, you have all these empty office buildings, and, you know, you you you a lot of these, you know, a lot of these mortgages, are are either upside down or you have leases that you’ve restructured. All the leases you can restructure, there’s just less demand, etcetera. What do you see, at the banks that you are following when it comes to CRE?

Derek Pilecki: 13:23

Yeah. I mean, we’re seeing some some stress on the on the office portfolios. But what what we’re seeing generally across the industry, office is about 4% of bank loan portfolios. So not a huge number, like but, you know, significant. And then generally, in a generic bank, of that 4%, about half is somehow related to medical.

Derek Pilecki: 13:48

So, you know, doctor’s offices are in better use than a typical office building. Right? And then Yep. And then you break it down further to then there’s suburban office and then owner occupied office. And so there’s categories you can kinda cleave off to say, okay.

Derek Pilecki: 14:04

Those loans are probably fine. Like, if, you know, a company owns their office building and they have a loan against it, they’re less likely to default rather than an investor owned property. And so we are seeing some issues especially in Chicago. Right? I mean, the there’s Chicago downtown core is really problematic, and we’re seeing across all the gateway cities with long commutes.

Derek Pilecki: 14:26

You know, New York, San Francisco, LA, people just don’t wanna get spend an hour and 15 minutes commuting to an office downtown. To counter that, we’re seeing return to work. Right? I mean, so people companies are saying mandate people’s showing up in the office.

Andres Sandate: 14:44

Mhmm.

Derek Pilecki: 14:45

What they when they do return to work, say, it’s 3 days a week, it’s Tuesday, Wednesday, Thursday. You have everybody there Tuesday, Wednesday, Thursday. You still need the same amount of office space. You it’s not like you can do a hoteling arrangement. Some people show up on Monday Friday if you have everybody there the same day.

Derek Pilecki: 15:01

Now certainly, some back office operations, you won’t mandate to come back to the office. So, like, I think that the natural demand for office has to be lower going forward. New supply is also close to 0, so we have that offsetting a little bit. But, you know, certainly, there’s gonna be problematic issues within the office portfolios. But I don’t at this point, I don’t think it’s gonna be, you know it’s it’s certainly not a capital issue.

Derek Pilecki: 15:26

It might be an earnings issue for 1 or 2 banks occasionally, but we’re coming from such a low level of credit losses in 20, 21, 22 that we’re kinda just normalizing here. So it’s what we’re not clear on is will we got come back to a normalized credit loss ratio and that’ll it’ll stop there, or will it keep going to, a more problem a higher problem level? I would say these things take a long time to play out, and they’re not it’s not going rapidly. So we’re not seeing, like, a sudden surge in in credit losses in the bank portfolios as of right now, but that doesn’t mean we can’t see it as we get in back half of this year or next year.

Andres Sandate: 16:06

Yeah. And and, you know, the the the conversation started with interest rate risk and that being, you know, probably more of a prominent, part of your underwriting and certainly the discussion amongst management teams and boards. I wanna ask you about as as as a as a bank investor, again, it’s not the only thing that you do at Gator. You look at all different parts of the financials from insurance and capital markets and asset managers, etcetera, and even Fintechs. And I wanna talk about some of those other areas.

Andres Sandate: 16:37

But on on on the subject of banks, a couple more questions. You you made the comment in our preshow about this is the first cycle with private credit really having a a seat at the table. And, you know, for the longest time, banks were the only game in town largely. Now you have private credit, asset backed, the podcast. We interview a lot of private credit investors, and you hear different things from different investors.

Andres Sandate: 17:04

You know? Some work a lot with banks, and bank partnerships are really big part depending on the size of the the private credit firm and franchise. But when you think about banks and private credit in the same conversation, what are some of the initial thoughts that come to mind, as you think about where we are in the cycle?

Derek Pilecki: 17:23

Yeah. I mean, I think that whole aspect of having private credit involved this time is is really interesting, especially from a, even a more macroeconomic view. Like, the the worst recessions, like, say, take 9091. That recession was terrible because we had a liquidity crisis amongst the banks, and there was no alternative. The banks just stopped lending.

Derek Pilecki: 17:43

There was nowhere else to get loans. Kinda same thing in the great financial crisis. Right? I mean, it was liquidity crisis. Lack of lending makes a very deep recession as opposed to 0102 where the banks were in pretty good shape.

Derek Pilecki: 17:54

They continued lending through that recession, and it was a pretty shallow recession. So, like, to the extent that banks are pulling back and not making new office loans or CRE loans, and but we have credit private credit stepping in, you know, at a higher price, but still you can still get credit. Will this make, any potential recession we face more shallow? Right? It’s not like you can’t get a loan at all.

Derek Pilecki: 18:20

You can get a loan at the right price. Yeah. And so I see banks working with private credit. I mean, the the regulatory environment, the regulators want the banks to take less risk. Right?

Derek Pilecki: 18:31

And the bankers would rather provide leverage to private credit than make a direct loan themselves. So to the extent that private credit can make the make the commercial, mortgage and then get some financing from a large regional bank. I mean, I think that makes the banking system safer. The private credits taking the first loss risk. They’re, you know, they’re experts taking credit risk, and they’re not beholden to the same regulatory issues that the bankers are.

Derek Pilecki: 19:00

I think that’s a a pretty elegant way for the system the banking system to take on less risk while still funding these projects.

Andres Sandate: 19:09

Yeah. So you you raised, the the the the notion of the regulatory environment, and the regulators want the banks to to to take less risk, which does, if you will, play into the hand, if you will, of of the growing private credit, asset class, and and industry. You’ve seen some gigantic funds raised, and you seem to be, you know, able to pick up almost any paper these days and read about the golden age of private credit, and there’s a insatiable demand for yield. With that said, what you know, you you have a little bit of a regulatory background. Right?

Andres Sandate: 19:51

You you mentioned, you know, your your your dad worked at the Federal Reserve, and I would love to get your perspective on the regulatory environment as it relates to banks. And what is this looking like for them over the next, you know, 3, 4, 5 years? Because I’ve heard from numerous private credit firms that have said, you can’t walk into a bank and get a loan anymore. Now, you know, I I don’t know how much of that’s conjecture, how much of that’s reality. You said, you know, regulators are saying they want banks to take less risk.

Andres Sandate: 20:26

What is what does the reality look like on the ground?

Derek Pilecki: 20:28

Yeah. I mean, I think it’s hard to get loans these days. Like, I think it’s, you know, I think there’s a lot of bankers who are just taking care of their core customers that they’re not looking to expand into new relationships. They’re certainly not looking to add on credit without any deposit relationship, which a lot of real estate investors don’t have deposits. Right?

Derek Pilecki: 20:47

I mean, they’re they just they’re asset rich and cash core. So, you know, I don’t think that bankers are looking to really ramp up their commercial real estate lending at all. And so I think that’s you know, I think there’s a when you think about the banking industry, like, 30 years ago, 30, 40 years ago, every bank looked like JPMorgan. Right? I mean, a commercial mortgage, commercial bank, you know, a little bit investment bank, trust bank, credit card, mortgage, and now regional banks have been shrunk down to they do small business lending and they do CRE.

Derek Pilecki: 21:20

And so when you look at some of the metrics of CRE as a percentage of loans or percentage of capital, there’s a lot of banks that are over their skis on having too much CRE. And I think the regulators wanna bring that down. And, you know, CRE is a risky a risky business. You know, we’ve had pretty clear sailing for a number of years here, and I think regulators I think that they get back to your original question of what’s the regulatory environment. Like, I think the regulators are under a lot of stress.

Derek Pilecki: 21:48

Like, I think those bank failures last year embarrassed the regulators.

Andres Sandate: 21:51

Yeah.

Derek Pilecki: 21:51

And I I think that environment’s gonna persist. Like, the regulators are, they’re, you know, they’re defensive. Right? Like, bank failures are no good. And the way those bank failures went down where it was a pretty obvious risk of interest rate risk, you know, it’s unacceptable.

Derek Pilecki: 22:08

And so I think the bank regulators are under a lot of stress, and I think in turn, the bankers are under a lot of stress because the regulators are not, you know, they’re trying to protect themselves by making sure the banks don’t take any unnecessary risk. So

Andres Sandate: 22:24

Yeah. We can’t we can’t have another SVB or another weekend where a Sunday night rescue has to happen. Right? Not at all. Because it just keeps spooking the markets.

Andres Sandate: 22:32

Yeah. Yeah.

Derek Pilecki: 22:33

For sure.

Andres Sandate: 22:33

Just when you think you’re on solid footing.

Derek Pilecki: 22:36

I I would say that, like I mean, I know this is asset backed for podcast, but, like, the deposit insurance system is still vulnerable. Right? I mean, we still have there haven’t been enough changes to the deposit insurance system since SED that, like, there could still be a massive run on the banks because we have everybody has a app on their phone, and you can zap all your money to your Schwab account if you’re worried about your bank. And so you could have a run on the bank still. And so, like, I think we you know, regulators and legislators really need to take a look at deposit insurance.

Derek Pilecki: 23:11

And, I mean, I’m in favor of unlimited deposit insurance, like or massively increasing the deposit insurance level. There’s

Andres Sandate: 23:18

plenty 250,000 just isn’t, yeah, isn’t sufficient for even consumers on some cases.

Derek Pilecki: 23:23

I mean, exactly. Like, there’s plenty of 75 year old or 80 year old people who have more than 200 $50,000 who can evaluate their bank. Like, look at SVP. It had $16,000,000,000 market cap to 48 hours before it failed. Any depositor would look at that and say, they’re fine.

Derek Pilecki: 23:39

You know? And so, like, I I just think it’s unreasonable to have such a low deposit insurance limit.

Andres Sandate: 23:45

Yeah. No. It’s a great point and something that hopefully, you know, when the, when the regulators, can get back to focusing on, regulation, it’s, it’s something that I think is gonna be important, particularly, you know, given that we’re in an election year. Let’s let me ask you about, you know, when you think about the the overall investment landscape of financials, one thing that, I I recall about your approach and strategies, you look for the inefficiency. You look for the you look for the areas that are harder for the maybe the generalist analyst, who who dabbles in banks or dabbles in financials to to really uncover.

Andres Sandate: 24:30

Is it fair to say that that complexity and that, inefficiency and just the the the large number of publicly traded banks creates a pretty attractive playing field in which to look for ideas. Is that is that fair?

Derek Pilecki: 24:47

Yeah. I think that’s exactly true. Like, in the small mid cap financial area, there’s a lot of unique business models that, you know, you need some specialized study to understand. You know, take student lending for instance. There’s 3 publicly traded student lenders.

Derek Pilecki: 25:03

You you have to invest some time to understand student lending, and and and you the benefit is you only get to cover 3 companies. And so but I’ve done that, and, I just I don’t see a lot of more people, you know, dusting off the the playbook to see, like, oh, let let me dive into student lending and see if there’s an opportunity there. But, you know, especially with the given the the headlines of, you know, free college or Sure. Or giving student loans, like, why would you even bother? And but, you know, there’s some pretty interesting companies in this.

Derek Pilecki: 25:37

You know, those 3 companies are pretty interesting, and there’s, you know, pretty, inexpensive valuations amongst those 3 companies. But that that’s just an example of, like, within financials, there’s a lot of nooks and crannies of small to mid cap financials. You know, one of my favorite ones is a couple years ago, you know, Genworth we purchased shares in Genworth. And, you know, Genworth’s a life insurance company, they wrote a lot of long term care policies and long term care is just a terrible business because you’re writing policies for 60 year olds for when they might go in a nursing home at 85. And so everybody underestimated the cost.

Derek Pilecki: 26:13

And so Genworth has been really struggling with these policies. They also have a mortgage insurance subsidiary. And so they went through a long transition where they are trying to raise rates on their long term care policies and moving the, mortgage insurance subsidiary out from under the life insurance company into its own subsidiary under the holding company. They finally made progress, IPO’d 20% of the mortgage insurance subsidiary and it’s publicly traded. It’s called EnAct.

Derek Pilecki: 26:43

And so when I bought the shares a couple years ago, if you valued Genworth’s life insurance subsidiary and all their long term care policies at 0. Saying that, hey that’s ring fenced. And then their the value of their publicly traded mortgage insurance subsidiary, you’re buying Genworth at a discount, like 20% discount to the value of its mortgage insurance holdings. And that mortgage insurance companies continue to grow. They had some tax assets that reduced their cash taxes and, you know, that stock had worked.

Derek Pilecki: 27:17

But it’s the complexity of, like, okay. This long term care business is terrible, but there’s this mortgage insurance subsidiary. Should this trade at a discount? And, you know, when they started they announced they’re gonna start buying back stock, that’s when I I took my position in Genworth. But that’s an example of the complexity that’s out there within financials that, you know, Genworth is not a a highly trafficked name amongst investors.

Andres Sandate: 27:43

Yeah. When when you think about the, the the additional, nooks and crannies, to use your term, of of the financial sector, there’s some there’s some areas I’d love to ask you about. One of those is fintechs and and just how we saw you know, before 2021, 20 yeah. I would say 21, you saw a lot of Fintechs, getting a lot of VC, and they were gonna disrupt banks. And they were gonna, you know, claim to be a better version, and a and a more efficient version of a bank.

Andres Sandate: 28:19

And you saw a lot of VC give a lot of capital to to these these tech, startups. And then sort of like they woke up and realized, wait. This is a different business, you know, than this is a lending business, not necessarily about just grow, grow, grow it at at, you know, at at any price. And I don’t know that they’re gonna keep funding these these businesses, and I think we’ve seen a lot of pressure on some of these fintechs, and some of them will probably go away or have gone away. What did that whole, maybe you’re not investing.

Andres Sandate: 28:50

You’re clearly not investing, in in in IP pre IPOs and and VC. But what did what did that tell you about the tech community? I’m just curious when you saw sort of that happening, because I’m sure there are, lots of examples over your long career of, you know, we’re gonna go disrupt banks, and we’re gonna do this better and cheaper. But what what what comes to mind when you think about that episode?

Derek Pilecki: 29:16

Yeah. I mean, I think there was a lot of innovation to come from that episode. Like, there there’s a lot of, you know, outside the box thinking. And so, specifically, when I think about Venmo and Cash App. Right?

Derek Pilecki: 29:28

I mean, those are pretty interesting businesses, and they were able to take a lot of share, and they were able to get a lot of consumers to participate in those those platforms and it forced the banks to come up with Zelle. And Zelle has been growing. It has very high payments, but, you know, Cash App and Venmo are gonna stick around for a while. I guess, so I think those are there’s interesting businesses that come out of that and they’re, you know, good customer innovation. You know, I think we have all benefited from having money, you know, peer to peer money transfer.

Andres Sandate: 30:00

It’s

Derek Pilecki: 30:01

easier to to live life to Yeah. You know, share expenses with friends, whatever. I think, you know, I I guess the area where I was most skeptical, you you mentioned the the personal lending. I guess the area I was most skeptical about disruption was on insurance. So auto insurance.

Derek Pilecki: 30:19

I mean, I I think that the big auto insurers like State Farm, GEICO, Progressive, Allstate are are very very good companies and, you know, they spend a ton of money on advertising. So to think that, like, they’re lazy companies that you could disrupt, I I I thought that was a stretch. So, like, these these, personal auto insurers that were gonna come and take over the insurance comp insurance world, I thought was was a little bit of a stretch. And you those companies have had a harder time. You know, personal loan companies, I mean, I I think it’s I think they’ve done a good job and have served to, fill the need there.

Derek Pilecki: 31:00

But, you know, personal lending, it’s a low multiple business. Like, look at Discover and Capital 1, they trade it, you know, best case, they trade it 8 times earnings. You know, 1.2 times book or 1.4 times book. Like, it’s, you know, for a Fintech to get a higher valuation on personal lending, I mean, it’s just not a high multiple business. Like and, you know, getting this is a little tangential, but, like, Goldman entered personal lending too, and they’ve exited it.

Derek Pilecki: 31:25

But it was like, why is Goldman getting into purse consumer lending? They could just buy Discover at 8 times earnings and, you know, you have the you have the greatest investment banking franchise of all time, which is a high multiple business. Why dilute it with personal lending? So, you know, I agree with you. Like, these fintechs who are trying to use their balance sheet to to grow, it’s it just lowers their valuation.

Derek Pilecki: 31:52

What you really want is a a Fintech that had some asset light business model which, you know, Square and and PayPal have done. Yeah. You know, they’re for asset based businesses that are payment oriented.

Andres Sandate: 32:04

Yeah. Yeah. And they they scoop up transactions. I wanna ask you about some other areas that, that that I that I think, you know, are quite interesting. The first one is property and casualty.

Andres Sandate: 32:17

You know, it just seems like every time you turn around, there’s another major natural disaster, there’s a major, you know, storm or fire, and it just seems like rates, not that there’s as much home buying. We saw the numbers come out yesterday. I think the April numbers for for home buying, it were down again for the 3rd consecutive month, but but a big part of this, reset is insurance. In Florida in particular, you live in the state of Florida. I can only imagine how much premiums are going up in the state of Florida.

Andres Sandate: 32:50

But overall, property casualty, maybe you have exposure to it today, maybe you don’t, but just curious about your take on that sector.

Derek Pilecki: 32:58

I mean, I I think, climate change is real and their insurers are pricing for it. Right? And so I think pricing has been going up. You know, I think on property, reinsurance prices didn’t go up as much this year as they had in previous years. Certainly on casualty reinsurance prices are going up.

Derek Pilecki: 33:17

And I think there’s there’s a lot of underpriced casualty business from the 2015 to 2020 time frame that, you know, people need to raise prices going forward. They generally the industry generally underpriced casualty business. So I’m and I think it’s an interesting area. You know, we’re not involved in a ton of insurance companies right now. We we own one homeowners insurance company that’s focused on the state of New York that, you know, is kind of benefiting from the big companies exiting Long Island.

Derek Pilecki: 33:46

And so that coastal exposure on Long Island is, you know, there’s a lack of capacity there. And so that’s the the really the only insurance company that we’re we’re involved with at the moment.

Andres Sandate: 33:59

The 2 areas, that, you know, I know you’ve you’ve you’ve, been involved in these areas for a long time, and you are one of the first ones, one of the the first financial specialists that that got, real constructive on the publicly traded asset managers, particularly alternative asset managers. So I’d love to spend a little bit of time talking about, asset management in general. So you have a deep background, as as as do I in asset management. And then I wanna talk for a minute about capital markets. So let’s start with asset management.

Andres Sandate: 34:33

When you think about the the the universe of asset managers, you you have this notion of traditional versus, alternative. You also have passive versus active. I’ll let you pick where you would like to start, passive versus active or traditional versus alternative or maybe both. Yeah. But when you think about asset management, these are gigantic forces that are disrupting this industry, changing this industry.

Andres Sandate: 34:59

And we even saw yesterday, I think, KKR announced, a partnership with Capital Group, you know, the the, you know, the sponsor of the American Funds. Long a bastion of portfolios for financial advisors announcing that they’re gonna partner up on a couple of of offerings, which is just fascinating. So what comes to mind when you when you think about asset management?

Derek Pilecki: 35:21

Yeah. I mean, I think private equity managers are a great business model. For a long time, I’ve told investors, you don’t invest in Blackstone or KKR’s fund. Just buy their their GP. You know, just own KKR KKR stock.

Derek Pilecki: 35:36

Now that being said, we’re at a interesting point where there’s a lot of big institutional firms that are are institutional investors who are over their skis on their allocations to private equity. Distributions aren’t coming as quickly as they expect, especially in VC, and so they don’t wanna make new allocations because there there’s a little bit of liquidity crunch there. So, like, are we at a temporary place where fundraising is gonna be harder for the big private equity firms? Not really clear to me what which way to go there, but I I know generally, I think those firms are gonna continue to grow and, you know, have very good business models. The one that I’m really involved with at the moment is Carlyle Group.

Derek Pilecki: 36:17

I really like the new CEO. I think, you know, the previous CEO transition had been botched by the firm.

Andres Sandate: 36:24

Yep.

Derek Pilecki: 36:24

I think that I think the new CEO has a a huge canvas to work on. Like, there is a there’s a huge expense cutting opportunity at Carlyle. Carlyle It’s Harvey Schwartz,

Andres Sandate: 36:35

the new CEO?

Derek Pilecki: 36:36

Exactly. So, you know, You know, Carlyle would always run their business of, you know, we’re gonna run the business on the management fee and pay ourselves on the carry. And, you know, the when the other publicly traded managers came out, Carlyle and I mean, Blackstone and KKR, all of a sudden they were earning 20 or 30% margins on their management fee and Carlyle has, like, how we we’re breakeven on our management fee. So, like, there was an just a a heavy spending culture at Carlyle that I think Schwartz is gonna, you know, not clamp down on, but just, like, make intelligent choices about Yeah. Improving the margins there and reducing some of the spending.

Derek Pilecki: 37:15

And then there’s a lot of opportunity on the, investment capability side of Carlyle and great brand name and, you know, great at raising money. They they just have some some gaps in their, investment arsenal that he can fill and grow the firm. So I think and, you know, the valuation’s way cheaper than the its peers even with those opportunities. So Yeah. And when you

Andres Sandate: 37:38

yeah. When you think about them, you think, you know, private equity, defense, government. I mean, the that’s a a a sort of a gold plated franchise. But when you think about them, you necessarily don’t think credit. You don’t think, secondaries, you know, in some of these other areas.

Andres Sandate: 37:54

And I think all of them, and I’d love to get your take, seem to really, from a from a capital flows perspective, really are eyeing not only foreign markets, as a source of growth, but also the retail investor as as a source of growth. And when I say retail, I mean, you know, trying to go after that high net worth, retail investor that’s being served by a financial adviser. It seems like all of the more successful ones that are growing, number 1, have product, and they have a way to distribute that product to retail, both globally, but also importantly in the US where that average investor is woof not woefully, but they’re under allocated to alts relative to, you know, their their family office or institutional peers.

Derek Pilecki: 38:42

I mean, we’ve had a bull market for the past 14 years. Right? So the there’s a ton of investors who have historically not invested in alts that have a lot of money now. And they’re, you know, they’re people with, you know, 5 to $25,000,000 or even more that historically have not invested in alts. So the, like, the access that the private equity managers are trying to get to those people are coming through investment advisers or financial advisers.

Andres Sandate: 39:10

Yeah. Let’s talk about capital markets. When when you talk, capital markets in the context of of Gator Capital Management, what what does that universe look like? I’m curious.

Derek Pilecki: 39:22

Yeah. I mean, it’s the investment banks. Right? So it’s the Okay. Goldman’s and Morgan Stanley’s, Barclays, you know, UBS.

Derek Pilecki: 39:29

The, you know, the capital markets really hit hit the cover off the ball in 2021, you know, with the SPAC craze and the IPO boom. You know, those businesses really were busy and had a lot to do. And then there was, you know, the pullback in 2022 really, you know, capital markets revenue is really at a cyclical low. And we’re just starting to see, like, that’s coming back a little bit, late 23, early 24. And, you know, 24 has been a good year for capital markets growth.

Derek Pilecki: 39:57

You know, the a lot more trading, a lot more business being done. I think, you know, when rates were going up so much in 2022, there’s a lot of on the debt capital market side, things were pretty quiet. So now we’re, you know, I think the stable rates, you know, 10 years staying here around 4.50 makes a a better environment for issuance, and people are like, okay. This is, you know, there’s not as much volatility. We have business to do.

Derek Pilecki: 40:24

Let’s let’s raise some debt and, you know, lock in some funding. And so I think capital markets businesses are in a a nice recovery mode from the the cyclical lows of, you know, 12 to 24 months ago.

Andres Sandate: 40:38

I wanna ask you about securitization. You know, it it it up until 2008, you know, a lot of folks didn’t know what a CDO was, didn’t know, maybe they don’t know, but, you know, you saw so much innovation, in the asset backed securitization markets. And then it was I would say largely, you know, the veil was lifted with the GFC, and we saw a lot of banks suffer. And there was just it it it exposed just how interconnected the global capital markets really were. I had a guest on last week who talked about there’s there’s somewhat been a loss of innovation in the securitization markets because you saw this talent leave, and you saw some of these securitization markets sort of seize up.

Andres Sandate: 41:24

And you have private ABS. You have public ABS. But, obviously, and some of the bigger, areas like auto, student loans, mortgages, etcetera? I mean, are origination volumes just generally down, and that’s why we don’t hear as much about securitization? Why has there been, for example, such a a more and more chatter and talk about private ABS?

Andres Sandate: 41:55

I’m curious, like, do you traffic in in these in these, universes, or does it touch the capital markets names that you follow?

Derek Pilecki: 42:04

Yeah. I mean, it’s it’s very my exposure to that is pretty small. So, like, the

Andres Sandate: 42:10

Okay.

Derek Pilecki: 42:10

I I think there has not been a lot of innovation because there’s been some regulatory changes and about what risk retention is. And so I I I think that there’s not been you know, people haven’t been paid to take more and more risk or come up with more innovative structures. And so there’s just been lack of innovation there, and it’s been more it’s it’s boring because it’s like this the structures are tried and true, and there’s not much innovation there. And so it’s Yeah. You’re just basic business.

Derek Pilecki: 42:37

And and

Andres Sandate: 42:37

that would that would explain why some of it’s maybe moved to to the private markets. Let’s talk about, we we touched on this earlier, but I wanna ask you. When you when you talk about nonbank lending, in that universe, you know, you talked about Stripe and Venmo and Cash App. And the I look at those as more transactional, like, processing and the technology. When you talk about nonbank lending, a source, you know, 10, 15 years ago, it was Prosper, and it was all these peer to peer type of lendings.

Andres Sandate: 43:10

I’m not thinking that’s what you’re you’re talking about when you say nonbank lending. So I’d be curious, like, how big is this market? Who are the players, and who seems to be doing a decent job at it?

Derek Pilecki: 43:24

Yeah. So I mean, non bank lenders on the consumer side are, you know, OneMain Financial. It’s a subprime lender. It’s the old Citi Financial, AIG, American General Business, you know, or I mentioned Sallie Mae, the Mhmm. The student lender.

Derek Pilecki: 43:40

You know, I I think it’s lenders like that, like LendingClub, Upstart, or currently non bank lenders SoFi. And so those are the companies that are non bank lenders. On on on the commercial side, there’s some commercial mortgage rates. There’s some commercial finance companies that are are non bank lenders.

Andres Sandate: 44:04

See? It wasn’t my kids today. It was my dog.

Derek Pilecki: 44:09

I was hoping to get to see one of your kids today. I’m I’m bummed I’m not showing

Andres Sandate: 44:13

up yet. You you might you might see one jump in. I mean, that’s that’s the nature of it. So so there’s a number of nonbank lenders across mortgages, across student loans, and these other areas.

Derek Pilecki: 44:25

Yeah. I like I like nonbank lenders. They tend to be monoline. They they tend to Yeah. Have higher returns on equity than banks.

Derek Pilecki: 44:33

They tend to grow a little bit faster, but they don’t have as much stability, right, because they don’t have the deposit franchise. So they, you know, a lot of times they’re funded in the capital markets and it it, you know, they can run into problems with the the balance sheet if they’re not more stable on their funding side. But they’re interesting businesses and they’re innovative and and they they can grow faster than a typical bank. And so I think they’re interesting businesses from time to time.

Andres Sandate: 45:00

But like you said, earlier in our conversation, the complexity, the inefficiency, they can run into problems just because they don’t have the deposit base. All the more reason why, you know, only specialists probably are really starting, you know, to really be constructive on doing the underwriting, doing the work, and the research.

Derek Pilecki: 45:20

That’s right. I mean, I think it’s, you know, a specialized area that, you know, it’s trafficked in by a lot of financial sector specialists, not necessarily generalist investors.

Andres Sandate: 45:32

Yeah. How much, you know, when when you look back, at the time that you have been running Gator Capital Management, and and you’re doing that away from, you know, call it Wall Street in New York. You’re doing that in Florida. And and I know you used to get this question from investors, and I’d love to get your take on it now, you know, years removed. How much does being outside of kind of the trading of ideas amongst other funds, other PMs, like, how much has that benefited you?

Andres Sandate: 46:10

I’d I’m curious, where you can really, you know, sort of burrow in and concentrate and not be caught up in the noise and the hype. How much has that impacted, your business and your approach? I think I

Derek Pilecki: 46:20

I think it’s an interesting question. Like, I definitely talk to other investors some, but not to the my network amongst my peers is not extensive. Like, I’m not, you know, I’m not in touch with other investors on a daily basis. So, you know, I I see them at conferences a couple times a year and we’re we’re cordial. But, you know, I just kinda march to my own beat and, you know, do my own research.

Derek Pilecki: 46:44

There’s a few few people that I talk to that, you know, to share ideas, but really it’s, you know, a lot of my own research and, you know, just doing my own independent thinking away from what’s fashionable amongst, you know, bounce amongst the financials crowd. So

Andres Sandate: 47:04

I think that’s

Derek Pilecki: 47:06

a huge benefit.

Andres Sandate: 47:07

Yeah. It sounds like it is a benefit. And, you know, without talking about your book and and and the strategy, you’ve always, operated the beat of your own drum. Right? You you tend to not hold the names that the sector or the index is hold.

Andres Sandate: 47:22

You tend to do a lot of your own idea generation and research independent, and and successfully, relative to, you know, your index and your peers. I wanna ask you, you know, kind of couple of final questions. As you think about, you know, financials, we’re we are in an election year. It seems like you can pick up any newspaper, turn on any news channel these days, and get an opinion one way or the other depending on what you’re looking to hear. But, you know, financials and you talked about this at the beginning of the conversation.

Andres Sandate: 47:58

A lot of the things that get talked about in the media that make headlines aren’t necessarily the things that you’re paying attention to, and one of those things you talked about was interest rate risk. So I’d love to ask you in an in an election year with the Fed attempting that soft landing, what’s your, you know, what what’s your outlook, for the sector? You know? Yeah.

Derek Pilecki: 48:21

How

Andres Sandate: 48:21

do you sort of assess how Powell and the Federal Reserve have done given, you know, a a quite tricky hand to play? And, clearly, this is gonna have a big impact on on the names that you follow.

Derek Pilecki: 48:35

Yeah. So I guess one thing that I’m trying to reconcile is the, you know, my portfolio when I look at my portfolio now, not by design, but just when I try to be objective and say, would my my portfolio benefit from a Biden victory or a Trump victory? I think it would benefit from a Trump victory. The problem is I think Biden’s gonna win, which and I know that’s not a consensus view. Like, I think especially amongst financial people, everybody clearly thinks Trump’s gonna win.

Derek Pilecki: 49:05

But, you know, I guess my reasons for why I think Biden’s gonna win is I think the polls are wrong. I think, you know, people with landlines who get called for polls are 10 skew older and Republicans. So I think overstates Trump’s support. I think, number 2, I think there’s gonna be a turnout issue for Trump. You know, just we saw it in, you know, that primary in Indiana where Nikki Haley dropped the race months ago, and she still got 20% of Republican vote.

Derek Pilecki: 49:31

Like, I just think Republicans, there’s enough Brian O’ Republicans that they just won’t show up to vote for Trump. They just won’t vote at all. And then, you know, I I think there’s some social issues, I mean, namely abortion that are gonna really swing towards Biden’s favor. So, like, when I look at the election objectively, I think Biden’s gonna win. My portfolio is set up for a Trump win, not because I said Trump’s gonna win and I’m gonna buy there just naturally banks will be do much better under a bank, a Trump regulatory view.

Derek Pilecki: 50:06

And and so I don’t have that reconciled. Like, how am I gonna approach the election here with, who’s gonna win? I’m kinda waiting to see we have to get more into the need of the race before Yeah. I guess the one thing I would say about the election year, like, usually, election year, the market doesn’t do much until the election happens. Right?

Derek Pilecki: 50:26

And so, like

Andres Sandate: 50:26

That’s right.

Derek Pilecki: 50:27

We we’ve actually had a pretty strong market for an election year so far. Like, S and P is up 10%. We’re at sitting here at close to all time highs. That’s a little bit surprising. So, like, is the mark and how how do I interpret that?

Derek Pilecki: 50:40

Is the market looking through the election? Does the market already know who’s gonna win and it’s comfortable? Or is it just a a fed phenomena where we’re expecting interest rate cuts and the economy is stronger than everybody expected and and, you know, so the market can power through an election year because so it’s not clear and just trying to sift through that and, you know, you ask me tomorrow, I’ll have a different answer for you. Right? Yeah.

Derek Pilecki: 51:08

Yeah. Like, I’m trying to figure it out. Like, it’s it’s an open question in my mind. They’re like, why why has the market been so strong in the face of an election year?

Andres Sandate: 51:16

Yeah. That that that makes a lot of sense. I mean, you have to keep your your head on a swivel. Last question. You know, when you think about, the Federal Reserve and you think about Jerome Powell, you know, chairman of the Federal Reserve and trying to, trying to determine, you know, are we gonna see a rate cut this year?

Andres Sandate: 51:36

Are we gonna not see a rate cut at all? Are we gonna see a rate cut a a a rate rise? What what is your overall grade that you’d give, the Fed? You know? I’m I’m just curious because I would imagine, you know, you’re paying attention to this as much, if not more so than most of the people that I talk to.

Andres Sandate: 51:57

Certainly, the people that I have on our show, are paying a lot of attention to what’s going on in the macro economy, what’s going on in their portfolio. So I’m just curious what what kind of grade and assessment you would give him because it’s an incredibly difficult job.

Derek Pilecki: 52:11

Yeah. It’s a very hard job. Like, it’s, you know, in and I’m also looking at it with hindsight here. Right? I mean,

Andres Sandate: 52:17

it Yeah.

Derek Pilecki: 52:18

There’s some things like did qt or q quantity of easing have to continue? Did they have to continue to buy all those mortgage backed securities and treasuries Yeah. Into 2021 when the the market was red hot and that we had this back craze. Like, I don’t there’s some things that, in hindsight, I wish I bet they wish they could have a redo on. Right?

Derek Pilecki: 52:41

So it’s a very hard job. I guess I didn’t agree with the last couple rate increases. Like, I felt like, going to 4 and a half percent on the Fed funds was enough. Like, I didn’t think I didn’t think that they needed to do the last three rate increases. So, like, could they cut 3 times and go back to where I thought they should be in the first place?

Derek Pilecki: 53:01

Yeah. I think this inverted yield curve is really hard for the banks. I think it’s, you know, but I I think the Fed also wants the 10 year higher. I mean, I think the the Fed would like I guess the other thing about the where where interest rates are is I kinda agree with some of the people who are saying the higher rates are causing inflation because, you know, if you think about housing supply, we’re short housing. We need more housing.

Derek Pilecki: 53:26

Higher rates does not promote more housing. Right?

Andres Sandate: 53:28

That’s right.

Derek Pilecki: 53:29

So, like, rents are gonna go up because there’s not enough housing. And so what are we doing here? Like, let’s and every time I see a solution from the administration, it’s let’s create more housing demand. Let’s lower the cost of mortgages. Well, that doesn’t create more supply.

Derek Pilecki: 53:47

We need to address housing supply. That’s the issue. And more housing supply will lower, prices, lower rents, and so and lower inflation. So, like, we have to figure out housing supply, and I don’t know that higher rates is fixing housing supply. Yeah.

Andres Sandate: 54:04

So that yeah. Interesting. This has been a really great, you know, tour through the financial markets. I you know, we’ve talked about so many sectors within financials, you know, including banks, insurance, asset management, capital markets. I wanna give you the last word, though.

Andres Sandate: 54:24

You know, we we’ve known each other for, you know, a a number of years. You’ve been running Gator now for 16 years. Congratulations. When when you think about, you know, where, the next 15 or 20 years with with Gatorgo, and where you wanna take your platform and financials, You’ve built your team up, and, and you’re in Florida and you’re doing this. What what are the things that come to mind?

Andres Sandate: 54:51

Like, as far as, you know, these are the challenges I wanna tackle. These are the areas that are most exciting. You know, these these are the things as a as a CEO, as a portfolio manager that get me excited to get up and focus on this really highly complex area every day.

Derek Pilecki: 55:06

Yeah. I mean, I’m just excited about compounding my investors capital over the next 16 years. Like, you know, I’ve been doing it for 16 years. In 16 years, I’ll be 70. I think that’s a, you know, a nice career and, you know, I’m excited.

Derek Pilecki: 55:20

The firm’s at a decent size now. We compound investors capital for another 16 years. We’ll be, you know, bigger than I ever thought we would be. And so, like, that’s just the focus of, like, continue to put up good investment performance, find the opportunities in these small and mid cap financials where we can put up excess returns for our investors. And and, you know, I think with the I think it’s a very dynamic industry, and I think there’ll continue to be opportunities, for our investors there.

Andres Sandate: 55:48

That’s great. Well, Derek Pilecki, portfolio manager of Gator Capital Management, headquartered in Tampa, Florida. Thank you for joining me today on the Asset Backed podcast. Tell us how people can learn more about you, where can they, get in touch with you, and, hear more of of your views on financials.

Derek Pilecki: 56:08

Yeah. So our website’s gatorcapital.com, and you can send me an email. My email address and phone number are listed on the website. And, You’ll you can also follow me on Twitter under the handle Gator Capital. Fantastic.

Derek Pilecki: 56:20

For having me, Andres.

Andres Sandate: 56:22

Yeah. Derek, it was a pleasure, and, I look forward to having you back on to get an update on what’s happening in financials. Thanks for joining me today on the Asset Back podcast.

The recent turmoil at New York Community Bank (“NYCB”) has dragged down the stocks of small-to-mid-sized banks again this year. The exchange traded fund for mid-sized banks, the SPDR S&P Regional Banking ETF (“KRE”), underperformed the ETF for large banks, which is the Invesco KBW Bank ETF (“KBWB”) in the 1^st quarter. The KRE was down 3.33% while the KBWB was up 10.01%. The underperformance of the mid-sized banks versus the large banks continued in April. Large banks are perceived by investors as having less credit risk, more robust credit reserves, and more liquid balance sheets.

There are obvious headwinds that the banks are facing: tepid loan growth, competitive deposit environment, and an uncertain credit environment; however, we see opportunity in selected small-to-mid-sized regional banks (“SMID banks”). We think stock investors are overly pessimistic in their assessment of SMID bank credit concerns. We believe the larger issues for SMID banks are interest rate risk and loan volume growth. Regarding interest rates, we see banks having a wide disparity of performance based on the positioning of their securities portfolios, their percentage of fixed rate loans, and how they manage their deposit franchise. Many banks have navigated the move in higher rates well and remain well-positioned for the current environment. We also see differences in how banks manage their loan growth. Some banks continue to grow loans and deposits and accept that margins in the near-term are narrower due to the inverted yield curve and competitive deposit environment. We think these banks will be rewarded when the yield curve normalizes, and they realize wider net interest margins on a larger book of business.

 

Within SMID banks we group our favorites into three buckets: Puerto Rican banks, growth banks, and small banks with unique stories.

 

Credit Risk

 

Credit risk is perilous for banks. The current environment poses four areas where banks may experience heightened credit losses. The first area is office buildings. The second area is rent-regulated apartment buildings in New York City. The third is commercial estate properties (“CRE”) where the rapid rise in interest rates has caused the value of CRE to decline. The fourth is rapidly rising debt costs for borrowers with floating rate debt.

 

So far in the Q1 bank earnings season, banks have reported better than expected credit metrics. The increases in non-performing assets and criticized loans are not alarming given that bank credit metrics were at record lows in 2022 and 2023. We’ll have to remain vigilant about credit risk to see if metrics deteriorate in the coming quarters. In the meantime, we will stay focused on banks with historically strong credit cultures. As we meet with bank management teams, we remain alert for any changes in risk appetites. Many market participants have a negative view of bank managements’ ability to see pending problems in their loan portfolios. We note that risk management and monitoring of loan portfolios has improved from when we started investing in bank stocks. We realize that bank stock investors may need to see the other side of the credit cycle before putting higher multiples on bank stocks and this contributes to the current opportunity we see.

 

Interest Rate Risk

 

Market participants are divided on the outlook for banks. Some investors see an opportunity because banks are cheap and poised to benefit from interest rate cuts. Others are concerned about potential credit losses or rising interest rates. We believe selective opportunities exist, with certain banks offering attractive valuations and potential for earnings growth, while others are at risk as they have significant holdings of fixed-rate loans and securities on their books.

 

Banks benefit from higher reinvestment yields, but some banks have more near-term opportunity. If a bank has a lot of loans and securities maturing in the next year at low yields, they can take the proceeds from the loan payoff to make a new loan at today’s higher yield. Unfortunately, many banks made a lot of 5-year and 7-year fixed-rate loans in 2021 and 2022 that won’t mature until 2026 or as late as 2029.

In a more robust deposit environment, banks would generate loan growth which would allow new production to be put on the books at normalized spreads.

 

In 2022 and very early 2023, almost all banks paid aggressively low deposit rates even as the Federal Reserve raised the Federal Funds rate. Most bank customers had become accustomed to the zero-interest rate environment and were not in the habit of managing their excess cash for higher yields. The media focus on Silicon Valley Bank’s failure in March 2023 caused many bank customers to change how they managed their excess cash. This change in customer behavior forced banks with weaker deposit franchises to raise deposit rates to retain customers and deposits.

 

Banks have deposit franchises with varying degrees of strength. Many different factors can create a strong deposit franchise such as a long history in a marketplace, a strong branch and ATM network, a strong sales culture within the bank of asking for additional deposits from customers, and the size of the bank. Banks with weak deposit franchises use higher rates to attract price sensitive customers.

 

When Silicon Valley bank failed, the banks with weak deposit franchises had to raise their deposit rates more aggressively to retain their deposits. During Q2 and Q3 of 2023, these banks raised deposit rates to a level that stabilized their customer bases. We estimate this level is about 3.75% to 4.00%. Although these banks have weak deposit franchises, their net interest margins (“NIM”) have already compressed. In a stable rate environment, they should have loans and securities repricing to higher rates as they mature and their NIMs should gradually widen. In a declining rate scenario, they should be able to reprice their deposit rates lower. This will lead to wider NIMs. There is also the possibility that they will strengthen their deposit franchises and attract less rate sensitive deposits. We think this scenario is less likely, but there are a few banks where this is a possibility.

 

Banks with stronger deposit franchises are experiencing continued deposit cost pressures. They have not had to raise deposit rates as aggressively because their customers are not as price sensitive, however, with money market rates above 5%, even customers of these banks with strong deposit franchises are looking to better manage their excess cash. This has put continued pressure on these banks to retain deposits. Even JP Morgan Chase has not been immune. On its most recent earnings conference call, the CFO said that the bank expects to see continued movements by customers to seek higher deposit rates.

 

We believe the current high level of interest rate risk will dissipate with time. We believe the inverted yield curve and the significant rate increases by the Federal Reserve is causing the small-to-regional banks to under-earn compared to our estimate of their normalized earnings power. Despite this under-earning, we observe that the small-to-mid-sized regional banks trade at the low end of both absolute and relative valuations. It is a classic value situation of the market assigning a low multiple on stocks with depressed earnings.

 

New York Community Bank

 

At the end of January, New York Community Bank (“NYCB”) reported Q4 earnings. The surprisingly bad earnings report caused the stock to decline 37% in one day. The stock has continued to slide despite a $1 billion recapitalization led by former Secretary of Treasury Steven Mnuchin.

 

NYCB’s poor earnings report and stock price decline in January was a catalyst for the entire regional bank sector underperforming so far in 2024. Through March 31^st, the SPDR S&P Regional Bank ETF (“KRE”) was down 3.33% versus the S&P 1500 Financials Sector Index which rose 11.67%. The January earnings season was constructive, but NYCB’s report changed investor sentiment on the regional banks. The question presented to us as bank investors is “Are NYCB’s problems idiosyncratic or systemic to all banks?”

 

We believe NYCB’s issues are idiosyncratic to NYCB. NYCB has long been a New York City apartment lender. Their track record over many decades has been spectacular with near zero losses. But, in 2019, NYC passed a law that limited how much landlords could raise rents. In the current inflationary environment, landlords’ costs are rising, but they can’t raise rents, so investors are concerned that landlords will get squeezed so much that they will default on their loans.

 

The NYCB acquisition of Signature Bank highlighted a potential regulatory oversight. NYCB crossed the $100 billion asset threshold, placing it in a new regulatory category with stricter capital requirements. Regulators should have recognized this deficiency in capital and forced NYCB to raise its loan loss reserves and raise additional capital instead of reporting a bargain purchase gain. If regulators were more proactive, the issues with NYCB purchasing Signature could have been avoidable.

 

We think the regulator’s treatment of NYCB was idiosyncratic because of NYCB’s concentration in NYC apartment loans and its crossing $100 billion in assets with the Signature Bank purchase. We think SMID banks underperformed their large bank peers starting on January 31^st because of NYCB’s unique issues.

 

 

 

Best Opportunities in Regional Banks

 

Within SMID banks we group our favorites into three buckets: Puerto Rican banks, growth banks, and small banks with unique stories.

 

Puerto Rican Banks

 

Banking in Puerto Rico is an oligopoly. In 2006, there were 11 banks in Puerto Rico and the economy had just entered a recession that would last 15 years. Through bank failures and consolidation, there are just three commercial banks operating in Puerto Rico. We have seen the Puerto Rican banks expand their margins and improve their returns. We also see early signs that bank stock investors are taking note by placing higher valuations on the Puerto Rican banks. We’ve owned First Bancorp and OFG Group for several years and continue to think they have attractive upside.

 

Growth Banks

 

We have written about Growth Banks in the past. We continue to like this group of banks. They have cultures that foster organic growth. For banks to grow, they must generate capital through retained earnings. So, many of these growth banks also have high returns on capital. One way to identify these banks is to screen for banks with the highest tangible book value per share growth over a 10-year or 20-year timeframe.

 

The banks we hold that fall into this category are First Citizens, Western Alliance, Pinnacle, United Missouri, Esquire, Axos, Customers, and Webster.

 

Small Banks with Unique Stories

 

We also own smaller banks that have unique stories: NYCB collateral damage (DCOM & CNOB), small cap M&A banks (OSBC, BANC, & BFST), ultra cheap but solid banks (FBIZ, OPBK, & UNTY), and a purchaser of loans from other banks (NBN).  While each of these positions is small due to liquidity considerations, we think each will generate attractive returns.

 

 

Andrew Walker:

This episode is sponsored by tegu, the Future of Investment Research. From the beginning, Tegu has been committed to creating efficiencies in the research process by making it easy to access the content that investors need to get differentiated insights today. They’re taking it one step further by bundling qualitative content, quantitative data, and better automation and technology together in the same platform. Instead of piecing together data from fragmented sources, just log into tegu to get expert research company and industry specific metrics and KPIs, SEC filings and more all under the same license costs. You can even take a look at your work offline with an Excel add-in that updates almost any model with the latest financial data, keeping all your custom formatting intact. Tegu is the fastest way to learn about a public or private company and the only platform you’ll need for fundamental research. To try it for free today, visit tegu.com/value. That’s T gs.com/value. Alright, hello and welcome to the yet another value podcast. I’m your host, Andrew Walker, also the founder of yet another value blog.com. If you like this podcast, it would mean a lot. If you could rate subscribe, review it wherever you’re watching or listening to it with me today, I’m happy to have Derek Palecki. Derek is from, well, Derek, are you the CIO Eric Gator or what’s the official title?

Derek Pilecki:

Yeah, I just call myself a portfolio manager.

Andrew Walker:

Portfolio manager at Gator. Well, Derek, thanks for coming on.

Derek Pilecki:

Yep, thanks for having me.

Andrew Walker:

Look, really happy to have you before we get started today, just want to remind everyone quick disclaimer, nothing on this podcast is investing advice. That’s always going to be true, but particularly true today because as I was telling Derek before we started recording, I’ve been following Derek’s letters for probably 10 years at this point and we’re just going to be going through the financial sector space in general. So we’ll be talking about a lot of different companies, a lot of different stocks. Just remember not investing advice, please consult a financial advisor, all of that. So Derek, we are talking today, I believe it’s March 12th is the official day. Tons of stuff happening in the financial space. We can talk about anything. We could talk crypto, we could talk regional banks, we could talk just all sorts of stuff. I’ll just start by asking you, as we sit here March 12th, how are you thinking about the financial sector day? What’s most interesting on your mind these days?

Derek Pilecki:

I mean, I think that the way the sectors from trading in the wake of NYCB news is really the most interesting, right? I mean, we got through most of earning season, the banks were reporting just fine. NYCB was one of the last big of the larger banks to report and just totally changed the narrative for the whole sector. And so a lot of names are down, A lot of names that had really good earnings in Q4 are down a ton. And so I think that’s the most interesting thing right here.

Andrew Walker:

So I guess on the names that are down, I wrote a piece on this, it was so crazy, as you said, every bank had reported NYCB is one of the last to report. They report and they disclose. I don’t think it was unknown, the rent regulated portfolio they had, but I think the degree and the magnitude and everything really shocked people. They report the stocks down 50% in a day, 50% the next day, whatever, but every other bank gets hit. And I did think it was kind of interesting that everybody just kind of went and said, oh, all these banks that reported great credit trends, everything Valley Western Alliance, some banks that don’t even have rent regulated exposure were getting hit five or 10%. And some of them have got it back, some of ’em not. I guess you could take two minds to that. You could say, Hey, the market shot first and ask questions later. Or you could say the market’s looking at these and saying, Hey, lending is complicated and if we missed it at NYCB, maybe we’re not missing it on rent regulated, but maybe we’re missing it on government leasing somewhere else or all this how of stuff. How are you thinking about that?

Derek Pilecki:

Yeah, I think investors in the regional bank space have PSTD to some extent. We just went through March of 2023 and I think the NYCV news was like, oh no, not again, and let’s just cut our risk and move on. I think a couple other currents, one that you mentioned about okay, credit quality, we’re seeing the first signs in NYCB here, NYCB was supposed to have perfect credit. I mean they’ve had perfect credit for years, decades with New York apartment buildings. There’ve been no losses and this is a change. And then the other narrative of them crossing a hundred billion dollars and supposedly the regulators tapping them on the shoulder and saying you have to increase liquidity and increase your loan loss reserves to look more peer. All of a sudden you have these banks that are approaching a hundred billion, okay, what do we have? What do these banks have to do to get to those levels? And so I think there’s several things going on there, but a lot of banks that had just fine earnings that are pretty far away from a hundred billion dollars are down 15%. I think that’s pretty interesting.

Andrew Walker:

A few things I want to follow up. So in March, 2023, let’s just start there. That was deposit risk, especially at Silicon Valley Bank. You had people just, they were pulling their deposits left and and you saw how quickly, I do remember people were comparing WAMU in 2008 where five or 7% of the deposits left in 48 hours because people were still literally going and trying to deposit checks. Whereas Silicon Valley Bank, you just wired out. A lot of people were rethinking deposit risk and I’m of two minds of it. Yes, deposits are scary, but I’ve heard a lot of people throw around deposit risk on the heels of NYCB and I kind of look at and NYCB wasn’t really having flight until the morning before the bail-in or bailout or whatever happened, and I kind of think if deposits were going to leave, they’d already left. So how do you look at deposit risk in these, especially regional banks these days?

Derek Pilecki:

Yeah, I think the big surprise from March of 2023 was the level of uninsured deposits in the banking industry. I saw one, I think it was either Steven, I think Steven’s put out a report that said that the average level of uninsured deposits or the median level of uninsured deposits in the regional banks was 39%. And even being a bank investor, that seemed like a shockly high number to some extent. I understand 250,000 is not a high level for an insured deposit account. I have a retired school teacher who has say, been a diligent thrifty woman all her life and she’s gotten a little over a million bucks, like 250 thousand’s, not a lot of money for somebody who’s been thrifty and in their seventies. And so we need to raise the level of deposit insurance for consumers. It needs to go up and for operating accounts for businesses, it needs to be higher. Silicon Valley was just off the charts mean they had bill.com had a nine figure checking account that’s the government shouldn’t have to insure it or the industry shouldn’t have to insure those accounts.

Andrew Walker:

It circle had 4 billion in uninsured deposits sitting had it. I saw that number and I was kind of like, dude, just let the fricking guys fail 4 billion in uninsured deposits. Are you kidding me?

Derek Pilecki:

I mean, I guess I’m of the view of as a society, we can prevent bank runs by just saying everything’s insured, right? There’s no societal benefit of bank runs. Nobody benefits from them. There’s no discipline imposed on the banks by depositors zero. Silicon Valley had a 16 billion market cap when they went to go raise that capital. There’s no depositor who would look at that market cap and say, oh, my deposit’s at risk. The depositors just don’t enforce discipline on the bank. So the theory that we have this concept of a limit on deposit insurance is questionable. In my mind.

Andrew Walker:

There were people who were long First Republic or Silicon Valley bank stock who get paid professionally to look at this and you go to them and be like, Hey, what do you think about the health to maturity issues? They’ve got negative equity, Justin, and they wouldn’t know what you were talking about. And that is just absolute shame on them. But if a professional investor doesn’t know what they’re talking about now, they’re probably not a financial investor like you if that was the case, but if they couldn’t be expected to pick that up in a 10 K, how can you expect mom and pop who are just going and getting a toaster oven when they open a deposit accounts? Get that? I’m completely with you there.

Derek Pilecki:

I completely agree. And so then question in my mind is why hasn’t it happened already? Why haven’t we raised deposit insurance? And I guess there’s no political capital right now to raise deposit insurance. It makes it look like you’re bailing out rich people by raising deposit insurance where you’re actually making the system safer. So hopefully that’ll change in coming years and more sanity in Washington. But who knows

Andrew Walker:

I, oh, go ahead. Go ahead.

Derek Pilecki:

I guess the other thing is in Dodd-Frank, I think they implemented something where congress has to sign off any increases in deposit assurance rather than the FDIC just making a regulation change. So they’re just going to make it harder to raise deposit insurance.

Andrew Walker:

The two most frequent banks that we got asked about and that I think are probably among the most interesting right now are Valley and Western Alliance. So let’s start with Valley and for people who don’t know Valley is, I believe they’re Jersey based, but they’ve got a lot of New York City lending and people looked at them when NYCB kind of had all their issues. Valley was the first thing they shot, right? Because there’s a lot of similarities there and people are just lobbying in tons of questions. I don’t believe, I know they’re not a top five position for you. I don’t know if you’ve got a position one way or another, but just wanted to ask you, I know you cover all these things. What do you think about Valley these days?

Derek Pilecki:

Yeah, I mean I don’t own a position in Valley. I haven’t owned a position in Valley. It’s on my to-do list of things to work on. I think it’s interesting. I think they have a very conservative credit culture. I guess the obvious scary things of New York City exposure, Manhattan exposure, a lot of fixed rate loans, but I think there’s a potential opportunity there. I just haven’t done enough work to say, Hey, they’re clean. I feel comfortable owning it.

Andrew Walker:

I like that. I like answer. I do think one interesting thing is Valley, from what I remember was very close to taking over the Silicon Valley Bank remains and First Citizens obviously beat them to that, but Valley kind of made it known. They were the backup bidder if I remember correctly. And then NYCB obviously won a lot of the signature leftover assets, and I do just think it’s interesting in March, 2023, there was a lot of stories like, Hey, if you were approved to be a bidder, that was the all clear signal from the Fed. This is a safe bank, these are good and valid. Getting hit now may be right or wrong, but NYCB obviously it was not the all safe. Go ahead. Clear regulators are on your side. Obviously they had issues and regulators were the ones who kind of tapped them and revealed a lot of those issues. I

Derek Pilecki:

Mean, that’s the head scratcher about the story of the regulator tapping NYCB on the shoulder and saying raise liquidity and loan loss reserves because the time to do that was when they gave them the deal in March of 23, instead of taking a bargain purchase gain on the signature deal, have them put all that extra money into the loan loss reserve. Back then it wasn’t. I mean they were crossing a hundred billion. It seems like that with a little bit of foresight on the regulators part, that would’ve been the time to get everything to the level that they wanted.

Andrew Walker:

So NYCB trips over a hundred billion, and what happens is the regulators kind of unexpectedly to N-Y-C-B-I think go to them and say, Hey, we’re going to treat you like a hundred billion bank today. Loan reserves go up today. Capital requirements go up today. Take a harder look at your bank today, dividend coming down today to get the capital reserves. I guess my question there is obviously they bought the Signature Bank, but a lot of the loans that they’re having trouble with in my opinion, are the loans that kind of NYCB had written previously to Signature. I don’t think they bought most of signature’s rent regulated book, which obviously the DS had a lot of trouble selling, but NYCB is having a lot of issues with, I don’t think a lot of the office book came from signature. I guess my question is, if they hadn’t bought signature NYC B’s a 60 to 70 billion bank right now, what’s happening with NYCB? Is it just kind of they’re muddling along? Nobody’s really looking under the hood at this thing because to my mind, a lot of the issues are still there. What’s happening right now with them,

Derek Pilecki:

And I think if they don’t buy signature, they’ve already had problems because their balance sheet was upside down as far as fixed rate loans versus deposits. And so buying signature, they was made them a lot less liability sensitive. I mean, they’ve got a lot of cash in the signature deal and they were able to use that cash to pay off some FHLB borrowings, pay down some broker deposits with that cash, so their balance sheet would’ve been upside down if they hadn’t done the signature deal, so they might’ve already had problems.

Andrew Walker:

Okay, that’s perfect. Let me ask you another one. This is to as of your Q4 letter, I think your fifth largest position, so Western Alliance, and that is a bank that I remember the day, I hadn’t really studied it. I remember the day signature failed or First Republic or one of them. This stock went from like 60 to eight in a day, and I remember looking at be like, oh, I want to buy this, but oh my God, bank runs. What does someone know? And they’ve been clear, their depositors were a little freaked out by it and all this sort of stuff. As you know, I sit today trades for about $60 per share. The returns on equity at this franchise have been great. Their credit especially, they talk about how they’ve got great, great controls for dealing with trouble loans, recovering trouble loans, everything. So it trades for 60 tangible book value is about 46. I just want to ask you, what’s the thesis there because I’ll dive into it more in a second. I want to ask you what your thesis on it is.

Derek Pilecki:

Yeah, so I think Western Alliance is in this category that I consider growth banks. They earn high returns on capital. If you look at the long-term, outperformers and regional banks, they’re the ones who grow tangible book value at the highest rates and usually you need a high ROE to grow tangible book value at a high rate, and you also have to avoid doing dilutive acquisitions. So Western Alliance for the most part, does all organic growth. Occasionally they’ll make an m and a transaction to buy a platform business that they can then grow, but for the most part it’s all organic growth and they earn a very high ROE, so their tangible book value grows over time. They have not been a huge capital returner. They’ve been reinvesting that capital back into loan growth, and so they’ve just been a faster grower than the rest of the industry.

I think the management team’s very good. I knew him when he was the CFO at NBNA, the credit card company 20 years ago, and I was impressed with him then followed his career. I think he is a very pragmatic bank manager. I like him a lot. I’m a little worried about he’s 69 years old, so usually bank CEOs don’t manage far into their seventies, so I hope he continues to run the bank, but we’ll see. I agree with you. I love their credit risk management. They’re very proactive when issues start to arise that way. Loan losses have been low so far, so I think they’ve been tainted with the Silicon Valley brush because they had one business that was venture banking. They had bought a bank in the Bay Area Bridge that had a lot of Silicon Valley clients and they had some deposit outflows, not only from those clients but from tangential businesses because of the headline risk.

Andrew Walker:

This episode is sponsored by tegu, the Future of Investment Research. From the beginning, Tegu has been committed to creating efficiencies in the research process by making it easy to access the content that investors need to get differentiated insights today. They’re taking it one step further by bundling qualitative content, quantitative data, and better automation and technology together in the same platform. Instead of piecing together data from fragmented sources, just log into tegu to get expert research company and industry specific metrics and KPIs, SEC filings and more all under the same license costs. You can even take a look at your work offline with an Excel add-in that updates almost any model with the latest financial data. Keeping all your custom formatting intact. Tegu is the fastest way to learn about a public or private company and the only platform you’ll need for fundamental research to try it for free today, visit tegu.com/value.

That’s tus us.com/value. I guess so I’m no financial experts but financial expert, but the thing I always struggle with is to me, I look at a bank and it’s really hard for me to look at US regional banks and understand these guys were reporting until last year, 20% plus returns on tangible equity every year. I guess the two knocks I had on them was one, I just didn’t understand how a bank could consistently be this good outside of some of the guys who get cash and flows from buying gift cards at the kiosk and they’ve got that and they’ve just got free money there, which has much different types of risks. There’s a different set of risks there, but I wasn’t sure how a regional bank could kind of earn a 20% return on equity consistently. So I’ll just ask you what’s the secret sauce these guys have and then I do have a follow up.

Derek Pilecki:

Yeah, I think some of it’s the efficiency ratios. So banks tend to be very old organization and very bureaucratic systems are very ancient, so there’s a lot of expenses, there’s a lot of people involved. It’s very efficient moving around a lot of paper for some of the newer bank organizations that have been built on more modern architectures, they have less branches, they have less people involved. If you look at Western Alliance, the number of branches they have, they’re not a consumer facing bank. I mean they’re commercial banks, so they don’t have branches on every corner and they also have less people in the bureaucracy. They use technology to automate their processes to some extent. And so I think having that low efficiency ratio and then also just driving those returns through asking for higher yields on loans and being more aggressive in deposit pricing is where you get the higher returns.

Andrew Walker:

Okay. Yeah, I guess the other knock I had on Western lines, and this isn’t a huge one, but after First Republic especially, it’s always go check the fair value of the loans and the held to maturity securities because First Republic wasn’t really held to maturity securities. They had those, but it was a lot of loans to rich guys, 2% 30 years, and any bank that looked at and be like, no, we have to pair value those when interest rates to 7%, it’s not huge for them, but I think they’ve got about 3 billion of fair value marks on their loans. I’m just looking at their 10 K and I think their overall equity was in the 8 billion range, if I’m remembering correctly off the top of my head. So it’s kind of like, oh, it’s 6 billion, 6 billion actually. So it’s kind of like, oh, well you mark to market and you’re paying a little over two times tangible book value and even with a great franchise that will acrete back, but even with a great franchise that mark to market, what do you think about that?

Derek Pilecki:

Yeah, so it’s not quite two times book value. It’s 60 bucks, $46 a share, so it’s like one,

Andrew Walker:

Oh, well, I was taking the 3 billion fair value mark on the loans out of that six, so then that’s kind of how we’re slipping to that.

Derek Pilecki:

Okay. Yeah, I mean they grew their single family book at the wrong time. Yeah, I mean I think the earnings power is there. I mean it’s going to be a little bit of a drag. I think there’s a ton of banks that have group of fixed rate loans that I don’t know, they’re going to just be an anchor around them for a while. I think Western Alliance is in that group, but it can’t have a perfect investment. Everything is, I agree it’s a knock, but it’s not a big deal

Andrew Walker:

And the best way to get rid of that put up 20% ROEs for a few years and all of a sudden that loan book looks a lot smaller. When you were mentioning I didn’t realize how tech enabled Western Alliance was, and when you were mentioning that, I want to talk more about the Discover Capital One merger in a little bit, but just it does strike me the way you were talking about Western Alliance is the way a lot of my friends who are along Capital One talk about Capital One where they say, look, yes, you’re buying them at 1.1 times book or something, and yes, obviously if we go into a recession, credit cards might not be the best place, but what you don’t understand is Capital One is so tech enabled, right? They have redone their, it is the most modern architecture of any of the banks and you’re paying 1.1 book, but as you compound that, it’s just going to result in much better returns, lower expense. I guess my two questions to a, am I thinking about the comparison between Western Alliance and Capital One correctly there obviously two very different banks, but is that kind of the right frame and B, I’d actually love to shift to talking about Capital One.

Derek Pilecki:

I agree. I think Capital One has been forward thinking on their tax spending and they’ve been trying to get to a more modern architecture, so I agree that they’re probably better positioned than the other big banks from a technology. I guess my question with Capital One is, is that technology spending going to lead to a bigger bottom line or are they going to find other ways to spend that money? My issue has been Capital One’s advertising program. When we see their ads all the time, we see the high profile celebrities in those ads. Taylor Swift, how expensive is it to have Taylor Swift in your Capital One ad, Samuel Jackson, Charles Barkley, Jennifer Garner, they’re all over the place. Is the extra profit from the tech spend more efficiency going to drop to the bottom line and it’s going to shareholders or is it going to get reinvested in advertising?

Andrew Walker:

Sue, would your argument, if I’m taking your argument to its conclusion, is your argument like yes, they’re more efficient, but they’re almost spending the old thing where the CEOs used to love to have a branch in Hawaii or something because then they could go to Hawaii on vacation or they love to have a celebrity endorser as you’re saying, because then they get a hobnob with celebrities. I guess the best would be like Amazon making its way into media because then Jeff Bezos gets the hobnob with all the Hollywood celebrities. Is your argument kind of like, yes, they are more efficient, but you’re worried that this marketing spend, it’s not actually return on investment. It’s kind of the CEO’s way and the execs ways of getting to hobnob with important people?

Derek Pilecki:

I don’t know that, I mean, I respect Richard Fairbank a lot that he’s very forward thinking. I just worry that he likes advertising, spending college football bowls or whatever and not sure. I’m not convinced that their return on marketing spend leads to higher returns. Yeah, I think there’s a lot of waste in that spend, and so I’m worried as a potential shareholder that that’s not going to come to me, that it’s going to get burned up in just additional ads.

Andrew Walker:

Another one just high level I’ve thought about is they’ve got the Capital One. It’s not quick slow. They’re going after the high end credit card customers and they’ve been talking about how they’re putting a lot into it and they think the return on investment is measured in seven to eight years. And I’ve always kind of looked at it and been like, I mean Capital One, I don’t know, going after the Chase Sapphire, they’re literally trying to compete with Chase Sapphire reserved and Amex black or gold or whatever it is. And I’ve always kind of looked at and be like, is starting up a de novo high spend credit card where these people are very likely to switch for the best rewards and you’re trying to grab ’em. It just didn’t seem like a great return on investment and I believe they said it would take seven or eight years to capture what they’re grabbing customers out us. That doesn’t seem like a great return for a bank to me.

Derek Pilecki:

I mean, I think Capital One’s been going after that high spend customer for a number of years. I think it’s been a long time. They were subprime at first and then they went to the barbell strategy of subprime and high spenders. So I think it’s a super competitive space. I mean it’s JP Morgan and it’s American Express and everybody’s going after these high spenders, and so I think they’ve been doing it for a long time. I think it’s hard. I think it’s a super, I’m not aware or not up to date of what the returns marginal returns are in that space. With that, do you

Andrew Walker:

Have any thoughts on the discovery merger?

Derek Pilecki:

I think it’s a super interesting strategic move, right? I’m sure Capital One’s been wanting to buy Discover for a number of years, and I also hear that JP Morgan was a bidder or was interested in Discover for a long time. I think one of the most interesting things is moving the debit card spend to the Discover Network by Capital One, but they didn’t move all their credit card spend away from MasterCard to discover. And I think about it in terms of you have different interchange rates. You have Amex at the top, visa and MasterCard in the middle and discover at the bottom and Visa and MasterCard. Their take rate is, although it’s been increasing in recent years, it is not huge. The issuing bank gets most of that discount. And so why Capital One not moving the business away from MasterCard to discover tells me that even with paying MasterCard Capital One’s making more money with issuing MasterCards than if they moved everything to Discover. And so if that’s the case, and this would be the ideal time to move all that business, how do they get the Discover discount rate higher? And I think that’s a hard, that’s going to be a thing for Capital One to work through.

Everybody wants to get to the Amex positioning where Amex says, we have the big spenders. If you accept Amex cards, we’re going to bring you the high spenders and they’ll spend more than any of your other customers. And so all these stores say, okay, I want to have access to that Amex customer. The Discover customer is not the high spender, right? I mean it’s kind of middle America and if you layer on Capital One on top of Discover’s Middle America customer, you kind of get this hodgepodge of Subprime Middle America and then the high spenders that Capital One’s been going after. So is that going to allow Capital One to raise discover’s discount rate to parody with MasterCard, visa or even above it? I don’t know. That’ll be the interesting thing to follow with a story.

Andrew Walker:

The two interesting things that struck me, and again I’m not an expert on it, but I think it’s a really fascinating deal, is number one, the call option on buying Discover taking one of the largest credit card issuers in the United States. And even if initially they’re not pumping all of their spend through Discover, pumping, a lot more spend to try to get more merchants IT maybe keep the rate low to start, but eventually try to close the discount. I think that’s really interesting. I think it’s really interesting. Now they’ve got a hammer with MasterCard and Visa every time they negotiate, Hey, we’re launching Capital One, we’ve got Quick Sliver, now we’ve got Quicker Gold. We’re launching that. Is it going to be on MasterCard or is it going to be on Discover? We’ve got our own network. You guys need to give us a really good rate here or else you’re going to miss out on a hundred billion worth of spend.

I think that’s interesting. And then the third thing that’s interesting is if you think back to what we were talking about with Western Alliance Cap One, I don’t think anybody thought, I mean Discover is selling because they had a lot of regulatory issues. They had a lot of internal controls issues. I don’t know of anyone. I’ve done a few extra calls. I don’t know of anyone who’s out here being Discover. I mean their underwriting system, their tech, my God, those guys are light years ahead of everyone else. But people do say that about Capital One and you think about bringing all of the Discover customer base, all of their marketing spend everything, all their underwriting onto the Capital One platforms, they guided too. I think it was a billion in synergies, but I’ve had some people who’ve been like, look, when you really look under the hood, I would be kind of surprised if maybe it’s not pure cost synergies, but just in terms of better underwriting, better marketing spend, they think they’re going to blow those synergies out the water. So I think all of those are very interesting considerations. I don’t know if you want to add anything to that.

Derek Pilecki:

I mean, I would just say that the cost synergies seemed really low compared to the potential, right? I mean just what you said, getting rid of Discover’s IT system and just moving those customers onto the Capital One’s platform should be a lot bigger savings than what they outlined.

Andrew Walker:

Yeah. Let’s see. So Capital One Discover is actually a nice segue into one of the things you mentioned when we were talking about NYCB regulators. I don’t think there’s an antitrust issue with Discover Capital One. Clearly the market’s worried about it. We don’t have to talk about the antitrust issue here, but regulators and banks is really interesting right now, right? They tapped NYCB on the shoulder and that was a big issue. You just hear a lot of banks are saying, Hey, the banking regulators are being a lot more aggressive with us. Basal three rules are coming in and banking’s a regulated industry. If we took capital requirements up to 25% tomorrow, bank investors would not be very happy. That would be So how are you thinking about just the overall regulatory environment with banks and financials these days?

Derek Pilecki:

Yeah, I think the regulators have been under a lot of pressure recently. There’s the article about the improprieties that came out in the Wall Street Journal about how there’s sexual harassment or an unsafe workplace. I think there’s and SVB ramifications, why weren’t they more on top of that issue? And then they constantly are going to get pressure. Banks are too big, but every time we go through one of these episodes, the big banks just keep getting bigger. I mean, first Republic went to JP Morgan, right? And so it seems like we’re going to continue this wave of a consolidation into the big banks and people hate the big banks, so that just leads to more regulation. I think it’s tough here with we’re heading into what seems like a little higher credit losses. So rates have come up 500 basis points in the past couple of years. A lot of CRE lending seems like it’s going to have to get equity injections to roll over to get extensions. So have the regulators been too lax and now they’re going to certainly come down hard on the banks? Are they going to be start looking through loan files more diligently? Are they going to start questioning bank’s, risk management systems? I think that’s all higher regulation, higher regulatory costs for the banking system.

Andrew Walker:

Do you think about anything when it comes to, obviously we’re in election year, I think people overblow elections a lot of times. How is the election year going to impact Lululemon’s earnings? Not a lot, but with banks it does make a difference. The banks are so regulatory controlled. Do you think at all about the election when it comes to, and this isn’t just banks actually I keep saying banks, but I know you cover, actually we’ll switch to talking about a few other sectors. You cover all financials, just financials in general, do you think at all about the election and outcomes there?

Derek Pilecki:

I think the best benefit for the banks is with mergers will be easier in the Republican administration. So I actually think that Discover Capital One is going to have a trouble if Biden wins the election. I agree based on typical antitrust view, it should get passed, but just I think in this environment, there’s no way they’re going to let it or it’s going to be really difficult to have a big bank merger like that get passed.

Andrew Walker:

It’s so crazy that Discover Capital One is an antitrust cross airs because I remember Sprint T-Mobile when that went through, and I probably disagreed with that going through, but their argument was this is not a four to three. You had Sprint T-Mobile, Verizon at t, they’re like, this is not a four to three, this is a two to three at t and Verizon are so much bigger and so much more competitive. We come in and we form the third competitor and that merger has actually worked, I think in large part because cable was an unexpected entrant more than anything else, but that has worked here. I just really struggled to see what the issue is. Discover they’ve bungled that network for 15 years. It’s not going away. At worst, it’s four to four, but to me this is three to four, right? Because Capital One saying, Hey, we buy them, we’re going to inject all this spend.

We’re actually going to a competitor to the big 2.5 and it’s not like any of the assets are disappearing. I just really struggle to understand the antitrust case and I almost think, I know it goes against Liz Warren, a lot of them and I have no issue with them, but I know it goes a lot against a lot of the thinking to be like big Bank m and a, let’s go. But it actually seems like something that they should be cheering because this is introducing a competitor to the big two and a half in my opinion.

Derek Pilecki:

I guess the tough part is Capital One will be the biggest issue of credit cards. So does forming the giant credit card company like that raise concerns? But I agree with you that it should pass on. If you look at other industries, it’s still going to be a super competitive market.

Andrew Walker:

Let’s go to something completely different. I read your Q4 letter. I’ll include a link in the show notes for anyone who wants to follow along. And your Q4 letter came out and announced a new position in Robinhood and I read it and as soon as I read it, I was like, oh my gosh, this is a beaten down stock, completely overlooked. This is a great thesis, I need to do work on it. I started doing work on it and they announced earnings the next day and the stock was up 30% or so. So I was like, ah, I missed it. But I want to talk about Robinhood as of your Q4 letter, your second largest position. I don’t know where it is today, we don’t have to disclose or anything, but I just want to ask about the overall thesis for Robinhood. And it’s really interesting right now, crypto markets, retail trading coming back in a big way, the stocks had a big run, but just want to ask how you’re thinking about Robinhood these days, overall thesis, all of that.

Derek Pilecki:

So I bought Robinhood after they reported Q3 last year. So Q3, the stock was a little squishy. I think there were two issues I think this month of September. Crypto trading was a little soft and then they might’ve lowered their guidance for an end interest revenue because the yield curve shifted. And so I looked at those are two environmental factors. So it wasn’t like the company failed to produce anything, it was just if you’re going to own a stock for five years, the environment’s going to change, especially a brokerage stock. So Guy I generally don’t buy or sell stocks because the environment at the margin things in the margin, the environment changed, but the stock was down 15% after they recorded earnings on those two issues. So I knew the stock was close to cash, it was about cash value. I think their net tangible assets was about eight bucks a share and the stock was eight bucks.

I had been short the stock when they originally came out of the IPO, I just thought it was overvalued. They had their meme stock issue where they shut off trading GameStop because they were short on capital and I just thought it was overvalued at the time. They were spending a lot of money, it wasn’t profitable. But in the meantime, since the time I was short to Q3 earnings, they’d gotten religion about getting expenses and under control, reigning in stock-based compensation. And then they also had been introducing new products and they had this very clear product roadmap of introducing new things to customers to grow. The customer base was growing, customers were adding new assets. And then I guess to top it off, I remember when I first got in the business in 1999, Ameritrade was a rocket ship that year. It was up 13 times on the internet stock bubble, just new accounts, customer acquisition costs were low.

Lifetime value of a customer was high. Ameritrade just grew like crazy. I was like, okay, Schwab just acquired Ameritrade. And so the industry is in need of another competitor. Schwab. I mean Schwab really, maybe we will get into this in a second, but I think we really need another competitor to Schwab and I thought Robinhood could potentially be that other competitor. So buy-in net cash value. I felt like there was a little downside risk given that there had been profitable to the previous three quarters. And then you also have that upside optionality of if we go another bull market or customers start growing that they could have a lot of upside there. So that was kind of the thesis, like asymmetrical positioning of the stock and I didn’t expect it to double in two months. I mean that’s just luck. I didn’t expect the Bitcoin ETF to launch Robinhood to start going up.

So from here, the stocks at 16 and a half, it’s down a little today. It’s moved a long way in a shorter period of time. The other, but I think that they Q1 numbers are tracking pretty well, right? They’ve spoken to a couple of conferences. They’ve said customer deposits are running above recent quarters. Has the stock moved at this point? It’s kind of like a game of expectations where the people who’ve bided up to 17 bucks, what are they expecting the company to say on customer growth and net new assets versus to what the number that actually prints. So I’m agnostic about the stock here. I still own it, haven’t sold any shares, but it’s gone up so much. Who knows? It’s trying to call the next wiggle.

Andrew Walker:

No, this is why when I read it I was like, oh, this is such a good thesis. I’m kicking myself like, Hey, it’s trading. I had close to net cash liquidation value. Now you would always have the question, I think about something like there was this company context logic, the ticker, there was WISH and they had a billion in cash and they were just incinerated cash so quickly that the billion became 400 million before you knew it. But you do have the worry of, hey, are they going to just, with Robinhood, it would be a, are they just going to keep pouring money into customer acquisition at negative costs just because it’s growth at all costs? I think they had solved that or b, I do remember during the GameStop, what if they have regulatory issues and get hit with fines? But I just love the combination of the downside protection of the assets and the upside of, Hey, I’ve seen this before.

They’re funding customer growth and by the way, if we catch another rocket ship, it’s hard to remember, but October, 2023 was kind of bleak at the time, but if we catch another rocket ship, this thing could skyrocket I guess with Hood, how much of their, because during 2022 when everything kind of crashed on the heels of the manis and everything, it felt like they were talking more about becoming a regular broker, moving away from Hey, we want retailers just like day trading and celebrating memes and how much of their growth now is correlated to crypto going up retail really being interested versus your more traditional, the people, the mid thirties who you would traditionally think are putting $10,000 into an E-Trade account or something,

Derek Pilecki:

Right? So I think they’re starting to get more longer term customers. I still think it’s a lot of brand new investors. They’re very friendly to brand new investors. The average account size is $2,000 means a lot of small accounts. They have the best user interface, but they don’t have a really good desktop app. The user interface is on the phone, and so they just introduced retirement accounts, so you couldn’t get an IRA account until a couple months ago. All those new products are an effort to get bigger accounts. They have this gold subscription where for $5 a month you become a gold subscriber to Robinhood and you get 5% on your excess cash. So I mean compared to Schwab, that’s huge. And so I think that’s incenting people to say, Hey, start using us for your checking account or leave your excess cash in your brokerage account and that’s driving new customer bigger balances and new customers.

Andrew Walker:

Could you imagine if IBKR heard what you just said, $5 a month to get 5% on your cash, we’ll give it to you. Just bring your cash over here. Thomas is going to be having a stroke when hears that.

Derek Pilecki:

I hope not mean, I hope IBKR continues to work on the user interface. I mean to make it easy for new investors, I mean it’s very good for professional investors like us. We can kind of struggle through that and love IBKR, I’ve been a customer for 15 years, but I love it. But for somebody who’s brand new to investing, it’s a little tougher, right?

Andrew Walker:

You open the IB KR account and you’re like, did I just download a nuclear launch codes or something? It’s so crazy. I’m completely with you. Whereas I can’t remember if I did tried Hood, but I’ve tried some hood competitors when they were giving out a lot of freebies in 2021 and it’s literally you just load it and they’re like, press buy here and you have a stock. It’s so intuitive and so simple. You mentioned Hood has a lot of $2,000 customer accounts. Is it even profitable to have a $2,000 customer account just between KYC regulatory servicing the client? Is that even profitable?

Derek Pilecki:

I think it probably is at the margin. I mean $2,000 customer account, they’re probably not subscribing up for the Gold Service. They leave a couple hundred bucks. They don’t pay ’em any interest on the couple hundred bucks cash that’s in the account. So they make 10 bucks revenue a year off that maybe 20, I don’t know. They’re not mailing statements, right? I mean they’re just sending emails. They probably do have to mail a quarterly statement. So what does that cost? A dollar a statement? So the marginal cost is four or $5 a year.

Andrew Walker:

A few years ago you were following the Fannie’s and Freddy’s pretty closely. Are you still involved there at all?

Derek Pilecki:

I’m still involved,

Andrew Walker:

Yeah. Hit me.

Derek Pilecki:

Yeah, I worked at Fannie before business school, right? I worked there for five years and I think eventually it’s going to come out of conservatorship. I mean, I only own the preferreds that own the common. I think the common gets diluted pretty well, pretty hard. I think that there’s the senior preferreds and the junior preferreds and the government owns the senior preferreds, and so the companies have been building their capital, but the government senior preferred state keeps accreting, and so I don’t think that gets forgiven. I think that’s gets converted to common and that, so the common doesn’t really make sense to me, but I think the junior preferreds, they’ll take a haircut, but the haircut’s not going to be anywhere close to the junior preferreds are trading 12 cents on the dollar. I think it could be. Even if they take a 30 or 40% discount, it’s still a lot upside from here.

Andrew Walker:

So just on the fannies, I guess the two things, I mean, look, you’ve pitched it. Bill Ackman’s obviously pitched them before. I guess the two things is it’s been, we’re in 2024, it’s been 15 years since, and I know a lot of people come and say, Hey, the best play on the Trump administration winning is the Fannie Preferreds, and I hear that. I get it. You think you put a conservative administration in, they want to get the government out of things, but Trump was in office four years ago, and I remember four years ago when he came into office, you were like, he’s going to get the preferreds out of conservatorship. And I just wonder, is it in the government’s incentive? Is the Trump admin really going to do it? Is Biden admin really going to do, is any admin really going to do it? Because yes, you’ve got constitutional, people are saying this is unconstitutional. You’ve got hedge fund owners who own the preferreds, but the government’s making a lot of money here and they’ve been able to delay this a long time. Is it really in anyone’s interest? Is this ever going to actually happen?

Derek Pilecki:

I think it’ll happen at the end of an administration. So I don’t think it’s the first thing Trump does. If he comes in, I think it’ll happen towards the end of an administration. There’s possibility Biden loses. They could do something because Biden could use it as a honeypot for housing finance, and so they could use the proceeds from an IPO to fund some pet housing programs that Democrats have. I don’t know from what, when I talk to people in Washington, I don’t know that the Biden administration’s really getting ready for that scenario. So I don’t think that it’s likely to happen this year under Trump. I agree with you. The story was Trump Trump’s going to get them out of conservatorship. I think Secretary Ian who decided not to do it because I think there was some people questioning or saying that, oh, he had good ties to some junior preferred holders, so he’s definitely going to do it. And I don’t think it

Andrew Walker:

Wasn’t good ties. I remember when they got elected and he put ’em in, I was like, oh my God, these are going to convert this. Because

Derek Pilecki:

I don’t think he wanted to ruin his reputation. I mean, I think he had a pretty successful stint as treasury secretary, and I don’t think he wanted any questions about his ethics there. And so I think he put a kibosh on it is my read of it.

Andrew Walker:

I completely agree. I was just going to finish the story. He had ties to a lot of preferred shareholders, and I remember when he got elected, a lot of people were looking to be like, this might be corrupt if it went through. But it does feel like there are a lot of ties here that these are going to get released. Speaking of Secretary Mnuchin, he pumped money in $2 per share, lots of common, lots of warrants into NYCB. The stock is three 40, so his investment is a lot different than what shareholders are looking at these days, but it’s tangible. Book diluted for the warrants is a little over six. I think they’re saying there’s probably going to be a lot of capital reserve building in the next few months, but do you have any thoughts either maybe not on NYCB, but just on his investment into NYCB?

Derek Pilecki:

I think it was a super good investment on his part. I mean, at that entry price, we don’t see how he’s going to lose money. I guess the thing I have a question about is did they raise enough capital, a billion dollars, 1,000,000,006 if they exercised the warrants?

Andrew Walker:

The warrants are cash, the warrants are cashless. So I don’t think that would bring anything in. Okay.

Derek Pilecki:

Yeah. So I guess it’s an open question. Do they know that the CRE issues are small enough that the billion’s going to be fine, but it looks like a good entry price from here?

Andrew Walker:

When I was hearing them talk on the heels of it, I was with you. I was like, Hey, why not just buttoned up? If you’re about to raise capital, you go over so that you kill any concerns. And I was kind of with you, but it seemed to me like I think the regulators, as the regulators tapped NYC on the shoulder, as we talked about earlier, it seemed like they talked to a lot of regulators. And the one thing with the bank, especially with loans that are deteriorating but deteriorating slowly, it seemed to me like the regulars might’ve given them the green light. Hey, put this money in and we’re going to give you the two years to kind of zombie bank accrete your way out of this. Right? And if you can do that, there is, to my understanding, a very good deposit base there. There’s some good franchises if you can do that. And the PNPR is I think about 850 to 900 million per year. So even if you take all of that and put it to reserves, if you’re buying it at $2 and the government’s promised to give you the runway to get to the other side, like buy at $2 with tangible book at six, take two years, put it all towards reserves, that $2 investment looks really, really attractive. Sure. Is kind of how I was thinking about it.

Derek Pilecki:

I mean, I think that’s a fair way to think about it. I don’t know that those discussions take place, but I wouldn’t be surprised.

Andrew Walker:

Yeah. The other funny thing I heard was I think it’s the, obviously NYCB is having the rent regulated issues, and I think the board is nine people, two landlords, two tenants, and then five appointed from the mayor. And they’re like, man, maybe you make that investment and you’ve got a line into the mayor’s office like, Hey, we’re going to fund everything you do, but man, you are appointing five people who are really favorable to the rents going up 4% instead of 3% next year or something.

Derek Pilecki:

I mean, I think it’s super interesting about NY CCBs loan loss reserves because they’re in the asset class that they had literally a hundred thousand dollars of losses over 30 years. And so since they come public in their early to mid nineties, and so they had always run with light loan loss reserves because they always said, look at our history, close to zero losses. And then right when they do the signature deal and get to Q4 and the regulators tap on the shoulder, they also have a couple of loan issues. It’s like, oh, hold on a second. This portfolio is not supposed to have issues. They’ve always had this great history of credit. They ran with lower loan loss reserves because they always had better experience and now do they not have that experience? So I think that whole dynamic makes it a super interesting story. Are these two loan issues that they brought up, are they just the only two or is there a whole bunch of ’em that we don’t see yet? There’s stories about them doing interest only loans. And I think it’s a fascinating situation.

Andrew Walker:

As you’re saying, it blew my mind when their Q4 results came out and they say, Hey, we’ve got this 22 billion loan portfolio or whatever it was, and over the past 10 years, write-offs in it, have rounded to literally zero. And then it just surprised me. Everyone’s freaking out about this. I’m like, what are you guys freaking out about 22 billion of loans and you guys are freaking out. They’ve had no write-offs. This is money good. And then you look at it and say, oh, all of a sudden 13% of these loans are getting criticized. And even there you’re kind of like they were doing it at 60% LTV, but if you had zero losses for 30 years, you would have to think there’s a lot of cushion there. It’s crazy how quickly things flipped. And that margin flipped with obviously it’s all the 2019 law, but as one friend told me, it was like, look, they had a great franchise, but what that franchise was was you were underwriting political risk, whether you knew it or not, you were underwriting political risk. And that chicken came home to roost in 2019 and it just took a couple more years for the problems really to show themselves.

Derek Pilecki:

For sure. Sure.

Andrew Walker:

Hit me.

Derek Pilecki:

I wanted to talk to you about a subject, sorry to drive you off course, but talk. I’ve been having this discussion with a lot of bank managements in its own buybacks, and so my thinking on buybacks has evolved, and I wanted to go through the subject with you. You might have a different view, but

Andrew Walker:

I’m excited.

Derek Pilecki:

I’ve become less enthused with buybacks. And so as a bank investor going through a couple of cycles, I see that the banks who have high capital have an easier time getting through. Also, they get some opportunities at the end of the cycle buying failed banks or more distressed franchises. So I guess I’ve been trying to counsel a lot of my banks that I meet with to don’t be so quick on the buyback trigger. Some of ’em are like, well, our stocks below tangible book value, and a lot of people are telling us the buyback goods of the creative. I’m like when you’re at 90% a tangible book, it’s not that accretive. It’s basically the same as buying it back at tangible book and you have to buy so much. If you’re a Barclays or a Citi group and you’re trading 45% a tangible, you should be buying back your stock at 90%.

I don’t know if it’s that a creative to book value. Also, you should think about capital in the sense of optionality. Just because you don’t buy back stock today doesn’t mean you can’t buy it back in six months or a year. You have optionality by retaining the capital, you retain optionality and so that’s good. As a bank manager, I guess one of the reasons why investors really like buybacks is it prevents management from making dumb acquisitions. So if you’re a shareholder of Coca-Cola, you want them to buy back stocks so that they don’t buy Columbia pictures. I mean that is a dumb value to strain acquisition. You’d rather just own more Coca-Cola, right? And so I totally get that. You don’t want bad acquisitions, but if you’re a bank management team and there aren’t that many hostile bank mergers or there are no hostile bank mergers, you really don’t go outside of the banking industry. Maybe you would overpay for a bank if you had a bunch of capital in your storehouse, but you also have the optionality. If there’s a good growth situation, you can make more organic loans and grow that way. And so I’ve just been changing my view of iax and talking to bank management teams about not being so quick on buybacks and just wanting to get your view or pushback from you.

Andrew Walker:

No, look, I do love, one of the great things about banks is when they trade interchangeable book, if you trust the book, you can create a lot of value quickly, in my opinion by buying. I guess I would ask you two things. So number one, the level you’ve mentioned 90% is not that different than a hundred percent for buying back stock. And I guess how do you think about that level? How do you think about that level changing in terms of with the ROE the bank can produce? Because let’s take Western Alliance, which we talks about and let’s just to make numbers simple, say that we think they can do 20% returns on tangible capital. That means every dollar that they spend buying back their stock is not a dollar. They can invest at 20% returns on tangible capital, but humorously, because a bank that gets 20% returns on tangible capital should be worth a lot more than book value. It’s trading even cheaper when it’s at 90. So how do you weigh those two measures? Where’s the line for you where yes, now’s where I think they should start leaning into the share repurchases.

Derek Pilecki:

I actually think Western Airlines is a great example of a bank management team that aligns with what I’m thinking. They were issuing capital, they had an ATM issuance back when three years ago when the stock was above a hundred and they had loan opportunities. They were hitting the ATM raising capital and making more loans and then when the stock during, maybe it wasn’t during Silicon Valley, it was maybe during covid when the stock was below tangible book, they were buying back shares at 80% of tangible book. I think they’ve shown flexibility of both issuing when it is a high price to tangible book buying back when it’s below tangible book. Now, I wouldn’t say with their high ROE buying it back to tangible book, if they can’t put all that capital work and it’s below tangible book, I was okay with them buying back stock, but as soon as I got above tangible book, they’re like, we’re not buying back any more shares above tangible. We’re not going to dilute tangible book by buying above tangible book.

I guess I think some investors think you need to buy back stock to get your equity account lower to show a higher ROE so that you got a higher valuation. And I think investors are the market smarter than that, right? The market can suss out what’s the natural ROE of the business holding aside whether capital level is correct or not. If a company like First Citizens has excess capital, the market can kind of figure out, okay, their reported ROE is depressed because I know they have excess capital. And so I don’t think you can fool the market by artificially making your equity accounts smaller to show you the best thing

Andrew Walker:

About banks is the first number they report kind of below the income statement is it’s not ROE, it’s return on average assets. So you can kind of just look at the return on average assets and anything in the high approaching one or above one is great, but cool. Your ROE is 20 because you’re running 5% set one and you’re about to get seized by the regulators. Okay, great. Your already looks great, but you’re about to get cs. I’m with you. I think the market does a good job of looking through that individual metric.

Derek Pilecki:

Yeah, I agree.

Andrew Walker:

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That’s TG us.com/value. No, it’s an interesting thought, especially for someone whose largest position is for citizens. People can read the Q4 letter and First Citizens has done a fantastic job of they’ve done these distressed deals, but I think what a lot of people like is they do to the distressed deals and then they take all that excess capital and they buy back stock like crazy. So it’s an interesting thought process. I don’t know. I do worry. You look at something like there are other things, but there are a lot of small regional banks or even smaller than regional that have specific niche focuses, right? And a lot of people worry these trade well below book value. One reason is because people are worried about the concentration risk. If you’re lending all to one niche, then if something goes wrong with that niche, you’re going to have huge problems all at once.

But B, a lot of these guys, you talk to the management teams and they think buying back stock is almost like a sign of failure and they just rather invest in loans and often their ROAS and ROEs are very good, but the market is clearly worried about empire building and refusal to buy back share. So it’s just I’m with you. There can be better uses for share buybacks, but the two things that’s striking me are that gray area and a lot of the market’s going to start saying, oh, these guys are just building capital. And then the other issue is like Valley Valley gets passed over for Silicon Valley by First citizens, and if you’re running with excess capital for three years and you don’t get chosen for that one swing, that’s a big opportunity cost. And does that also start encouraging you to make that one swing a little too aggressively where the one swing, NYCB maybe signature saved them, but it pushes them over a hundred billion? Or Jamie Diamond’s always talked about how you regret some of the bailouts he did in 2008. Maybe you make a swing and you pay too much for it or it’s too much for you to handle and you do that because you’ve sat on your hands for three years.

Derek Pilecki:

I think your point about empire building is really important because I think there are a lot of small banks where the management team does not own a lot of stock. Their biggest assets, they’re W2, and so that prevents from wanting to sell because if they’re the seller, they’re out of a job and they’re not going to another bank. They kind of need to retain their paycheck. And so finding those situations where the bank CEO thinks like an owner, and I find the guys who try to grow tangible book value growth also think like owners. They think of that’s how I’m going to get value out of this bank. And there’s a lot of smaller banks who, you run a small bank, you’re the king, right? I mean people have to come to you for capital. Every small business in your town, your city comes to you for capital, and so there’s not much incentive to leave those jobs, and I think that’s why bank m and a has been nothing this year. Some of it’s the bond marks, but these bankers don’t want to sell or they see selling at not all time highs as a sign of weakness. And so I think that’s that’s keeping bank m and a tempered down.

Andrew Walker:

My favorite thing about banks is you read the proxies, and this is more the community banks that have gone through the Demutualization process, but when you read ’em and they’ve put in the golden parachutes for the management teams and the directors, I’ve never seen golden parachutes for directors before. I really started looking at community banks and two years ago I was like, God, these guys are getting paid for nothing. But now I read it, I’m like, oh my God, thank God. Finally a little alignment in this stupid little three branch bank where the CEO is making 500,000 and the director’s making 50,000, as you said, the kings of town. Finally, they have an incentive to sell. It’s so funny how that incentive and look, there’s no hostile bank m and a, right? You cannot do a hostile bank m and a. You need to look under. And so as a shareholder, your one hope is that in some way, shape or form management is aligned with you to either grow tangible book value to create value that way, or to sell and let somebody else take your deposit basis and grow a tangible book value.

Derek Pilecki:

The other thing, Andrew, I wanted to mention, we’ve talked about banks a lot and I would just want to share, I think banks are below average businesses, right? I mean, I’m an investor in banks. I invest in all types of financials. I think there are some really interesting business models within financials, asset managers, alternative asset managers, some specialty insurance companies. I think there are some good growth banks that will earn above average ROEs for a long period of time with good management teams, but I think the average bank is a below average business. It’s very competitive. Intensities high, high. I think it’s increasing. I think they’re getting chipped away by fintechs. I think the very big banks are great. They haven’t captured the consumer business, so the small banks are left with just commercial business and a lot of commercial businesses just CRE. And so it’s a very volatile asset class.

So I think I would not say, Hey, let’s go invest in the KRE together for the next 20 years. I don’t think that’s a great winning strategy. I think banks are cheap now. They’re cheaper than they are historically. I think that’s going to change if we get a little bit of normalization of the yield curve and maybe credit’s not as bad as the market thinks, but I think, and I think there are some interesting banks that are good growth banks that will compound for years, but the average bank, I think it’s a struggle. And I think that deposit flight last year kind of highlighted that. So I just wanted to mention that

Andrew Walker:

Obviously it’s a deposit flight, but do you think it’s also, it’s well documented, right? JP Morgan, their tech systems, their consumer app, there’s this increasing in the regulatory burden. The tech burden for banks is going up, up, up, up. Do you think part of that is 30 years ago the difference between a community bank and the chase at the time was not that large because you didn’t really need the internet presence, your regulated, so do you think it’s just that return to scale and that issue that so many people talk about, Hey, the us we’ve got this dichotomy between we have 5,000 banks, but we’re regulating and the systematically important banks have this huge advantage where your deposits are safe there. Is that all kind of the issue that makes these below average businesses these days?

Derek Pilecki:

Yeah, I mean, I think the big banks have the scale of the branch networks, although people don’t go into branches as much as they used to. People like to know that there’s a B of a branch or a Chase branch on every corner. I think there’s also scale to advertising, so they feel comfortable with, they see the ads, they feel comfortable that there are banks there. I think for the most part, the consumer banking business has been captured by the large regional and the universal banks. I just think people with means have checking accounts at the big banks or for the most part. And so I just think the consumer is not in play for small banks on average. Yeah, they have some friends and family accounts, and maybe if you have your commercial account there, you also have a checking account there. But the average consumer, the middle market consumer is not going to small banks. They’re going to the big banks.

Andrew Walker:

Well, Derek, I have so much more to ask you about. Genworth was actually what I reached out to you about that I wanted to originally talk to you about. There were lots more questions, regulation, but you’ve been super generous with your time and I have a physical therapy appointment I need to run to. So look, Derek, I’ll include a link to his Q4 letter in the show notes if anybody wants to read it. And look, he’s the best in financial, so you should be following him on Twitter, following his letters and everything. Derek, thanks so much for coming on and looking forward to having you on Again,

Derek Pilecki:

Andrew, thanks for inviting me. Great to talk to you.

Andrew Walker:

A quick disclaimer, nothing on this podcast should be considered investment advice. Guests or the hosts may have positions in any of the stocks mentioned during this podcast. Please do your own work and consult a financial advisor. Thanks.

 

Financials Pilecki Reprint

 

One of the top contributors to the Fund in Q4 was a newly purchased position in Robinhood Markets. We understand this may surprise some of our partners as a money losing, VC-funded financial technology company appears to conflict with our investment history of preferring highly profitable companies with low valuations. We had followed Robinhood for several years before purchasing shares. In fact, we shorted the stock from December 2021 to April 2022. We continued to follow the stock and have admired Robinhood’s innovation of the mobile app, engagement with its customer base, and its introduction of zero-commission stock trading.

 

After reporting earnings in early November 2023, Robinhood’s stock declined 15% due to a slight adjustment in guidance as a result of changes in market interest rates as well as a seasonal slowdown in customer trading activity during September. We did not think either of these issues justified the stock declining 15%. We also believed the valuation was attractive and started to buy shares.

 

Here was our investment thesis when we purchased Robinhood in November 2023:

 

1. Robinhood was trading at $8.07, and its tangible book value was $7.92. This valued Robinhood at just above 1.0x book value. We felt this valuation provided a good amount of downside protection. In fact, Robinhood has been buying back its shares in recent quarters because of the low price. Robinhood is marginally profitable, and we do not see book value declining except in severe market scenarios.
2. Robinhood is growing accounts and consistently attracting new net assets from customers onto its platform on a monthly basis. Robinhood adds about 30,000 new accounts per month and attracts over $1.0 billion of customer inflows per month. At this rate of customer inflows, Robinhood is growing at an 18% per year rate without considering market appreciation from their customers’ investments.
3. Robinhood has better positioning as a customer advocate than industry leader Schwab. Although Schwab has a great franchise and large market share, we think the company has wrecked its business model in the name of imitating Robinhood. When Robinhood was launched, the company’s innovation was free stock trading. Schwab copied Robinhood’s free stock trading model. Schwab’s move caused Ameritrade’s management to panic and agree to an acquisition by Schwab. Schwab’s management team thought they could make up for the lack of stock commission revenue by forcing their customers into holding their excess cash in Schwab’s affiliated bank and paying an unreasonably low interest rate on this excess cash. The table below shows the interest rates major brokerages pay their customers on excess cash.

 

Broker	Interest Rate on Default Option for Residual Cash	Default Option
Schwab	1.35%	Schwab Bank
Fidelity	4.98%	SPAXX
Vanguard	5.29%	VMRXX
Interactive Brokers	4.83%	Broker interest
Robinhood	5.00%	Broker interest (Gold subscription)

 

Schwab is clearly on the wrong side of customer advocacy on this issue.

4. Robinhood is introducing new products at an impressive pace. They have already introduced Gold Subscription Accounts, retirement accounts, UK accounts, and credit cards. In addition, Robinhood has several new exciting products that they’ve announced but not launched, such as futures and advisory accounts. They can also introduce other products in the future, such as trust accounts, corporate accounts, advisor accounts, and mortgage lending. We believe these new products will help Robinhood take market share and grow faster than the industry.
5. Robinhood appears to be getting its expenses under control. Robinhood has been reducing its expenses, including stock-based compensation. In Q3 2023, Robinhood beat analysts’ estimates for EBITDA by $30 million due entirely to lower expenses than previously forecasted. We think Robinhood’s management is realistic about reducing the company’s expenses while still investing in new products.
6. There is historical precedent for stock market investors to place high valuations on discount brokerage firms during periods of high growth. In late 1998 and early 1999, Ameritrade’s stock price climbed 17x in six months as individual investors opened new brokerage accounts to trade stocks at the beginning stages of the Internet bubble.
7. Robinhood’s business is still small, but this allows Robinhood plenty of room to grow. We think this potential growth will create substantial shareholder value.

 

There are risks to Robinhood:

 

1. Low-end customer base – Robinhood’s average account value is only $4,000. It has millions of very small accounts. Most of these accounts will never amount to anything. There is also the risk that existing customers will look to “graduate” from Robinhood when they start saving and investing more substantial amounts of money.
2. Potentially damaged reputation from meme stock operations – When GameStop’s stock went parabolic in early 2021, Robinhood’s customer base traded the stock like crazy. Robinhood’s systems had trouble keeping up with the order flow, and Robinhood had trouble meeting its skyrocketing net capital requirements from the increase in customer trading. Robinhood paused the trading of certain stocks during very volatile days, and customers could not transact. There were many stories of customers not able to trade out of losing positions. The damage to Robinhood’s reputation continues. But, we believe the damage is dissipating as Robinhood continues to show growth in customer accounts and customer assets.
3. Robinhood has had consistent insider selling. Several executives have programs in place to sell shares regularly. We don’t have a satisfactory answer for this selling given what we believe is a low stock price.

 

Although Robinhood’s price is above where we purchased shares, we think Robinhood is still attractive because the downside is limited to tangible book value. The upside could be multiples of the current stock price depending on customer acquisition and market share gains. We are excited about management’s efforts to grow the business by introducing new products to attract additional customers. Management also recognizes the opportunity to gain wallet share with existing customers. We believe the industry needs additional competition after Schwab’s purchase of Ameritrade. We think Robinhood has the potential to produce good returns as they step into the opportunity left open by the Schwab-Ameritrade merger.

Garrett Brooks:

Good afternoon everybody, and thank you for joining us. My name is Garrett Brooks with Slingshot Financial. We are a Colorado registered investment advisor and your institutional representative for Gator Capital Management. With me this afternoon, happy to have the man, the myth, the legend himself, Derek Pilecki, Managing Member of Gator Capital Management and Portfolio Manager of Gator Long Short. Gator Long Short …

Derek Pilecki:

Hey Garrett.

Garrett Brooks:

… if you remember – oh, hey Derek. How are you doing?

Derek Pilecki:

Thanks for having me on.

Garrett Brooks:

Thanks for joining. How are things in your world?

Derek Pilecki:

Things are good. We’re just wrapping up earning season. We’re coming, the end of Q3 earnings so, it’s been good. Conference season’s starting. I went to the [inaudible 00:00:52] conference last week and headed to the Piper Sandler conference next week, so getting to meet with a lot of current holdings and prospective holdings, so it’s been good.

Garrett Brooks:

Fantastic. And for those joining and just becoming familiar with Gator Capital and the Long Short strategy here, which we’ll get into deeper in a second, Derek is a financial sector specialist, has been his entire career and so we spoke on a call like this back in April/May, I think it was, and you had said to me you were squarely focused in your sector, what you knew and you felt that the market was serving you up a big fat pitch at that time. And clearly the volatility in the sector, still a lot of uncertainty there and I know that you are just finding a ton of opportunity both for the long and the short book in your portfolio, but was hoping that you said, just came out of earning season, you could share with us your thoughts, first on the economy and the broader equity markets in general and then how that’s translating into the financial sector where you are squarely focused and finding that opportunity.

Derek Pilecki:

Sure. I guess to start with the economy, I would say we’ve been in a while here coming out of the pandemic where things have been super confusing and there’s been a lot of crosscurrents and I think most people would’ve expected the economy to have weakened by the stamp by this point, but the consumer continues to show strength and the economy seems to hum along. I would say we still have yet to see the full effect of interest rate increases. A lot of people have fixed rate mortgages, so they’re not seeing their payments go up from the higher rates, but there’s some loans that are going to repriced higher or any new business is slowing down because they have to take out new loans. So we could still see a weaker economy going forward. I would say that there’s been a lot of dynamic changes in the economy due to COVID.

First it was a product cycle where people just sat at home and order products and then as we got to move back out around, services really took off and now people have to go back to work. So it seems like consumption’s going to go down, but people are going to work more. So just a lot of different things, unusual for … some things that we haven’t seen for 50 years with inflation ramping up and then ramping back down. So I think the economy’s in pretty good shape. I’m worried about certain sectors of the economy, especially the big ticket items like housing and cars, just where people would have to take out a loan to make those purchases. I’m also worried about the construction trades. I think a lot of construction projects that are in process are going to completion and construction trades are working on those, but then the new projects that should be getting started in 2024, late 2024, 2025, they’re not really penciling out from an economic return standpoint for developers.

So I’m worried about the construction segments of the economy, not new homes, more just commercial like office buildings or new hotels. There’s just not new commercial billings that are getting started, so I’m worried about that and I’m worried about the knock-on effects of that. We’re starting to see some indications of slowness like FedEx telling their pilots that they have to want them to go work for a regional airline because Christmas is not going to be as strong as they had thought.

And so we’re starting to see some little incidental evidence that the economy is going to slow, but so far I think whatever happens will be relatively shallow. I think we’ve gotten some good news out of the Fed that they’re done raising rates. I know they don’t exactly say they’re done raising rates, but I think if you read the tea leaves, they’re not going to raise rates. I don’t think inflation’s going to re-accelerate from here. I think financial conditions are tight enough that there’s no way inflation can accelerate, but that’s my general economic view.

From a market standpoint, we’ve had a relatively strong market this year, but it’s been concentrated in a few stocks. I think there’s a lot of stocks that are inexpensive here. I think valuations are pretty interesting. Normally stocks discount a recession and they’ll bottom before we actually see the recession. So I’m not saying I think that the economy’s going to be weak, so we should [inaudible 00:05:40] out of stocks. I’m saying more I think the recession is here, but it’s going to be shallow and stocks might be bottoming now and getting ready for a run. So that’s my near term market view.

Garrett Brooks:

Great. And then how about in the financials, specifically in the sector that you follow very closely. I guess, what sorts of things are you seeing? Obviously there’s still a lot of chatter, a lot of commentary. I think I like to consider them more narratives surrounding the sector. I know that there’s, in talking with you closely, there are certainly some misconceptions and what can you share with us from your seat and looking very closely at the individual names in the sector?

Derek Pilecki:

So looking at financials, I mean I look at all different types of financials. Obviously banks, but also insurance and capital markets and asset managers and REITs. Banks are pretty topical because we had a regional bank crisis earlier this year. I think there’s a couple issues with the banks that bank valuations are as cheap as they’ve been, so it seems like the whole sector trades at seven times next year’s earnings, so that’s full expense.com. It’s expectations getting worse next year. It seems like almost every bank trades for seven times earnings. Which is cheap relative to where they usually trade. They usually trade nine and a half to 12 and a half times earnings.

I think the market’s discounting two things, net interest margins are getting squeezed. I think that’s close to coming to an end as deposit costs have risen to become more competitive money market rates and then some fixed rate loans are finally starting to reprice and we’ll move higher. So margins should start to expand going forward. I think the other big bogyman for banks is credit; is if the economy weakens, are we going to have credit issues? So far I think the office building sector is really the only source of concern within credit and a lot of banks have three to 5% of their loan portfolio in offices. A lot of those offices are suburban or focus on the medical community where people have to use their office to see patients.

I think a lot of banks have some pretty big reserves against the office portion of their loan book. We’re not seeing other sectors show weakness yet, but there’s one or two banks that have one or two issues and maybe this is just the start of a credit issue. So we’ll see. I think that other sectors of financials, insurance pricing is headed higher and the insurance stocks are doing phenomenal. Capital markets is kind of hit or miss. There’s not really been a strong IPO market or a big M and A market, so big investment banks aren’t really hitting all cylinders as far as the fees, but there’s pretty good trading.

Asset managers have been okay. We still have some pretty secular shifts from active to passive, and so the average asset manager trades pretty inexpensively. I think there’s some opportunities there. I think there’s a couple asset managers that trade at six times EBITDA and have diversified businesses. They’re not in large cap value, which is easily replaced by an index. Like they’re in either small cap stocks or fixed income products. They don’t necessarily have good passive products to follow along. So I think there are select opportunities there, especially finance, there’s constantly opportunities in that sector. And then in the REITs, I’ve really been short office REITs. I think the office sector is a problem. I’m surprised the office REIT sector has held up as well as it has given that they’re facing negative occupancy growth and negative lease rates. And so I think that’s a prime area for some shorts in the REITs.

Garrett Brooks:

Sounds like lots of opportunity. Sounds like there lots of value to be had there.

Derek Pilecki:

I would even add to it, within banks, with everybody trading at seven times earnings, it’s almost like the sector is not differentiating between banks that are well positioned for higher rates and banks that are not positioned for higher rates. It’s almost like people just trade in and out of the KRE, the ETF and they’re not differentiating between, hey, these banks are the best positioned for higher rates and these banks are really messed up with a lot of low coupon loans and that they’re going to be eating those low coupon loans for years. And so I think it’s a pretty interesting sector from both longs and shorts right now. I would say predominantly I’m net long the banks, but I also have plenty of shorts amongst the banks that have fixed rate loans.

Garrett Brooks:

And to that point, I know for a fact that there are a number of people who are simply trading the ETFs to try and get they’re either trying to bottom fish or trying to short, but doing the sector broadly, and that’s one of the key points I know that we’ve talked about before, you’ve seen through your career that generally a lot of your peers who were financial sector specialists following the financial crisis in 08/09, kind of became more generalists or lost interest with focusing on the sector. And so that’s leading to less competition for you and others like you, but for you and finding those gems, the hidden opportunities in the sector because so many people are simply placing trades with the ETFs broadly.

Derek Pilecki:

So generally there’s about two dozen financial sector funds, whereas there’s almost 200 technology sector funds. I just think that there’s less people looking at the sector and so that leads to some opportunities, especially in the small mid-cap stocks. There’s less liquidity. The multi-strat funds can’t really participate in the lower, the smaller market cap companies, so I just think there’s less people looking at them. And there’s tons of small cap financials to look at.

Garrett Brooks:

We talked a little bit about some of the different sub-sectors, the industries that are in the portfolio. In terms of themes, what would you say is really driving some of the performance that you’re seeing and we’re enjoying as shareholders?

Derek Pilecki:

If I look at the third quarter, the top three performers during the quarter were Genworth Financial, Jackson National Life Insurance, and First Citizens Bank. Starting with First Citizens there, they were the acquirers of Silicon Valley from the FDIC, so they bought the remnants of Silicon Valley Bank and they got a fantastic deal. So in Q1 and Q2, the stock was very strong and then it continued in Q3 where a lot of the banks pulled back during August and September where Citizens kind of just held its own and the market’s starting to figure out that Citizens is undervalued. I think Citizens, it trades for about $1,400 a share, book value is like $12.50, $12.70. I think book value is going to accrete over the next three years to like $1,800 and I think it can trade at one and a half times book, so it could get up to $2,700 in a three-year timeframe, and so you could have almost a double on the stock in a three-year time. And I think that’s pretty interesting.

Genworth’s been a stock we’ve owned for about 18 months. It has two main businesses, a mortgage insurance business and a life insurance business. They IPOd 20% of their mortgage insurance business two years ago. It’s Enact Mortgage Holdings and Genworth continues to own 80%. If you do some of the parts on Genworth, they have some debt outstanding. So if you take their value of Enact minus their debt, Genworth still trades at a discount to its publicly holdings of the mortgage insurance subsidiary and that totally assigns a zero to the $5 billion life insurance company. The life insurance company might be a zero because they were in the long-term care policy business and long-term care policies have just been mispriced and there has been a big black hole. But Genworth’s done a good job of repricing those policies over the past 10 years and they’ve, just to give you an example of how big the problem was, they’ve raised prices $22 billion on those policies and the market’s still assigning a zero value to the life insurance company.

So they’ve massively repriced those policies. Now those people are just getting to their mid-eighties where they’re making claims on those policies, so their claims are going to increase over the next 10 to 15 to 20 years, but I’m thinking that there could be some value in that life insurance company subsidiary, but it might not be realized for several years. So Genworth has held up this quarter and some of that discounts closed. And then Jackson National is a variable annuity writer. They were spun off from the Prudential UK a couple years ago. It was a very small percentage of your Prudential holdings, so say you’re based in London, you own Prudential UK, and then say you owned $10,000 Prudential UK, you got a $500 spinoff listed in the US in Jackson National. And so those investors all just sold off their shares and the stocks traded very inexpensively.

Variable Annuity’s are very tough, opaque business, so it should trade at some discount. I just argue that discount’s too steep and so the company’s done a good job of returning capital to shareholders. And so those three examples of things that have worked during the quarter, those aren’t Wells Fargo, Bank of America, Berkshire Hathaway, Travelers or JP Morgan. I mean it’s not the XLF/ETF. It’s small mid-cap companies with differentiated stories, unique stories that you don’t normally hear about, and I think there’s dozens if not hundreds of those companies within the financial sector for me to pick and choose from.

Garrett Brooks:

And right there, that hits the nail on the head. How can you explain such really impressive performance amidst a lackluster year to down year really in the process there, bottom up portfolio deeply, deeply researched, concentrated on small to mid-cap financials and businesses that Derek knows very well and oftentimes sees some sort of a catalyst in insight for either multiple expansion or some sort of a deterioration in the stock price. So that’s fantastic. In terms of the near term, I know that we’ve talked and talked with some advisors and you are very optimistic for the portfolio in the near term for the foreseeable future. What are you seeing in terms of opportunities and maybe some risk that we should be aware of?

Derek Pilecki:

So, I think in the near term, I think we’re in a good seasonality part of the year that the fourth quarter tends to be good. We started to see a little bit of a rally last week. I would expect positive market events over the next couple months. I think of this time as very similar to 1994/1995, where the Fed raised rates substantially in 1994 and then when they paused at the beginning of 1995. I think they did one last rate hike in March of ’95, but the market just ripped higher, especially financials. And so if the Fed’s pausing here, and that’s right, and the valuation of financials, I think there can be a substantial re-rating higher.

That being said, the recession is lurking out there and what is it going to look like? There has to be a lot of treasury issuance. The Central Bank, Chinese and Japanese investors and commercial banks are not buyers of treasuries right now, and they historically have been big buyers, so you’re going to have to have money managers buy all these treasuries, The Treasury’s going to issue, so that could be a risk. Then also if there’s surprise credit problems, more than what I think, and I outlined my concern about office buildings and loans on office buildings, but if there’s other segments of the economy that we can, I think they could some credit problems that would be a potential risk.

I do also want to just mention, obviously not all our picks work out great. We had the three biggest detractors in Q3 were Vornado Realty Trust, Axos Financial and Arlington Investment. So Arlington investment was a mortgage rate that was getting acquired, that was announced in Q2 and then the acquirer went down a little bit in Q3, so Arlington went down in sympathy.

Axos is a online bank based in San Diego. They have a super entrepreneurial CEO. It has been a short seller report around their involvement in crypto. I think it’s not an issue. I think the bank’s addressed the issue, but it underperformed slightly in Q3 and Vornado is an office REIT that had a terrible first part of the year and they bounced in Q3. I think it probably got oversold in May and just bounced a little bit on us in Q3. So I just want to be balanced about presenting stocks that work that don’t work in our portfolio.

Garrett Brooks:

Of course. So you’re saying not every single pitch is a home run, right?

Derek Pilecki:

Not every single one, right. Yes. I don’t bat a thousand.

Garrett Brooks:

Fair enough, fair enough. We would have serious questions, I think, if somebody sat here and said that everything that they’ve ever touched turned to gold. But with that being said, if anybody online here has questions, go ahead and pop them into the chat and we’ll address them as in the order that they come through. While we open that up and give people the chance to do that, I did have a question somebody asked me to ask of you, I should say, yesterday. And you touched on it a little bit earlier on, in terms of valuations, what’s being priced in and what’s not. This individual seemed to think that that long short financials would have a tough time and be seeing headwinds over the next three to four quarters, and I’d love to just get your initial reaction to that statement because I know it’s a fair sentiment and would love to hear what your thoughts are on that.

Derek Pilecki:

I think there are headwinds facing the sector, right? I think margins compressing and I think credit, and I think we got a little bit of an answer with the Fed pausing rates. I think the margins can bottom, if not this quarter, Q4 or Q1. And I think when margins bottom, that that’ll be taken off the table. And then credit, it’s always out there, right? And it seems like it’s closer than it’s been, but we are not seeing terrible credit quality amongst the banks. We just had the all time best credit quality over the past four quarters. Things are starting to tick a little bit higher. How bad will it get? It’s going to be a long process.

I think the banks are well run. I think the regulators are on top of the banks. I think from a credit quality perspective, we could argue that they weren’t on top of things from an interest rate risk perspective with Silicon Valley, but I think on credit quality, they’re reviewing loan files and I think credit’s pretty good. We will see where office loans go and we’ll see if there’s any other hot button credit issues going forward. So I agree that there’s some headwinds. I think the valuation, we’re way below the normal range for banks as far as valuations, and I think it’s way too cheap.

And I think from the long short perspective I touched on a little bit. All the banks are trading in seven times earnings, whether they have underwater bond portfolios or they’re perfectly positioned for this interest rate environment. And so I think that’s where the opportunity is of you don’t necessarily have to be long banks here. You can be long the ones that are well positioned and short the ones that are not.

Garrett Brooks:

Everything’s priced the same.

Derek Pilecki:

Yep.

Garrett Brooks:

Okay. Actually a few questions in here, a few good ones here. First one is, and actually this is going to kind of dovetail with the second one, I think here, but how do you position defensively and what does that look like currently?

Derek Pilecki:

I think I’m relatively defensive, so I’m about 90% gross long and I’m about 50% growth shorts. The net’s 40. I think that’s at the low end of the range. Historically, I’ve been above 50% that long, but I do see some, I’m pretty bullish about the calendar in the valuations, but I think there’s some things that are expensive and there’s also some banks that are not well positioned for the environment, so we’re short those. So I feel like we’re relatively defensive here compared to where we are normally, despite my bullishness.

Garrett Brooks:

Right. Great. I had a feeling that’s what you would say. The second question was actually what is long versus short positioning? You just touched on that, so we’ll jump into the next one. This has to do with real estate and it’s, do you think the banks will take larger losses on real estate portfolios?

Derek Pilecki:

I do think that there’s going to be a lot of work around real estate issues. I think to the extent that loans that, if a loan had a five-year term and it was written in 2019 and they have to refi it in 2024, I think that there might be some refis that sponsors need to contribute cash to pay down the loan a little bit to make the numbers work. I think the real problem is 2021/22 vintage, so as we get to 26/27, the valuations from 21/22 are not going to fly in 26/27, so we have a few years to go before that happens, but I think that’s the real vintage of loans that own commercial real estate that people are going to keep an eye on and how does that get refied. So luckily we have two or three years before we get there.

Garrett Brooks:

Interesting. Very interesting. Okay, one more question here, easy one. Do you take interest rate bets?

Derek Pilecki:

I think it’s hard not to take interest rate bets within the sector. I think there’s a lot of interest rate risk amongst the different companies. I would say, right now, that I’m relatively well positioned for higher, for longer. I think if the economy weakens substantially and there’s massive rate cuts, I’m going to have to make some changes to the portfolio, especially on the short side. I think some of my shorts would respond pretty favorably to aggressive rate cuts. I don’t think, my view of the Federal Reserve is they don’t want to be the ones that let inflation get out of control, and so I think they’re going to err on not cutting very fast. I think we’re in a higher for longer type scenario, and so, there is interest rate risk within the portfolio, but that’s how I’m positioned.

Garrett Brooks:

Fair enough. I would agree with you, higher for longer. It’s all about Jay Powell’s legacy from here on out.

We actually, that is all of the questions in the queue here, so it looks like we addressed everybody’s question. Derek, thank you so much again for your time. Love these chats. I know that the people in the field, the wealth of managers, the portfolio managers, the research analysts that I talk with, also love hearing from you, specifically on the sector, and congratulations on a phenomenal year and keep it up. Like I’ve said full disclosure, I am a shareholder and so I’m loving this and I know that the people who join us and who are listening and there are probably a number of shareholders who are also quite pleased with what you’ve done.

Derek Pilecki:

Thanks for having me on again, Garrett. Enjoy these chats.

Garrett Brooks:

Great, great. All right. Thank you everyone. Thanks for joining and obviously if you have any questions, feel free to pop them into the chat. You can always contact me and look forward to seeing you next time. Take care.

The Fund’s largest position is First Citizens Bancshares (“First Citizens” or “FCNCA”). We acquired our stake over the past three years. Initially, we owned and traded around a small position in CIT Group Inc. (“CIT”) during the summer of 2020. We felt CIT was undervalued and management was making progress in reducing risk during the Covid-19 pandemic. In late 2020, CIT agreed to be acquired by First Citizens. We added to our CIT stake the morning of the acquisition announcement because we thought the acquisition was so financially attractive that First Citizens’ shares would rally and pull CIT’s shares higher. Our CIT shares were exchanged for First Citizens shares when the merger completed. We held onto our First Citizens shares because we admired the management team, we felt the bank was undervalued, and we projected the bank would benefit from higher interest rates. Then, earlier this year, First Citizens was the winning bidder in the FDIC’s auction of the failed Silicon Valley Bank (“SVB”). We added significantly to the Fund’s First Citizens position on the following Monday morning because the deal was unbelievably favorable for First Citizens.

First Citizens’s stock price rose more than 50% that day and has risen another 40% in the months since the SVB acquisition. We have not sold any shares. We believe the stock still has the potential to double over the next three years. Despite this attractive upside, we think the downside is minimal. Our downside scenario is an unchanged stock price in three years.

Here is our detailed investment thesis for First Citizens:

FCNCA trades at a discount to other large regional banks on a Price-to-Tangible Book value (“P/TBV”) basis. It also trades at a slight discount on a Price-to-Earnings (“P/E”) basis looking at sell-side 2024 earnings estimates (see chart below).

Usually when a bank trades at a discount to peers on a P/TBV basis, it is because it has lower returns than peers. At first glance this appears to be the case with First Citizens. It is projected to earn a 14% Return on Equity (“ROE”) in 2024 where its peers are projected to earn higher ROEs. However, when we adjust for the excess capital that First Citizens is holding, we believe it has a ROE similar to its peers and does not deserve to trade at a discount.

We believe there are other possible reasons why First Citizens trades at a discount to its peers. The main reason is it is not a member of the S&P 500 Index, so it does not have the demand from passive index investors. Other minor reasons for First Citizens’ valuation discount are a lack of familiarity within the investment community due to limited but growing sell-side coverage, not hosting quarterly earnings conferences calls until recently, not attending brokerage investment conferences, high nominal stock price and limited trading volume, and a low dividend compared to peers.

One additional unusual reason for the valuation discount is the dual-class share structure of First Citizens Bank. The Holding family controls the Class B voting shares. This dual-class structure may discourage some investors from owning the stock. We disagree with this thinking. First, the Holding family has demonstrated an extraordinary commitment to shareholder returns. First Citizens is the best performing stock of its peer group over the last 30 years. We view the Holding family as owner-operators. We note that many of the best performing stocks have had owner-operators: Berkshire, Microsoft, Amazon, etc. There is data that proves companies with owner-operators outperform because management is able to focus on long-term value creation. We think this applies to the Holding family controlling First Citizens.

Another criticism of the dual-class share structure is the difficulty in applying outside pressure to gain voting control and/or board seats. I believe this is a non-issue for banks. The difficulty of a hostile takeover in banking is high. There hasn’t been a successful hostile takeover of a bank since Bank of New York acquired Irving Trust in 1988. Plus, the regulators limit ownership levels of banks before an investor has to register as a Financial Holding Company. Overall, we see the First Citizens dual-class share structure as a non-issue.

First Citizens’ stock outperformance in 2023 may be distracting some investors from the potential returns still offered by the stock. First Citizens’ stock has returned 78% this year. Its peers have had negative returns between 20% and 35% this year. We know it is natural for investors to say, “We missed it,” when a stock has performed like First Citizens’ stock has. The last thing these investors want is to buy First Citizens after the run and have it underperform once they buy it. In other words, they don’t want to be wrong twice on the stock. As we will discuss below, we believe there is significant downside protection in First Citizens because of the defensive nature of its balance sheet.

First Citizens has a very liquid balance sheet, which is perfect for the current environment. For example, First Citizens has 17.6% of its assets in cash compared to Truist at 5.6%. This liquid balance sheet gives First Citizens plenty of opportunity to take advantage of the wider loan spreads available in the current environment. The extra liquidity also reduces pressure to pay up for deposits. The high cash balance is the best indication that shareholders have a measure of protection from First Citizens’ balance sheet.

First Citizens’ balance sheet is defensive and well-positioned for growth.  The bank has almost no borrowings beyond the $35 billion FDIC note that has a five year term. First Citizens’ management did not invest in long-dated fixed rate securities, so unlike many other banks, it is not carrying a portfolio of underwater bonds. Also, First Citizens loan book is balanced between floating-rate and fixed-rate loans. This balance was created through the strategic acquisitions of CIT and SVB. The CIT franchise produced excess loans and the legacy SVB franchise produced excess deposits. We believe First Citizens is positioned well for the current consensus outlook for rates of “Higher for Longer”.

Investors are not assuming any growth at First Citizens based on its stock price trading just above tangible book value. Based on sell-side models, expectations are for minimal growth in First Citizens’s legacy banking operations and that SVB will shrink going forward.  We think this is wrong because we think prospects for the former SVB operations are strong. Certainly, the SVB franchise is diminished as several business development personnel have been poached by competitors. We think multiple competitors are targeting the venture capital community.

The current environment in the venture capital community is not ideal, but SVB was a powerful growth franchise. To offset these concerns, we note that the current deposit balances at SVB are already down close to 80% from year-end levels. So, we believe customers who want to leave SVB have already left. Also, we believe there is substantial goodwill within the venture capital community for SVB. SVB is intertwined with the venture community and continues to have strong relationships with the community. Lastly, we believe venture capital as an industry will grow faster than the overall economy. We think there is a good chance that SVB will continue to grow under First Citizens ownership. At the current valuation, we view this growth potential as a free option.

Regional banks as a group may re-rate higher. In addition to First Citizens trading at a discount to peer large regional banks, we believe regional banks trade at the low end of their historical valuations. Large regional banks trade for about 7.4x 2024 EPS estimates, we believe the normal valuation for this group is between 10x and 14x. We understand that at this point in the cycle banks should trade cheap, but time marches on and cycles can change quickly. We expect the group multiple to re-rate higher as the industry works through higher interest rates and the credit cycle peaks.

We do see some risks to our First Citizens investment thesis:

Aggressive rate cuts by the Fed.  First Citizens is among the most asset-sensitive of the large regional banks. If the Federal Reserve were to aggressively cut short-term interest rates in response to weak economic conditions, this would hurt First Citizens’s earnings. We think this scenario is unlikely given the recent bout of inflation that the Federal Reserve has been battling and the Fed’s “Higher For Longer” mantra.

Continued calls for increase capital requirements for banks. Bank regulators continue to make statements that banks need higher capital requirements. While we disagree with this sentiment, we acknowledge the potential reduction in returns for bank investors with higher capital requirements. We do believe First Citizens is well-positioned to comply with higher capital requirements due its excess capital position. We would expect First Citizens’ management to operate the bank with a significant capital cushion.

First Citizens may be over-earning in the near-term. First Citizens is experiencing two temporary benefits to earnings. One, as part of the SVB acquisition, First Citizens issued a 5-year note to the FDIC for a below market interest rate of 3.5%. Two, First Citizens marked-to-market the SVB loan portfolio at a discount to account for credit risk. As the old SVB loans payoff, First Citizens recognizes the discount into income. Both of these factors are causing First Citizens to over-earn in the near-term.

First Citizens is facing significant integration risks with the SVB deal. The SVB acquisition was a large deal. SVB was a complex bank in a new business line. Multiple competitors are poaching SVB personnel. The SVB customer base went through a traumatic event in March as it was uncertainwhether they would lose their deposits in the SVB failure. We worry about the integration risks that First Citizens faces with SVB. But, we are reassured that First Citizens has significant experience integrating complex and geographically disperse acquisitions.

Future M&A deals are unlikely to create as much value for First Citizens as the SVB deal did. Going forward the opportunity for value creating acquisitions is less likely now that the bank is much bigger than it was 15 years ago or even earlier this year. First Citizens has a successful M&A track record that includes a number of FDIC deals as well as the heavily discounted acquisition of CIT Group. The SVB acquisition was a monster deal that doubled First Citizens’ capital. While the opportunity for future FDIC deals is diminished, we believe the FDIC is happy to have another bidder besides JP Morgan Chase for large deals. We have been surprised about the lack of outcry over the extraordinary deal First Citizens got in buying SVB. We think the SVB deal clearly shows the FDIC executives are comfortable with First Citizens management team.

 Quantitative Tightening effect on banking industry deposit balances. Even though Federal Reserve’s Federal Open Market Committee seems close to the end of this interest rate tightening cycle, they continue to implement Quantitative Tightening by allowing the Fed’s portfolio of securities holdings to mature with limited reinvestment. Just as Quantitative Easing by the Fed accelerated deposit growth in the banking system, Quantitative Tightening is a strong headwind for deposit growth. SVB had some of the strongest deposit growth during Quantitative Easing, so we expect it will have deposit pressures with continued Quantitative Tightening. Of course, there are other factors that will influence legacy SVB’s deposit base such as: the strength of the venture capital cycle, competitive intensity from other banks attacking SVB’s old franchise, and SVB’s customer’s willingness to return to SVB under First Citizens’ ownership.

Legacy SVB’s business is dependent on the venture capital cycle and it does not look great in the short-term. Venture capital goes through cycles and it seems like late-2021 represented the peak of the latest cycle. The amount of venture capital raised in 2022 and 2023 is down significantly. There are many start-ups who have had to cut expenses and conserve capital. Venture capital exits are few and far between. Given the strength of the stock market in 2023, we are surprised the IPO market has not recovered. There is potential upside from excitement about artificial intelligence.

We think First Citizens is still an attractive holding despite its outperformance to date in 2023. We estimate First Citizens’ tangible book value will be $1,800 at the end of 2026. We think FCNCA can trade at 1.5x tangible book value at the end of 2026 or $2,700, which is double the current share price.