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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Garrett Brooks:

Good morning everyone. Thanks for joining us on this summer Friday morning. My name’s Garrett Brooks with Slingshot Financial. Slingshot is a Colorado registered investment advisor and we serve as an institutional representative for specialized investment managers, including Gator Capital Management. Excited this morning to have Derek Pilecki. Derek is the managing member at Gator Capital Management, the firm that he founded back in 2008. He’s the portfolio manager for Gator Long/Short, which is the flagship portfolio there offered in a few different formats, including the original hedge fund, a mutual fund, as well as individual accounts. Derek, joining us here fresh out of earning season, so I’m sure it’s been a really busy time for you, but thanks for taking the time, Derek, and glad to have you with us.

Derek Pilecki:

Hey, good to be with you, Garrett.

Garrett Brooks:

Yeah, absolutely. So as we have done, this is our quarterly update, finding long and short opportunities in the financial sector. Derek is a financial specialist, has been for over 20 years. Like I said, founded Gator back in 2008. Before that was with Goldman Sachs Asset Management and a few other buy-side firms before that, but always focused on the financial sector. So we are certainly glad to hear what he has to say. Financials did a little bit better than expected coming out of earnings and would love to hear your key takeaways from this year or this quarter’s earnings season, Derek.

Derek Pilecki:

Hey Garrett. So I would say the story about this season was a relief rally in the banking sector. So regional banks, of course, had the bank crisis in March kicked off by Silicon Valley’s failure, and the regional bank index was down about 30% through mid-May. As we got through the end of the second quarter and the bank started reporting second quarter earnings in mid-July, the bank stocks really rallied. I wouldn’t say that the earnings reports were off the charts. I mean, they were pretty ugly earnings reports. I mean, deposits were down, net interest margins were crimped, but things just were not as bad as what investors were expecting. So there was some stability. I would say for the most part, deposit costs went higher, but maybe not as high as some of the most bearish expectations. Really, the regional banking sector was too cheap coming into earning season and investors did back up. So there was a nice rally in the regional banking sector during the earning season.

Garrett Brooks:

Yeah, we saw that coming out. The regional banking ETFs has actually been really on a run here coming out of earnings. To that end, what would you say overall is the health of the banks? It seems like a distant memory now, the banking crisis. Do you think this is something that’s largely in the rearview for us or something that could reemerge down the road, which was the fear I think at the time?

Derek Pilecki:

So I don’t think there’ll be additional failures. I think there was one transaction where Bank of California agreed to acquire a merge with PacWest, and I think that was done without any government assistance. So I think that really signals the end of the crisis. I mean, people were worried about PacWest. They had lost a bunch of deposits during the crisis. I think that’s really a signal that, okay, now we’re moving forward, if banks get into trouble, there’ll be deals done without government interference. I guess, another takeaway from this earning season was credit quality seems to be holding up just fine. The expectations were a recession coming, credit’s going to get worse, just a matter of time, higher rates. I think some of those things could still play out, like higher rates are definitely going to slow the economy. But I think it’s pushed out a few quarters and so investors are like, well, there wasn’t a necessarily a huge uptick in non-performing assets this quarter that people are expecting that those turn into charge offs in Q3 or and Q4.

So I think just pushing out the risk of credit losses a few quarters is another bullish sign for regional banks. Then I would say that there’s still a wide variety of interest rate positioning amongst the banks. So there’s a lot of banks with floating rate loans and pretty low cost transaction balance deposits. Then there’s other banks that have a lot of fixed rate loans and are funded with very hot money or high cost deposits. Those are the two ends of the spectrum on interest rate positioning. Not all banks are positioned the same. So to the extent that we have the long end of the yield curve go up and rates stay higher for longer, I think there could still be some banks that stumble through the next couple of years.

Garrett Brooks:

Yeah, that’s a great point. I’m curious, I know when we spoke back in May, I was really surprised to hear you say that you’re still finding some banks out there that haven’t done much in the way of interest rate hedging. I would’ve assumed at that point that everybody would’ve gotten their ducks in a row and gotten that taken care of. Is that something that you’re still seeing, you still have some banks out there that aren’t necessarily hedged out properly?

Derek Pilecki:

That’s definitely the case. It seems like they’re just taking the view of these low coupon residential mortgages that they own can’t extend further in duration, which may or may not be the case, but it seems like short-term rates are going to… The Fed’s not going to cut rates this fall, at least that’s what Chairman Powell said last week. So their costs of funds as they roll over are going to squeeze them. So yeah, there’s definitely banks that are exposed here with a lot of low coupon mortgages on their books.

Garrett Brooks:

Which is again, a good… It bodes well for you with the flexibility to both be both long and short, when you see those situations pop up, you’re able to seize those as well. One of the other things I think that we were talking about back in May, and then I’ve heard you talk about a few times since that leading up to this past few weeks, we’re looking for not only what the actual performance of particularly the bank’s would be, but also the market’s response to that. So thinking if we get some bad news and the market continues to push through, have we seen the lows? I’m wondering now, with having seen some of this play out and the market’s response, what are you thinking looking forward?

Derek Pilecki:

Yeah, in the absence of new information or new crisis points, I think that the mid-May lows in the regional bank index are the lows for the cycle. I think that unless there’s a big turn in credit quality or the economy drastically slows from some exogenous event that we’ve seen the lows.

Garrett Brooks:

Yeah, that’s good to hear. The other thing that I was curious about because you had mentioned it a few times leading up to this as well, was keeping a close look on loan volumes within the banks and keeping an eye for do we see a tightening credit that could possibly exacerbate any type of economic downturn that we see? I’m curious, most recently, what are the banks seeing in terms of credit and loan volumes?

Derek Pilecki:

Yeah, you’re right. So I was worried after the regional bank crisis started that we’d see a credit crunch where the banks would just be so worried about their own liquidity that they’d stop making loans and that would slow the economy. I guess, we’ve gotten some new data points on that front that evolved my thinking a little bit. First, it seems like that has happened to some extent, that loan growth has slowed considerably from last year. But it’s not clear that it’s all supply side, meaning it’s not all the banks restricting making new loans. Some of it is demand side. So to the extent that rates are… The prime rate is 8.5%, borrowers just don’t want to borrow money 8.5%. So you’re not seeing as much loan demand. So loan growth slowed, but it’s not all the banks restricting supply, it’s some loan demand constraints.

Then we have seen, not every bank has been deposit constrained. There have been bankers who have been well positioned for this cycle and they’re able to continue lending money. So it’s not like the whole industry’s just cut off the spigot, not making loans. There are banks that are making loans. They’re asking for better terms on the loans, which is natural in a cycle. They want wider spreads and better terms. They might ask for the personal guarantee more insistently this time around, but there are banks still making loans. Then we’ve also have the private credit funds out there that are chomping at the bid to dis-intermediate the banks. So they want to make loans, good loans, that the banks are constrained from making. So it doesn’t look like we’re going to have the worst case scenario where credit crunch causes economic recession.

We are having a slowdown, a natural slowdown, because of loan demands down and the banks are fixing their balance sheets. But it seems like the banks are pretty much through most of the right sizing on liquidity and deposits. So they’re still making loans to the extent that borrowers want them. They’re asking for higher spreads and better terms. Then you also, if the banks are held in check by these private credit funds, being willing to provide credit at the right price. So I don’t see the scenario where we get a bank credit induced recession, which is good news for all of us.

When you think through the recessions that we’ve had in the last 35 years, 1991 and 2008 were really bank credit recessions that were pretty deep recessions, whereas the recession from 01, 02 is more like capital markets, internet bubble, isolated recession. It wasn’t a economy wide where Main Street wasn’t getting funding. The Main Street economy got funded through 01, 02, whereas 90, 91 or 08, 09 Main Street had trouble getting funding. So it doesn’t look like we’re going to have one of those deep recession scenarios.

Garrett Brooks:

The Fed, have they nailed the soft landing, so to speak?

Derek Pilecki:

Yeah, we’ll see. There’s a lag effect to higher rates, and so we haven’t gotten the full lag effect, but it seems like the economy’s pretty strong still in spite of it, in spite of all the rate increases. We’ll see what the next six to 12 months bring. There’s isolated pockets that are really, really struggling. I mean, the office sector is tough. There’s not going to be new offices built, construction of new offices. Those construction crews are going to have to go to other property types. There’s going to be a lot of office buildings that are going to be owned by the bond holders or the mortgage holders instead of equity holders. So that will go through a cycle. But other than that, there’s not really an obvious thing that’s going to contract in the economy right now. Maybe the venture capital field, there’s not as much venture capital funding, but really that’s not a huge, huge part of the economy.

Garrett Brooks:

Yeah, that’s great news. I asked the question almost a little tongue in cheek because I think sometimes when things start to take on the grand narrative of the soft landing that it’s almost we lose sight of the real data points coming in and more focus on the story. So everything you’re saying certainly is encouraging, and this is real actual data that we can point to and give an indicator of what the economy is doing. It seems like things are working out, so let’s hope that we stay on that path. One other quick question for you, because it was so timely, what are your thoughts on the Fitch downgrading US credit rating?

Derek Pilecki:

Yeah, I mean, I am in the Jamie Dimon camp of the US is the strongest superpower in the world. We’re not going to default. I would say we’re running pretty big deficits. The demographics have gotten marginally worse with the lack of immigration over the last few years. So we have a lot of baby boomers retiring and Medicare costs are going to go up and social security costs. So I would say the finances that are driving that downgrade are worse at the margin, but I still think that we’re AAA, or the country’s a AAA credit. I do think that it doesn’t take into account the ability to print money and inflate our way out of our debts. So I think it’s a lot of noise and you shouldn’t change your investment perspective because of that.

Garrett Brooks:

Yeah, I’m glad you mentioned Jamie Dimon. I absolutely love it. I love that he says it doesn’t matter while he’s on his bus tour through the US, it was very like USA, USA.

Derek Pilecki:

I mean, he’s right about that. I mean, he’s a big fan and he’s right on a lot of those points. A lot of times we just get so focused on the pessimism and what’s going to happen bad from here. He’s pretty good about making us feel good about all the good stuff that’s going on. The economy’s pretty strong. We all are living, most everyone’s living better lives than they were 30 years ago. So he’s right about to be optimistic on a lot of those things. He’s in a good position to see it too. I mean, he runs the best bank in the country, the biggest bank in the country, so he sees a lot of the good stuff that’s going on.

Garrett Brooks:

Yeah, absolutely. So shifting gears a little bit here from the sector itself, I have to point out your performance has been stellar year to date. I mean, looking at, easiest I guess to point to is mutual fund performance. I mean, you are hanging right in there with the broad market. Impressive, considering we have big tech, a few big tech names driving that rally and the financials been somewhat of a laggard. To that end, you’re absolutely clobbering the long only financials index year to date and then looking on longer time periods as well. So I’m curious, with that in mind, where are you seeing opportunities now? How are you positioning yourself going forward?

Derek Pilecki:

Yeah, so I think within financials, it’s going back to our discussion earlier about interest rate positioning. So I think to the extent that I’m finding banks that are still benefiting from higher rates and then I’m shorting against them, the banks that have a lot of fixed rate loans on their books and weaker deposit franchises. So to pull out two examples, there’s a bank in suburban Chicago called Old Second Bancorp, and it’s in the far west Chicago suburbs. A couple of years ago they bought a bank called West Suburban, which is sitting between downtown and Old Second’s branch network. West Suburban was a franchise that had a lot of property locations that this previous CEO had bought in the fifties and sixties. These are just in good neighborhoods, middle-class neighborhoods. People used the branches for transactional banking. They weren’t rich people. They were just like middle-class people who had checking accounts and had a few thousand dollars in their checking accounts and aren’t rate sensitive. So it was a great acquisition by Old Second.

So they’ve also kept most of their balance sheet and floating rate loans. So during this rate cycle, they haven’t had to pay out for deposits. They’ve raised their rates a little bit, but really they’ve benefited from the repricing the loan book. So their net interest margins expanded and their ROE is above 20% now. So I think price to book value, it’s rallied recently, but it’s still under two times book. I think that’s a pretty interesting position from the long side. You contrast it to a bank like Hingham Institution for Savings, which is on the south shore in Boston. This is a traditional thrift. They make a lot of apartment loans. They have a very fixed rate loan book, heavy balance sheet, and it’s funded with a lot of high cost deposits.

There’s a lot of CD funding. Their loan to deposit ratio is well above 100%. Usually a commercial bank will run with an 85% or 90% loan to deposit ratio, but Hingham has a huge, huge loan to deposit ratio. So that means they have to fund a good portion of their balance sheet with wholesale borrowings. So their interest rate spread has just collapsed during this rate cycle. So it’s getting to the point where I don’t think the Fed’s going to keep raising rates. They might raise one more time. Maybe they’re done. But if they were to raise rates again or two more times, Hingham’s close to earning negative spread on their balance sheet. This stock still trades well above book value, so it trades for 1.25 times book value. So I just think given that they’re going to earn sub par ROE for the foreseeable future, this should trade below book value.

So those are the opportunities there. I think the opportunities persist in banks because a lot of people are expressing the view of banks through the ETFs. There’s a lot of banks out there and collectively there’s a lot of banks and a lot of market cap, but each individual bank’s relatively small, so it’s hard to get positions. The big investors use the KRE to express their view on banks, but the KRE buys or sells the entire system across all banks, where they’re not selecting individual banks of, I want to buy these ten banks that are asset sensitive and I want to short these banks that are liability sensitive. You just buy them all or short them all.

So, I think there’s nice opportunity for people like me who do the work on the individual banks and say, “Okay, this bank’s well positioned for this rate scenario and this bank’s not.” So that’s where I’m seeing the opportunities going forward. I think they’re still upside to the banking sector. I think valuations are still cheap, but I also like the opportunities within differentiating between the banks within the sector and that’s one of the benefits of having the flexibility of the long short fund.

Garrett Brooks:

Yeah, absolutely, that’s a great point. To that end, a lot of the people that we work with are even broader, more asset allocation oriented. So you take the very selective nature, your ability to be both long and short, and then you combine that with a much broader diversified portfolio and you have a really, really interesting and nice differentiated return stream in the portfolio. I know that current clients have really enjoyed that. Going back to my point earlier in terms of when you look at the broad market, just a few concentrated names pushing that, when you’re able to maintain the same type of returns but they’re much less correlation, it’s a really nice fit for an overall diversified portfolio.

Derek Pilecki:

Yes, definitely.

Garrett Brooks:

That is great news. How about outside of banks, what are you generally seeing or what are your thoughts?

Derek Pilecki:

Yeah, so I think that investors are recalibrating to a deferred recession. So we are really thinking about with inflation coming down and the Fed potentially being at the end of its rate height cycle, but maintaining rates at this level for a while, what does that mean for companies and the market? Generally it’s been pretty bullish for some of the higher beta names. So to the extent that people are deferring the pricing and the recession, that’s helped the sector. So I think some of the interesting names in the sector. There’s some asset managers that are trading for low valuations. There’s ongoing fair thesis in asset managers that we have the shift from active management to passive management. So the ETFs are taking share. So the active managers have had negative flows and the stock prices have gotten very inexpensive. So there’s some active managers that have neutral positive flows that are trading for five or six times EBITDA. So I think that’s an interesting play there.

Then there’s some, especially finance, especially insurance companies that are interesting. So the mortgage insurers have been doing well. We own Genworth, which owns a mortgage insurer called Enact. So that’s been a good area. I mean mortgage insurance is doing great because the housing market’s staying strong here, even in spite of higher interest rates. People just aren’t for sellers of their homes. They’re able to make the payments. They have 3% mortgages. Volumes are way down. If somebody does have to default on a home mortgage, insurers aren’t taking losses now because all the business they wrote in 2020 and 2021, there’s embedded gains there. So mortgage insurance is another good area. So between asset managers and especially insurance, those are the other areas that we like in the portfolio.

Garrett Brooks:

That’s great spots to be, makes a lot of sense. One other question that I had for you, I was actually talking with a investment officer at a wealth management firm, and within the context of Gator and a few other types of specialty funds, he was curious. He views the world very much within the smart beta, the factor type of analysis and uses that in constructing portfolios. Now I have heard you, in the past, talk a little bit about your views on how you incorporate and think about factors in managing your fund. But I thought it would be helpful for people on the call here today and anyone who joins later on to hear what your thoughts are on factors and constructing the portfolio around factors.

Derek Pilecki:

So I mean, I guess, I look at factors to make sure that we’re not taking the same bet on both sides of the portfolio. This goes back to a learning from 2014. I had the view that banks were cheap and REITs were expensive, and so I was long a lot of banks and short a lot of REITs. Then the embedded factor risk there was if rates went up both sides of the portfolio worked or if rates didn’t go up… It was an interest rate bet on both sides of the portfolio. So banks benefit from higher rates, REITs get hurt by higher rates. So in 2014 rates didn’t go up and so the banks muddled along and the REITs did great. So I had the same bet on both sides of the portfolio. So pay attention to the different factor models. We use Bloomberg. We load the portfolio into Bloomberg, look at what the factors our portfolio is expressing and make sure that we’re not out of bounds on having the same factor bet on both sides of the portfolio.

Garrett Brooks:

My factor friends will be excited to hear that. Well I think that those are all the questions that I had immediately. I’m going to go ahead and open up here for Q&A. So anybody on the call that would like to ask a question, go ahead and pop that into the chat. I will answer them as they come in. Well Derek will answer them. I will address them and Derek will answer them as they come in. Give it just a second.

Derek Pilecki:

Feel free to answer them, Garrett, that’s fine.

Garrett Brooks:

Looks like just one in the queue here and this is a slam dunk for you. What is the net long positioning of the portfolio? So I guess what is long versus short positioning?

Derek Pilecki:

Yeah, so right now the portfolio is 90% gross long and it’s 40% gross shorts, the nets plus 50. That’s a pretty comfortable spot for us. Usually the nets somewhere between 30 and 75 or 80, and so 50 is middle of the fairway. Part of that reflects, we’ve had a nice run up in July, so a couple of our positions hit their price targets and we reduced. So we don’t necessarily take the net and say, okay, we have to be at one point or another. It really flows from names we’re finding and we’re still finding a lot more longs than we are shorts and so we’re comfortable at plus 50.

Garrett Brooks:

Yeah, we always get that question, so thanks for asking. It looks like that’s it. It’s a quiet bunch. I wonder if people are taking the call from the beach, lakeside, whatever it might be here today, hopefully. Hopefully everybody’s enjoying their summer. I know you’re now sharing your time between Tampa and New York City, which is of interest, I know to some of the people I’m sure who are on the call here.

Derek Pilecki:

Yeah, so I mean I rent an apartment in New York in March. A couple drivers to that. A little bit more corporate access, so it seems like every financials conferences in New York and there’s a lot more companies coming through New York on a regular basis. So just meeting with more management teams while I’m up there. Then there’s getting access to more investors and so we’re meeting with more prospective investors by spending more time in New York. So those are the two benefits. Our families, were rapidly approaching empty nest stage, so my wife and I have spent 20 years in Florida and we’re just looking for the next adventure. So we’re starting to spend a little bit of time in New York and getting some business benefits out of it.

Garrett Brooks:

That’s awesome. That’s awesome. I know you’re also off on a huge golf trip coming up here.

Derek Pilecki:

Yeah, next week I’m going to Scotland for a few days with some buddies. So I’ve never been over there and I’m a big golfer and just love the game. So we’re going to eastern part of Scotland around St. Andrew’s, Muirfield and playing. I told the tour operator, I don’t want to play any modern courses over there. I want to play all the old Scottish courses. So looking forward to that and getting a few rounds in.

Garrett Brooks:

Yeah, enjoy. I am not really much of a golfer myself, but I know certainly a lot of people in the business are. I don’t want to speak for you, but is it fair to say you’re up for a round? Anybody in the New York area or certainly Tampa area, you want to get out on the course?

Derek Pilecki:

I’m always happy to play. This fall or winter, if somebody’s down in Florida and want to play, please send me an email or give me a call or get in touch with me through Garrett and we will get out in the links.

Garrett Brooks:

That sounds great. Well, we’re right up on time here. Appreciate it, Derek. Any final words from you?

Derek Pilecki:

Yeah, I think super interesting year as far as what’s been happening with the banks. So we’re in recovery mode here. Worst case scenario is not happening in regional banks. I think markets had a pretty good run, financials have lagged. I think there’s some catch up left within the financial sector, still some catch up left in the banks. I think the economy’s looking pretty good here, so I think I’m pretty constructive. We don’t have to chase the high valuation stocks within the financial sector. There’s a lot of cheap stocks, still reasonable valuations, and I think there’s pretty good fairway in front of us.

Garrett Brooks:

That’s great to hear. Like you said when we spoke earlier this year, with the bank and crisis, all eyes right there in your sector. I mean, if the economy, if the market, keeps tossing you those fat pitches, I know you’re just going to keep smacking them right out of the park. So keep it up.

Derek Pilecki:

Sounds good. Thanks a lot, Garrett.

Garrett Brooks:

Great, thanks Derek. Thank you everybody. Obviously any follow-up questions or requests for information, you can go ahead and pop that into the chat now. As always, feel free to reach out directly to me and we’ll make sure to get all of your questions and requests addressed. But with that, I hope everybody has a great afternoon, a great weekend, and enjoys the rest of this summer. Thank you.

Bill:

Ladies and gentlemen, thrilled to be joined by Derek Pilecki of Gator Capital. If you don’t know who he is, you will shortly. And Derek, thank you very much for making the time.

Derek Pilecki:

Thanks for having me on, Bill.

Bill:

I think it only took me about three years of reading your letters and then listening to a podcast where I think I understand the name Gator now. And correct me if I’m wrong, but it symbolizes waiting for an opportunity and then pouncing when you see it. Is that fair?

Derek Pilecki:

I think so. I think that that’s fair. I think Gators are aggressive animals and that’s how I think about my investing style.

Bill:

Is something that’s interesting to me as someone who’s followed you for a while is, as a financial specialist, I wouldn’t perceive it to be the sexiest choice in the world, but your reputation speaks for itself. And I’m curious, if you don’t mind giving some background on how you got into it and why you think it’s the right place for you to be, I guess would be the way to say it.

Derek Pilecki:

So I got interested in investing during college. I went to Duke, but in the fall of my freshman year I was waitlisted at Duke and I was granted January admission, so I had that semester off. And so I grew up in Northern Virginia and I took some classes at American University and my classes were spaced out during the day, so I just sat in the library and read books, and I read investing books that fall. So I really got interested in all different stock types of investing in, it just started my path to becoming an investor.

As I went through my twenties, I got a job at Fannie Mae working in their asset liability strategy. And Fannie Mae used to be one of the aspired companies in America, but it’s a different company nowadays and went through a tough time 15 years ago. But when I worked there in the mid-nineties, it was a great, an admired company and I worked for some great people and I learned all about the fixed income markets. One thing that we didn’t do was stock investing, when we just invested mortgage backed securities and we funded those with agency debt. And so, I continued to do reading at night and just kept reading about stocks and investing and read Lowenstein’s Buffet biography, The Making of American Capitalist, and that really propelled me to… I want to run a portfolio one day. And so just, you knew that it was going to be a long path to becoming a hedge fund manager.

And since I had worked inside Fannie Mae, inside a big financial institution, it made it easy to follow financial institutions or banks when I came out of business school. They said, ‘What sector you want to cover?” And I was like, “Well, I know financials,” so that’s where I’ve added the most value. And I was a financials analyst the whole time I worked on the buy side for other people. And so then when I went to go start my own fund, wanted to stick with what I knew, I didn’t think people would pay me to pick healthcare stocks. Had the specialized knowledge that… and when I started my fund really in 2008, kind of like today, financials were a distressed area. And so there was a lot of opportunity there. I was surprised that they weren’t done to going down yet.

I started in July 1st of ’08 and financials still had a long way to go down from there. It seemed like they were undervalued when I launched. But there’s always just been a lot of opportunity within the sector. I even think till today there’s a lot of people who were portfolio managers during the financial crisis that have shunned financial stocks. And so I continue to see ongoing opportunity within the sector, just for specialists to pull value out of the sector because there’s a lot of companies and a lot of different business models that takes a lot of specialized knowledge to follow the sector.

Bill:

Do you want to describe what your definition of a financial is so that people understand the things that you’re looking at?

Derek Pilecki:

Classically, it’s the banks and insurance companies, but I also include in anything in the financial index and including real estate investment trusts, because when I started, REITs were part of the financial sector. So I’ve kept those within the financial sector. From time to time, I’ll include companies that have significant financial operations. So when eBay owned PayPal 12 years ago, I included eBay in my definition of a financial.

So GE is a classic example of industrial company, big financial operation, anything that has something like that. But there aren’t too many of those these days. A lot of those companies have separated financial firms out. I guess Harley Davidson’s still out there, CarMax is still out there.

Bill:

But something like Caterpillar maybe. But-

Derek Pilecki:

Yeah, John Deere has a big financing operation.

Bill:

That makes sense. Well, when I said it wasn’t necessarily the sexiest, I think there’s so much attention on tech and growth or I think there still is, but I remember once upon a time I was sitting at a table with Bruce Greenwald and I told him that my background was in agriculture, and he said, “That’s a fantastic industry.” And its taken me a while to understand why he said that, but I think it’s similar to financials in that there’s cycles that you go through and there’s opportunities within the sectors.

And as I’ve watched your writing and read what you’ve had to write over the years, it’s been really interesting to see the opportunities pop up. And I guess the most prominent and recent example that I can think of, if you don’t mind talking about maybe the last five years of evolution, but with Silicon Valley Bank and what you saw that made you change your mind, if I can say that in the right way, because I know you admired their franchise for a while and then at some point you said this might get a little bit dangerous here. So I’d just love to hear you riff on that and how quickly things might be able to turn in financials.

Derek Pilecki:

So I was long Silicon Valley back 2018, 2019. So I even owned it back when I worked for GSAM back in 2007. So I followed the company for a long time. I thought they had a very good franchise. They really had a hammerlock of, I think they banked 60% of all venture funded companies and an equivalent market share amongst venture capital firms. And so, you just had this great network effect within the valley of they connected people and got business because of that. And these venture firms left their deposits in the bank for very low interest rates because they got other value from the bank. And I just thought it was a great franchise. And they also grew with venture funding and venture funding was booming.

So I thought that in the late ’18, ’19 timeframe, I thought that the stock was undervalued. It was trading for around 10 times earnings. They were levered to higher interest rates, and I thought rates would go higher. I thought that people overly discounted the Warren income. And so I thought it was cheap and they were growing. People were calling for the top of the venture cycle in ’18, and I didn’t have a strong view on that. It just didn’t feel like it was the end right then. So I owned the stock, got into COVID and fed cut rates and Silicon Valley went down and there was a lot to do. And so it became a source of capital for me in 2020. And admittedly, I sold it way too early. It went on a huge run with the venture cycle. So, there were other things to do. There was a lot of distress in banks and I just didn’t think, I thought there was other higher, better uses of the capital.

But I continued to follow the company, regretted selling it still followed it, thought I’d get an opportunity one day. During 2022, the stock was selling off and the bubble was, the SPAC venture bubble was imploding. And in 2022, the stock was off, and so I started taking a more serious look at it, especially with rates going up. And I was surprised by their securities portfolio, they had all this excess cash and you could see in their financial statements, they had large marked to market losses on their securities portfolio. And quickly did a little bit of digging and it was clear that they had just bought mortgage backed securities. And as those prepaid, they continued to reinvest in mortgage backed securities. So whereas they might have started out with 4% coupon mortgages, they ended up with one and half percent coupon mortgages. And so as the rates started going up, they had these huge losses and it was frustrating.

I didn’t own the stock, but it was frustrated because I admired the company and admired the franchise and that they had just dug themselves this huge hole. So after the third quarter earnings release last year, I looked at it and I was like, “Oh, they’re insolvent.” Their securities losses are big enough that they’re technically insolvent for regulatory capital purposes. Regulators ignore the mark to market losses on held and maturity securities. So they didn’t show a gap negative value, but if you did the math with their $14 billion loss on the held and maturity securities, they had a negative $4 billion equity account.

And so, I actually tweeted that back in November, “Is today the day the market realize the Silicon Valley’s insolvent?” And the stock didn’t move. It just actually rallied. It rallied in January from 200 to 300. And I was like, “Okay, I guess the market’s just going to ignore this loss.” And I was really frustrated with the management team. And then everything happened in March and just finally, when they tried to raise capital and the depositors got scared and pulled money, and of course it imploded, but I admired the franchise. I’m really sad what happened to the bank.

Bill:

Is there a logical reason that regulators would not count mark to market? I understand how silly it sounds in retrospect, but maybe other than fighting the last war, what might have they been thinking as to why mark to market shouldn’t matter for regulatory capital purposes?

Derek Pilecki:

I think it goes back to the financial crisis. There’s a scenario where there’s a lack of liquidity in the market. When all the subprime mortgages, mortgage backed securities went down in value and people were saying, “Hey, the prices of these securities are way below what the ultimate cash flows are going to be. So we should ignore that the market price because the cash flows are going to be higher.” I think that’s where it came from, and that was because a lack of liquidity. And just no institutions had enough liquidity to pay fair value for those securities. And that turned out to be the case. Anybody who bought subprime mortgage securities post, I don’t know, October of ’08 realized a lot more cash flow than they actually paid for price.

And so I think what ignoring mark to market does, it allows banks to take more risks than they really should. So like Silicon Valley had a deposit base where it was all on demand checking accounts, and so people could pull their money out. As we saw, 40 billion the first day and a hundred billion was lined up for the second day of withdrawals. They shouldn’t have been in 30 year mortgage backed securities. They should have been in short term treasuries. Maybe they should have gone out one or two years on treasury securities because the market for the treasuries, short term treasuries doesn’t really move that much. But I think that it goes back to the financial crisis of why people were saying, we need to ignore mark to market because of the way the market price subprime securities back in ’08.

Bill:

Something that I’ve realized through watching this is there’s an assumption on the duration of your deposits. So it seems to me that some management teams will potentially try to barbell the approach. And that’s nice on a computer model until the depositors start to flee and then it becomes a real problem if they do. And you’ve written about, and I think anybody that’s looked at it, Bank of America, Schwab, it’s interesting to see some of these portfolios, but it appears as though maybe the deposit assumption is a little more sound.

Derek Pilecki:

I think there’s been a real change in what the duration of deposits is. During ’08, when WAMU had its initial stages of its run before it was sold to Chase, I think over a 10-day period, $17 billion came out of the bank versus Silicon Valley, $40 billion came out in one day. So I think with technology and everybody having smartphones and apps, it’s really easy to move money nowadays. And I think those assumptions about what the duration of checking accounts is, has to change. It has to be massively shorter. And I would extend this to say that I’m an advocate for increasing deposit insurance. I think clearly 250,000 is way too low. It hasn’t been adjusted for 15 years, hasn’t been adjusted for inflation.

We have these reciprocal deposits like IntraFi or Cedars where you can get FDIC insurance through your original bank because they put the deposits out to other banks. I think that’s just getting around the rules. We should just increase the deposit insurance amount for companies and individuals that should go to a million or $2 million. And for operating accounts for corporations, you can make it unlimited. And so that way we really would eliminate bank runs. If you think about who benefits from a bank run, nobody does. It’s just a negative thing for society. Why should we have bank runs?

And I don’t think you can expect depositors to evaluate the risk management practices of a bank. So look at Silicon Valley, at a $260 stock price, $20 billion market cap, two days before it failed. What depositor’s going to look at that market cap and say, “Oh, my deposit’s at risk,” or, “I don’t like their bond portfolio.”? That’s just not a good use of society’s resources to have depositors worry about that. That’s why we have regulators. The regulators should be in there saying the bank has too much risk. You should reduce risk. It shouldn’t be up to depositors. So, I think we should have more deposit insurance to eliminate bank runs.

Going back to your question about duration of checking account deposits, it has to be, banks just have to assume it’s shorter, with rates going up so much, everybody’s repricing, are you moving excess cash to higher yielding accounts? I think I totally agree with your premise.

Bill:

The one argument that I’ve heard against moving deposit insurance to something unlimited is like, does that take away from some of the smaller banks. Said differently, do some of the smaller banks benefit from the incentive to spread deposits out to different banks and is that a good or a bad thing? How do you think about that?

Derek Pilecki:

I actually think deposit insurance would benefit small banks because then you can leave your money… Bigger… Depositors wouldn’t be worried about a small bank. They’d say, “The FDIC and the regulators are looking at the small bank. I’m totally protected if I leave $2 million here, I don’t need to have an account at a big bank.” So actually, I think it would help small banks to have unlimited deposit insurance or higher, much higher limits.

Bill:

I think the flight to the large banks would probably support your hypothesis. Because it seems as though that deposits just went to the CFIs once the run happened. It seemed like everybody was looking for the big banks to put their money in.

Derek Pilecki:

I think the argument against higher deposit insurance is banks might risk loving banks or risk loving management teams, would take, raise deposits and invest in very risky projects. So during the financial crisis, there was a bank in Chicago called Chorus that was the number one funder of condo developments. And they had a huge portfolio of condo developments both in Chicago and Miami. And so if they had unlimited deposit insurance, would they be able to fund just more and more condo developments? And my argument there is, well, it’s up to the regulators to limit the amount of money they have in any one asset class or to evaluate the risk management practices. So like deposit insurance, unlimited deposit insurance could allow a bank to grow too fast. But I would say the regulators should be there to stop that.

Bill:

So speaking about the regional bank or commercial real estate and condos generally, I can’t help but have a conversation about banks and financials without asking you about what’s going on with, specifically office, but how big of a deal do you think this upcoming refi wave is going to be and how are you taking a step back and thinking about things from first principles?

Derek Pilecki:

I think it’s in a big issue. Rates have moved a long way. So I think there’s a lot. And we also have the banks less willing to refi people out of other people’s loans. They’ll extend existing loans in their own portfolio, but they’re not going to take other people’s loans off their books. So I think it’s going to be a difficult wave we’re going to go through here, especially with leases burning off and occupancy going down, [inaudible 00:19:47] going up. I think it’s going to be very tough. I think it totally depends on who holds the note. If a bank holds the note, they can work with the borrower, they can be flexible, they can extend the note.

If the note’s sitting in a commercial mortgage backed security, there’s not that much flexibility. The special servicer has to try to get maximize proceeds for the underlying bond holders. I think they are just handcuffed of how much they can do to extend the note and to work with the borrower. And so a lot of times they’ll just take it to auction, they’ll just foreclose and an auction off the property. And so I think that’s going to be tough. I think there’s going to be a lot of big… And you think about the central business districts, Chicago, New York, San Francisco, those big towers in those central business districts, those notes tend to be in commercial mortgage backed securities. There’s not a lot of banks who can make loans that size.

Bill:

Your hold size would be huge.

Derek Pilecki:

They’re just huge loans. And the big banks are pretty low risk-takers as far as… I don’t see JP Morgan or Bank of America are holding Office Tower notes in their portfolios. I think that they just let those go into to commercial mortgage backed security. So I think it’ll be a big issue for the commercial mortgage backed security market. And I think there’ll be a lot of foreclosures and a lot of auctions. I think it’s going to be tough. Just in the news last three weeks in San Francisco, Park Hotels turned back the keys of to two big hotels in San Francisco. There’s a mall that just got turned back. I think we’re going to continue to see more of that.

Bill:

And what does that look like practically speaking? And then the person that wins the auction comes in and they are likely financed by bank debt? Or is it private credit? Who steps into some of these transactions, do you think?

Derek Pilecki:

I think it’ll be a lot of private credit. They could have some bank debt, but I think it’ll be a lot of vulture funds that’ll come in and buy those properties. And they’ll generally use private credit. They might use a little bit of bank debt, but the LTVs on bank debt are so low that it’s probably not the most attractive financing for those vulture funds.

Bill:

Well that’s one of the things when I’ve been looking at, I like to look at M&T, I don’t own it. I don’t know anything about financials for real, but I know that they have a very positive reputation. And the LTVs appear, they’re only as good as the assumption of the value. But it seems as though there’s some equity cushion even in some of the regional bank’s portfolios that I think people are maybe a little bit overly scared. I’m not sure whether or not that’s true, but I know that you’ve identified some opportunity in regionals.

Derek Pilecki:

So, I think the banks, the regional banks have done a good job with disclosure around CRE. The amount of disclosure in Q1 earnings versus Q4 earnings just multiplied. So almost every bank put out a slide of here’s our CRE exposure, here’s our office exposure, here’s our essential business district exposure. And so you can really compare and contrast different banks. It seems like office exposure tends to be 3% to 5% of the portfolios. You have to subtract out owner occupied office from investor owned office, you have to subtract out medical office, which the vacancy on medical office properties is a lot lower than typical office properties.

So there’s a lot of mitigating factors, and I think that banks have improved their disclosure around that subject. So I think that’s one of the things I like about banks. So I don’t feel like there’s a lot of scams being run by regional bankers. They tend to be in their jobs for a long time. They’re regulated entities. They all expense stock options. They’re all, I feel like the disclosure is pretty good within the sector. They’re all regulated entities. They all have published call reports that has even more information than what’s in their SCC filings. So I think, to the extent that there’s other distress in the real estate sector, I expect the banks to disclose that.

Bill:

If somebody was interested. Where do you find stuff like the published call reports and some of the public filings that are not like the 10K or whatever? [inaudible 00:24:44].

Derek Pilecki:

I use CapIQ, write minutes. I don’t know if their bank regulatory modules enabled for everybody else, but it’s enabled in my subscription and that’s what I use. But the fdic.gov is where all the call reports are available. You can do searches and find it.

Bill:

I think a writeup that you put out a while ago that I liked because it shows how many assumptions there are in any given number in financials, and I think about what you’re saying right now, but I believe it was the Ambac liquidation. Just to watch your adjustments through that, it was really interesting. And I don’t know how that turned out for you, but your perception of the market, value of the stock versus where it was trading and the amount of assumptions, financials is fascinating because it’s a black box in a way, but I see you cut through a lot of the darkness.

Derek Pilecki:

Unfortunately, Ambac didn’t work out as well, and I don’t think it was because of those adjustments or the sum of the parts didn’t work. There was a legal case, a related legal case that had an opinion that Bank of America was able to use against Ambac to keep the settlement to a lower number than I had hoped for. But I think that’s one of the things I love about financials. You can go through the numbers and sometimes there’s value just sitting there. One of my early hits when I first started the fund back in 2010 was commercial mortgage reits had issued a bunch of CLOs or CDOs and you could go through. And some of the debt, all the senior debt was non-recourse to the equity.

So I remember this one had 10 securitizations outstanding. You’d go through each one and say, “Okay, for these six, the equity’s worthless. But on these last four, I think they’re going to recover some value for the equity.” And it had to report a negative book value because of the marks on the senior debt of the first six securitizations. But since they were non-recourse, you could eliminate that and you could get… the stock was trading for 80 cents. You could get six bucks on the book value if you would limit… but the reported book value was -15. So you could do the math and say, “Hey, as soon as everybody realizes this is non-recourse debt, the stock should be much higher.” And so occasionally, you get those types of opportunities within financials.

Bill:

I have seen you write or talk about, and I’ve talked to my friends about some of the mortgage reit preferreds right now, which is interesting in a similar way. Do you want to talk about those at all?

Derek Pilecki:

So mortgage reit preferreds, they issue these fixed to floating rate preferreds and mortgage reits had a really tough 2022 with mortgage spreads widening. The book values declined. And then there was a little hiccup in August and September last year where spreads just blew out. And when when spreads blew out, the preferreds always trade down like they’re distressed because if the equity goes to zero, then the preferreds get the next hit.

And so, when the equity all took 15% to 20% hits the book value during Q3 last year, the preferreds never took any losses. So they traded down. And then they traded down again in December on tax loss selling, and then they traded it down on Silicon Valley again. So this is a third bite of the apple, these mortgage reit preferreds. They’re on fixed to floating rate periods, and the fixed rate periods coming to an end and they’re going to reset to three month LIBOR plus a spread. And a lot of the spreads are 5% or 6%. So with the preferred trading at 75 cents on the dollar, they’re going to reset to 10% yields. And that works out to a current yield of 14% or 15%.

And so, I think as they reset to the floating rate periods in a year or two years from now, they’ll trade closer to par. And so there’s a couple that you can get 75% return or 45% returns over the next year as they trade closer to par during the reset period.

Bill:

Why would they not trade at par?

Derek Pilecki:

I think it’s just a small market. There’s small issues. I think mortgage REITs are, they’re not squirrelly companies, but they’re not operating companies. It’s just a few guys on a Bloomberg. So it’s just like an investment fund. It’s not like a bank. They trade well outside where bank preferreds trade, even with the distress in banks. And so, I think that’s pretty interesting because mortgage reits aren’t really distressed right now. They’re earning money, yes, spreads are wide, but it’s not like people are worried about liquidity in the repo market right now. So I think it’s an interesting opportunity.

Bill:

It seems to me like the consumer’s in good shape, the duration is extended, because rates have already gone up. So I don’t know, a lot of the risk that you take when rates are lower I think is e-risked. Now, of course it can always go higher, but it’s an interesting concept, especially when it’s trading at a discount to where it should go when the security starts to flip to a floating rate.

Derek Pilecki:

I would even say that with mortgage, the debt spreads this wide. There’s only really one way that could you go, is tighter. And so that would be good for the equity. So I don’t think the next news on mortgage reits is going to be necessarily negative. I think it could be positive with tighter spreads as we get into a better liquidity environment.

Bill:

How much of your job is focusing on stuff like consumer, the strength of the consumer and macro forces versus… I guess what I’m saying is the bottom up and the macro seem to be connected when you’re talking about financials. Is that fair?

Derek Pilecki:

Yeah, but the macro doesn’t change for me often. So consumer credit goes on long trends where it’s not like it’s going to turn on a dime of if the Fed raises 25 bps, my view of the consumer’s changed. My view of the consumer has been pretty steady for the past 10 years. I’ve long thought that we are going to have a long economic expansion. We’ve had a couple hiccups. We had the hiccup around COVID, which was unexpected. But absent that, since the financial crisis, we really haven’t had a recession. And I think it’s going to be a while before we have a recession. I think credit quality is pretty good. I’ve been worried about a recession more in the last three months than I have in the last 15 years because I worry that bank lending getting shut off could cause a recession.

When you think about recessions, ’90, ’91 and ’08, ’09, were pretty deep recessions. And both those times banks cut off lending. In ’01, ’02, it was a pretty mild recession. It was more a capital markets, CLEC debt, telecom debt implosion that caused the recession, not so much bank lendings stopping. So to the extent that banks stop lending because of liquidity right now, I’m more worried about a recession now than I have been. It doesn’t seem like… The stock market’s gone straight up. So the market’s not worried about a recession. And it seems like there’s enough banks still lending that the big banks can still lend. It doesn’t seem like we’re having a credit crunch right now, although I’m wary about that. Because I hear a lot of banks slowing down their lending and they need to raise capital or just their capital ratios grow, so they’re just going to stop lending. But I agree with you that macro and bottom up financials analysis is very similar in my sector.

Bill:

And when you talk about the liquidity, your concern about lending due to liquidity, is that because of these held the maturity or the mark to market losses, creating a scenario where they need to build capital buffers for the short term in case there’s another run on deposits or something like that?

Derek Pilecki:

Yeah. So, I think bank runs scare bankers. And so, that’s death for a banker. And so, I think the banking industry, everybody’s like, “I need more liquidity. I need to retain capital.” So I think a lot of banks have slowed down lending, they’re not doing anything in the edges, everything. I’ll take care of my core customer, but that’s about it. I’m not going to do anything to try to really grow aggressively here. So I think that’s the slowdown. It’s just self-preservation amongst bankers.

Bill:

One of the things that I was shocked by, and perhaps I shouldn’t have been, but I was , because I’ve had people on this podcast that I’ve talked about how good First Republic’s franchise was and qualitatively, I talked to customers and they’d say how much they love them. But that first weekend I was eating lunch at my grandma’s community and there were two gentlemen next to me and they were looking at their accounts and they said, “Why do we have this many deposits sitting there earning nothing and incurring risk when we could be moving it to risk-free treasuries earning a lot more?”

And I think one of the things that I learned was whether, I guess deposit diversity is so much more important than maybe, I mean, maybe this is banking 101, but I just didn’t realize that having a customer base of really wealthy people could actually become an Achilles heel if they are technologically savvy and all reading the same paper. What I thought was actually its greatest asset, I think maybe in a way became what brought it down. And that was an interesting learning.

Derek Pilecki:

I think it’s also the overlap of customer bases between Silicon Valley and First Republic. They’re both were headquartered in the Bay Area. I think they banked the same people to the extent that people got scared because of Silicon Valley and they also had big accounts at First Republic. It’s the same people. So I think you bring up an important point about diversity of customer bases. Because I met with a few banks in May, and these were banks in the middle of the country, Illinois, Louisiana, Tennessee.

And they were talking about to their customers after Silicon Valley, and their customers were like, “Why are you calling me?” And as the news came out there, the customers eventually were like, “Oh, I’m glad you did call me, since I got scared, but you had already called me and I felt better.” But there’s a lot of, middle America, this was not a Middle America event. This was a Bay Area, a venture community event. This was not… But certainly there’s large depositors in every community that got scared about their bank for a minute and they don’t seem to have left their bank. They seem to have asked their bank for higher rates or asked, “Can we do something to increase my deposit insurance?” But for the most part, depositors have not left their banks.

Bill:

Well it turns out middle America is not sitting on Twitter getting, people scaring them, which is something that I took issue with while it was going on, but that’s neither here nor there.

To what extent do you think of the increase? Because you mentioned the banks may have to pay depositors more now. How much do you think of that as credit tightening? Because I would think that if they’re going to pay depositors more, they’re going to have to ask for a higher rate on their loan, otherwise their NIM goes away. So that almost by definition decreases the amount of credit that they can extend, I would think.

Derek Pilecki:

It’s also going to limit the amount of demand that the borrowers have if they have to… instead of paying six and a half percent, they have to pay eight and a half. There’s a lot of projects that don’t pencil at eight and a half. So I think there’s also, it’s both sides. The bankers don’t want to lend and the borrowers don’t want to borrow at the higher rates. So, I think the banks are going to have a tough quarter this quarter on deposit costs. I think we saw some of it in Q1, but it was really just a one-month effect of Silicon Valley happened in March. You get three months in this quarter of deposit pressures. I think it’s going to be a tough quarter for profitability for the banks. Just deposit costs are higher. I think the whole, having the media say, “Bank crisis, bank crisis, bank crisis” and talk about rates. Rates have moved a ton, 5% on T-bills. People are asking for higher rates. And so I think that it’s going to be a tough quarter.

I think we’re going to get to, either as Q2 or Q3 is going to be the bottom, it’s going to get better from there, but this quarter’s going to be ugly. I guess the one thing that we’re was interesting, and Morgan Stanley had a conference a couple weeks ago, and a lot of banks gave negative outlooks for NIM in Q2 and not all the stocks went down. So when stocks stopped going down on bad news, is that a bottom? Banks have had a nice little rally since Mid-May. Are they a little ahead of themselves or is that just correcting, overshooting? It’s not really clear to me yet, but I think it’s interesting on some of those negative mid-quarter updates, the stocks didn’t necessarily go down.

Bill:

That is interesting. When you’re building a long-short portfolio and you have a bank, and it may not be as black and white as the question that I asked, so I apologize if there’s not enough nuance. But say you like one bank, do you try to pick a bank to short against it, or will you say banks generally are relatively undervalued relative to asset managers or something like that? How do you think about constructing a long-short portfolio when you’re constrained a sector?

Derek Pilecki:

I don’t pair off sub sectors within the portfolio. I’m sure plenty of banks. I think this opportunity right now is interesting because there’s great banks that have gone down. Banks are down 30% year to date. So there’s great banks that have gone down that don’t have interest rate problems. They might have some pressure on the deposit side, but it’s not life altering.

And so, I think that’s the opportunity alongside these high quality banks. But on the short side, there’s a lot of banks that are still shorts. There’s still a lot of banks that have fixed rate loans, that have big securities portfolios that are under capitalized. So, I’m not sitting here thinking regional banks are the opportunity, I’m not going to short any regional banks. I’m still shorting plenty of regional banks that have mismanaged interest rate risk and the stock should be lower. And so, that’s what’s so unique about this opportunity, is there’s opportunities on both sides, long and short.

Bill:

I think it’s interesting. And it’s interesting to think about, I’ve talked to somebody who said, he was actually a financial specialist, and he said a couple PMs wanted to go short NASDAQ because they wanted to do a value play. And he’s like, “I don’t want to do inter sector shorts and longs. If I’m a financials guy, I want to be…” So I was curious how you think about pairing up your longs and your shorts.

Derek Pilecki:

I try. I guess one thing that you can get caught in from time to time is, I short a lot of companies that are high, that trade at high multiples that I think that are just average businesses or that are okay businesses. And so, you can get caught up into high quality risk factor. If you think about it, risk factors, quality is a factor and value is a factor. And sometimes you can get caught up of you have too much of one factor versus another, and you might have the same trade on implicitly on both sides of the book. So I don’t want to be long on value and all quality. I want to make sure that I match better than that.

Bill:

Because being long mostly value would imply that the value, quality gap is too wide. So then if you were shorting quality, you would be doubling down on the same bet, right?

Derek Pilecki:

Correct. And sometimes that works. From mid-May to mid-June, long value, short quality worked within financials. If you look at the insurance brokers or Visa, MasterCard or S&P and Moody’s, they all lag the regional banks for four weeks. Now, does that continue? Probably not. Those are great companies. There can be episodes where it happens.

Bill:

Do you mind talking about Genworth? Because I think it is a really great example of how long… Actually Genworth is why I thought of you as the gator that waits. So I’d be curious if you’d talk a little bit about how long you followed it before you saw the opportunity.

Derek Pilecki:

So, I owned Genworth from 2012 to 2014, and then it went off into the wilderness and was trying to get acquired by a Chinese insurance company. And I just followed the company. It bounced between three and four bucks from ’14 to 2020. And then I was listening to earnings call and they were talking about buying back stock. The deal had fallen through finally, and they had IPO’ed, enact their mortgage insurance subsidiary. So I started listening to the calls more closely and just doing the sum of the parts. Genworth, the holding company, was trading at a discount to its publicly traded subsidiary enact. And so I waited eight years to buy the stock back. Genworth talked about in, I think it was January 2020, they said, or maybe it was March 2022, they said they’re going to buy back stock later that year. And that was the catalyst for closing the discount to the sum of the parts.

Genworth has two businesses, the mortgage insurance and then life insurance. And life insurance is dominated by their long-term care insurance business, which is terrible, a terrible business. It’s selling insurance policies to 60 year olds when they might go into a nursing home at 85. So it’s like a 25 plus year insurance policy. And everybody underestimated the cost, the percentage of people who would go into nursing homes and what the cost would be. And so they just lost oodles and oodles of money on those policies. They’ve stopped selling them and they’ve raised rates. So been able to reprice a lot of those policies. And I think the cumulative amount of their repricing is $23 billion. And there’s still a question of whether that life insurance subsidiary is solvent, even though they’ve raised prices $23 billion.

And so, there’s 6 billion of equity capital in the life insurance subsidiary. So in some of the parts, I value that at zero. I don’t know that it’s zero. I think that’s the upside in Genworth, is have they salvaged some value out of that life insurance subsidiary, so they’ll continue to raise prices on that book of business? Those people, some of the older policies, people are finally dying and the policies are going away. Some of their biggest cohorts of policies, people are just approaching the years where they’re going to make claims. So the next couple of years will have a better view of what the policy costs are on their bigger cohorts.

If they can salvage some value out of that life insurance subsidiary, there’s some real value there of the life insurance. So to give you an idea, they have about a half billion shares outstanding. And so the book value of the life insurance subsidiary is about $10 or $12 a share. The stock trades for $5 a share. So at $5, it’s just what the value of the mortgage insurance subsidiary is. So there’s some real upside, but it’s going to take a long time before we get any cash flow out of the life insurance subsidiary, if we get any at all.

Bill:

Is life insurance generally, I know that I got sold term. I was pitched on whole or whatever, but is it possible that life insurance has repriced enough or that the market will reprice enough? First of all, is it still marketed? And second of all, my question is, is it possible that it’s actually going to be a good business at some point, but it’s been so bad for so long that no one wants to touch it?

Derek Pilecki:

They’re trying to make it an asset-like business. So it’s different from just life insurance, is long-term care insurance business. I don’t think the way they used to write the policies is a good business at all. It’s a terrible business. So they’re trying to reuse, they have a claims infrastructure that could potentially be valuable. So if they can make long-term care insurance business priced like health insurance, and where it gets repriced every year, it could potentially be a decent business. UnitedHealthcare has been one of the best stocks in our lifetimes. So if they can get that same model, it could be pretty interesting. But I don’t know. We’ll see if the regulators will go for that. It’s going to take multiple years before they can try to implement that on a wide scale.

Bill:

It’s tough, man. I watched my grandma go through it. Getting old is not cheap and it doesn’t appear to be getting any cheaper. And the labor is very, very difficult to find. So competent people, you’ve got to pay them. And it’s a real kink in the system. So I don’t know. We’re going to have more and more people that need facilities like that, and it seems like we just don’t have a sufficient amount of nurses around.

So, it’s going to be interesting to watch. I’m sure capitalism will solve it. Prices will go up. But it’s interesting.

Derek Pilecki:

It’s tough. I think immigration’s a real issue in the country, number of new residents coming to the country that wouldn’t normally help out in industries like that is making it harder.

Bill:

It’s not a particularly glamorous job to help people die.

Derek Pilecki:

It’s a hard job.

Bill:

And emotionally taxing too. It’s a lot of getting connected to people to then just watch them leave. So I don’t know, it’s interesting.

Derek Pilecki:

It’s hard. It’s hard. Hard business.

Bill:

Huh. One idea that I heard you talk about that really, it really reframed the way that I think when I heard you talk about it was the Puerto Rican banks. And when you talked about them versus Hawaii and the regional oligopolies. And I thought it was so interesting because so much of what I read about Puerto Rico is not positive, that I’m curious how you’ve seen opportunity and what seems to be a lot of negative headlines, for lack of a better term

Derek Pilecki:

So Puerto Rico is an interesting place. It’s a US territory. It’s not a state, but the banks there are regulated by the FDIC. So they’re effectively US banks and all of them have operations in the mainland. And the island’s just been in this 15 year recession. And since the tax laws changed where the pharmaceutical companies didn’t get tax breaks for manufacturing the island, the island’s just been in recession. And so populations left. They’ve gone to Florida and New York. And I think there’s a lot of people, there’s a lot of Puerto Ricans who live on the mainland who would love to go back home if they could work. They’re here because they need jobs, but they prefer to be on the island.

And so I think there’s this opportunity for Puerto Rico to really turn around if jobs went back to the island. And so, we’ve gotten a little bit of a start on that. The reconstruction from the hurricanes has lit a little spark in the construction industry there. There’s potential for reshoring healthcare facilities. So there’s 25 manufacturing facilities on the island, to the extent that we reshore pharmaceutical medical devices from China back to the US. Puerto Rico and Indiana are the two big territories or states that will benefit from that.

So that’s another potential spark to Puerto Rico. And then there’s a lot of, the government being too indebted and going through this bankruptcy is limited growth. And to the extent that they’re coming out of that and improving their infrastructure, that’s another avenue for growth. So I think those are all positive things. And in the meantime, you’ve had this consolidation of the banking sector. They’ve gone from 11 or 12 banks down to three on the island. And just, like you mentioned, the oligopoly is just creating this pricing umbrella that makes banking much more profitable. Banking was unprofitable or marginally profitable for a long time in Puerto Rico. There’s just too much competition and now there’s a lack of competition or just the banks just don’t need to fight with each other, to the extent that there’s only three of them.

Bill:

It reminds me a little bit of Buffett’s airline bet in a different way, which maybe arguably didn’t work, but I think it’s a little too early to see whether or not his bet worked. But that consolidation to an oligopoly structure in a local market, I thought it was very insightful. So thank you for sharing that.

Derek Pilecki:

Thank you. So hopefully it works out like Buffett’s railroad bet.

Bill:

That’s right. That’s right. Indeed.

One time, and we don’t have to talk about it, but when we were talking, you had mentioned that your firm, you went through a period where managing the portfolio, managing the business created an interesting tension in your life. And I wanted to talk to you about that because I think there’s a lot of listeners that are trying to manage that. And if you don’t mind sharing some of your learnings and what you went through, that’d be great.

Derek Pilecki:

So when I started Gator, I had this vision of I’m going to start this portfolio and I’m going to start raising money, and then I’m going to reinvest the cash flow to grow the business. And that was my vision of, I want to grow a business. I don’t want to milk it. I want to reinvest and just grow it. So I thought that we could have four or five PMs and we’d all be managing a couple billion dollars and it would be a great business to have. And so we started going down that path, and I started growing and hired a former colleague from GSAM to start a fund for him.

And there was a couple of things going on. I had very good performance the first five years of the fund, and then I started growing. And so just growing my own product took demands of my time of new investors. People wanted to talk to me with performance. And then at the same time, I hired this other person and was trying to grow the firm. We hired a few additional employees, and then you have to keep raising money to pay off those investments. And so at the time, I would’ve said, I can handle it all. I can. I got the investing down, I’m expanding the firm. These other investments don’t take a lot of my time. Right about that time, my performance, my fund turned down, there was 18 months where I underperformed the sector in the market. And in hindsight, I think those stresses of raising money for my own product and then also trying to expand the firm and managing this other PM created a lot of stress that affected my performance.

I can’t look at anything specifically and said, “Oh, I made that mistake,” but there was a series of investment decisions that didn’t work in a row. And I have to think that I was, that pressure affected my investment performance. And so, I got to, after about a year and a half, I realized I wasn’t going to be able to raise money for the second pm. And so I closed his fund down, had to let him go, which was stressful as a friend. And-

Bill:

Yeah, that’s tough.

Derek Pilecki:

I had spent a lot of money trying to do it, trying to hire him and raise money for him. And then closing his fund was like, it’s like the stunk cost. All that money’s out the door. I’m never going to recover it. I think I spent about $800,000. And so I look back at it, I live in Tampa and the beach is about 45 minutes away, and I don’t own a beach condo because I tried to start this other fund.

And so, I think about it in those terms of like, “Oh, I tried to open this fund for my buddy instead of buying a beach condo.” And buying the beach condo wouldn’t have aligned with my values at the time. I was very much of, I want to reinvest the cash flow into the firm. And so that’s what I wanted to do, and it didn’t work. And so, since then I’ve narrowed the scope, my vision of Gator, just my fund. It’s financials only. We’re not going to be anything else. We’re not going to have other products. I’m just going to be focused on putting up the best numbers I can for my fund. And so it was a humbling experience, it was lost of money, didn’t give my investors good performance during those 18 months. So all that is just a learning experience that has kept me focused in the years since.

Bill:

Well, I appreciate how honest you were. I went back and looked, and I would argue that your investors are still probably okay, but it’s tough. There’s demands. I’ve noticed it with some of my friends that are out raising and I’ve got one friend that might be close to closing his fund. And I’m hopeful for him because I think it allows you to get back to the drawing board of what is just the investing side of it rather than the business side, which can be taxing.

Derek Pilecki:

The investing side’s what we all love, and that’s what produces the value. So you need to stay focused on that because the whole thing unwinds if the investment side doesn’t work.

Bill:

So I do have to ask, what is going on with the mutual fund that you run? What was the purpose of taking that over?

Derek Pilecki:

So I had started a mutual fund in 2013 as part of the business expansion. And so when we got to 2017, I got this opportunity to take over this other mutual fund. So it’s the Caldwell & Orkin fund. It’s the oldest long-short mutual fund. So it started in 1992, and Michael Orkin ran it and Michael was going to retire. And so I won the bake off to the board, just selected me to take over the fund. And the idea was I already had a mutual fund. I have the hedge fund, long-short investing, I was the best position to run a long-short mutual fund. And I thought it could add to my firm, because I talked to advisors who want to put their clients into the hedge fund, but then they’ll have some clients that don’t qualify for the hedge fund. Not everybody has 2 million liquid to go in the hedge fund or kids accounts or whatever.

So the mutual fund serves a purpose of, an advisor can keep their clients in the same type of investment. The qualified investors can go into the hedge fund, and then the smaller clients can go in the mutual fund. And so that’s the idea behind the mutual fund. The overlap between the portfolios is significant. It’s not exactly identical, the hedge fund uses a little bit of leverage. And the hedge fund invest, because the hedge fund only has monthly liquidity. It can invest in some smaller cap companies. So those are the two big differences between the two products, the mutual funds out there and trying to build the performance and grow that fund. But I think of it as, it’s not distracting from managing money, it’s just two vehicles. We also manage some separate accounts for some clients. So just, it’s all investing.

Bill:

It’s symbiotic. It had to be rewarding to win the bake off. That’s a cool fun to take over. And that’s neat. I would think that it would be, I don’t know. That would be somewhat validating. I don’t know if you need it. I need validation in my life. I like to win and sometimes hear nice things about myself.

Derek Pilecki:

It’s interesting. I think the mutual fund business is dying. I’ve been involved in it for about 10 years now, running my own mutual fund for 10 years and the ETF structure is such a better tax structure that, I don’t know, mutual fund won’t die because people have unrealized gains. They won’t liquidate. They’ll just leave them out there. But I don’t think, it makes sense to start new mutual funds from here. I would not advise anybody to open a mutual fund. It’s just, they’re trying to raise money and the way the platforms make it hard to get on their platform, the cost or having to have advisors sponsor you to get on the platforms and then have to pay the platform’s money makes it very difficult, I think.

Bill:

Distribution is a hard part of this business. I would think that you would have plenty of distribution, but I don’t think that’s reality. It’s not as easy as my returns are X, put me on your platform. It’s a lot harder than that.

Derek Pilecki:

I think the mutual fund is five stars and nobody’s calling up and saying, “Hey, we need your five star fund on our platform.” They’re like, “Pay me $25,000 and we’ll think about putting you on our platform.”

Bill:

That’s wild. I was going through, I’ve gotten an annuity, which is the bane of my existence, but it’s a nice thing to, you inherit something. It’s not the end of the world, but I was looking through and it’s like the same managers are all of the options. And I just got to thinking to myself, I wonder what these guys are all paying to be the choice. It doesn’t take a whole lot of digging to see the backroom dealing or whatever that goes on with being carried. It’s crazy.

Derek Pilecki:

It is crazy.

Bill:

But the nice thing is, I think with platforms like this or podcasts, education is widespread, I think people are starting to wake up to some of it. It’ll never go away. And you’ve got to have business to business relationships. But I don’t know, some of the paying for placement rubs me the wrong way in the financial industry. It should be more pure than that.

Derek Pilecki:

[inaudible 01:01:53]. I guess the brokers get away because they’re not technically fiduciaries, but it’s serving their own interests rather than their client’s interests.

Bill:

And it’s upsetting because I talk about her sometimes. I’m not trying to throw her under the bus, but my mom, she’s like, “Oh, well this is carried by this person. They must be good.” And it’s like, “No, that’s not at all what’s going on. And also, look at the fees that they’re charging and these…” But there’s a… what is it? It’s almost like an authority bias when somebody recommends somebody else’s. It’s like, “Well, they came vetted through this person, so they must know what they’re talking about.” It’s like, “No, it’s just, a lot of it’s a grift, ma. I don’t know what to tell you.”

Derek Pilecki:

But I think, you use your mom as an example. I’m hopeful that the younger generation sees through that more. I think there’s a little more cynicism or more, “Tell me for real why this is happening.” So I’m hopeful that younger generations just see through that.

Bill:

I am somewhat too, the only thing that I am not particularly optimistic on is it requires reading the documents. And I don’t know that people love to read the docs. I don’t know, maybe ChatGPT and Bard can read the docs for people and tell people what’s really going on.

Derek Pilecki:

Yes.

Bill:

That may be a really good thing to come out of AI. Who knows? One question, I got it from a buddy, that I wanted to ask you. What is your view or how should I think about, in your opinion, some of these rent a bank type structures? Where does finance…? Is this a new phenomenon? Is this an old phenomenon happening again? What’s going on with that?

Derek Pilecki:

So rent a bank, mean banking as a service?

Bill:

Yeah.

Derek Pilecki:

People like these FinTechs using banks.

Bill:

Right. Like Chime has a bank that it uses in another state. And I’m not trying to pick on them, it’s just a structure that I see a lot of places.

Derek Pilecki:

Well, I think a lot of banks have gotten into that, thinking the whole, with 0% interest rates, they’re like, “Oh, look at all these deposits we’re going to pick up.” And I talked to a bank just last week, I talked to a bank that’s heavily into the banking as a service, and I think they have 12 programs. Three are onboarded and they’re constantly talking to new fintechs to… And they’re like, the cost of these deposits is super high.

Because the FinTechs have these contracts and they’re renegotiating the banks against each other that it’s going to turn out that these banking as a service, all these banks that are getting into it are going to not be happy with the cost of the deposits. So I think there’s a lot of growth or there’s a lot of interest amongst banks to rent out their balance sheets, but at the rates they’re going to have to pay for these deposits, it’s not going to be interesting. So I don’t know if that makes banks less interested in them, but I think the winners there will either be the consumers or the FinTechs, will capture that surplus and the banks will not be winners.

Bill:

Because it’s got to result in spread compression. Or I guess if you don’t want your spread to compress, you take more credit risk or duration risk. You got to get paid for something, right?

Derek Pilecki:

Right. Yes. I think it’s interesting. I think, it’s because the FinTechs will own the customer relationship, so they get the value. The banks, it’s a wholesale relationship for the banks, so they’re not customer facing. They’re not going to get the value. I think that’s one of, if you go, you know how we have Apple Pay now and all the banks let you put your credit card on Apple Pay and then you can use your phone to… I think that was bad on the bank’s part to just allow to sign up and say, “Hey, we want to be on Apple Pay, put your credit card on Apple Pay.”

Because I think it takes a lot of the… allows Apple to have the customer facing relationship with the customer. And so I think Apple is going to extract a lot of value away from the credit card banks on that relationship. So I think the banks just, they haven’t given away the store, but I think that they gave up too much in that scenario. And I think the same thing with these FinTech banking as a service things, the fintechs are going to capture the value.

Bill:

Well, there is no greater fox to let into the henhouse than Apple. And I hear what you’re saying. People say, “Oh, Apple Pay is so easy.” They don’t say, “Paying with Bank of America via Apple is very easy.” No one is thinking of it in that way. They’re just thinking, oh, “Apple Pay is the best.” So then if Apple gets a certain transaction volume, then they go to Bank of America and say, “Well, everybody’s using my format, so I don’t care that it’s your customer. It’s really my customer.”

Derek Pilecki:

And so Apple’s going to go to the banks and say, we want a bigger cut of the interchange fee, and the banks live on the interchange fee. So, there is a limit to that because the consumers get a lot of the interchange fee in the form of rewards or airline miles or whatever, but it makes interchange fees a lot less profitable for the banks to have Apple involved.

Bill:

And those are pretty high margin fees. That’s not like the kind of fees that you want going away, I wouldn’t think.

Derek Pilecki:

Correct. Yes

Bill:

Interesting. Well, I don’t know. What do you think, just generally, ALT managers had such a good run. What do you think that higher rates and the ability for people to find yield does to some of the, I guess, private equity and alt managers, if anything? The answer may be nothing, but just curious for your thoughts on that.

Derek Pilecki:

That’s interesting question. I think alts have this mind share amongst institutional investor where they’re like, “We can provide returns for you that are higher and with no market to market. So there’s new volatility, higher returns with less volatility.” And we know that it’s actually a more volatile asset. It’s just not marked to market. But I think there’s some consternation amongst institutional investors right now of, that they’re over exposed to alts. They’re not liquid. They gave VCs too much money. The returns on the 2020, 2021 vintage VCs are going to be severely negative.

And I think the institutional investors are going to eat that. Are they going to continue to be… I looked at some of the fundraising numbers in the last year or two for the big private equity firms, and they don’t seem to be lights out. It seems like they raise funds, they’re not upsizing funds. Maybe a few funds didn’t quite meet their fundraising targets. I do think that the private equity firms generate good returns overall, and I think that we’re just in part of the cycle where the returns, the forward returns don’t look ideal because rates have moved up so much. But I think some institutions will retain some liquidity. They’ll probably increase the allocations, the fixed income and liquid fixed income to meet their return targets and improve their liquidity. So I think there might be a little bit of air pocket for alt fundraising here, but…

Bill:

That would make sense. Almost like a short term cyclical dip in a potentially secular long. Look, if I was an allocator, I would like to get wined and dined by private equity firms. So I don’t… And it’s nice to not have to mark your book to market, as we’ve learned in the last year or two.

Derek Pilecki:

So I would say the number of IPOs and number of small companies are way down from the mid-nineties. We’re down to 3,000 or so publicly traded companies down from 5,000. A lot of that stems from the Spitzer investigations. You can’t pay research analysts for investment banking deals. So there’s not that hamper conquest or the Montgomery Securities out there, Alex Brown’s or whatever, bringing small growth companies to market. They’re just going into private equity firms or private equity funds because it’s more efficient to raise capital through private equity than it is the public markets.

And so that’s going to continue. You can’t pay for research through stock trading commissions. That business model’s gone. So firms aren’t bringing small firm… investment banks aren’t bringing small growth companies to market like they used to. And so that’s a bull case for private equity, but they’re just a more efficient capital vehicle.

Bill:

Eventually, you would think that you got to flip it to the public market once it gets to the biggest firm, I guess. You got to have some liquidity events sometime, but it seems as though they’ve been able to flip the assets to each other or extend and refi out. I don’t know. But it’s been interesting to watch. And one of those things that I’ve heard forever is going to come to a halt, but I just continues to go on, which I’m learning more and more things just tend to go on for a lot longer than people say they can.

Derek Pilecki:

For sure. For sure.

Bill:

So, look, I want to say thank you to you so much for coming on the program. It’s an honor to do a program that deserves a guest like you. And I have followed you for such a long time and I just appreciate you coming on. So thank you.

Derek Pilecki:

Thanks for having me, Bill. Really enjoyed our conversation.

Bill:

Indeed. We’ll be in touch and should you ever want to come on again, just let me know.

Derek Pilecki:

Sounds great.

Bill:

All right.

A second but higher risk opportunity is in select regional banks. Coming into March, regional banks were already at the low end of their long-term valuation range. In March, the regional bank index declined 29%, and many well-run regional banks declined more than the index. We admit there are many new negatives for regional banks in the aftermath of the Bank Crisis. Still, we think they have become too cheap and have the potential to outperform as we get clarity on the going forward business model.

 

We see four new negatives for regional banks: 1) uninsured deposits will decline unless deposit insurance limits are increased, 2) banks will operate with higher liquidity going forward, 3) deposit repricing is accelerating, and 4) regulatory uncertainty is high.

 

One of the largest surprises from the Bank Crisis of 2023 was the high level of uninsured deposits that all banks held. We believe that the concern regarding deposit haircuts at SIVB has caused anxiety among depositors across the country. Unless deposit insurance limits are raised, which looks doubtful at the moment, we think the banks will operate with lower deposit levels as uninsured depositors find more comfortable places for their cash.

 

We think the FDIC should raise the limit on deposit insurance to $1 million for consumer accounts and $5 million for commercial accounts. The $250k deposit insurance limit, put in place in 2008, has not been adjusted and is now too low. For any small to medium-sized companies, there is variability in their cash flow that prevents them from keeping bank account balances below $250k.

 

The main argument we’ve heard against raising the deposit limit is “moral hazard.” We think this is an unsound argument. Commentators use moral hazard to scare people into believing that if depositors don’t monitor a bank’s counterparty risk, then bank management will run amok and take too much risk. However, in our career, we have never heard a bank management team say, “We dialed down risk because we couldn’t get this big depositor to keep his money in the bank.” The people who scream moral hazard are putting forth the argument that depositors should be responsible for monitoring their bank’s risk management. This is the job of bank regulators. As we saw with SIVB, these bank regulators did a poor job of supervising the bank. The bank’s equity and debt holders should therefore serve as another line of defense in risk management after the regulators. We would argue that the equity holders at SIVB also did an inadequate job of forcing the bank to take less risk. We do not believe depositors should act as the risk managers for banks, and as such we are in favor of higher deposit insurance.

 

We think higher levels of deposit insurance will help regional banks retain deposits. The U.S. economy needs regional banks because they play an important role in creating credit for the economy, specifically for small and middle-sized businesses. If deposit insurance limits are not increased, then regional banks will likely have to shrink, which will reduce the availability of credit. Less credit means the economy will grow more slowly or even possibly shrink.

 

Banks are going to run with a higher level of liquidity. For a banker, there is nothing more terrifying than a liquidity scare. We will have a period of lower loan growth while bankers transition to more liquid balance sheets. Once bank balance sheets reflect higher liquidity, banks will generate lower profits due to the decline in loans as a percentage of deposits. Bank securities portfolios will be shorter in duration and more liquid and will yield less, but the banks and the banking system will be safer.

 

Deposit costs are accelerating for banks. The media focus on the Bank Crisis of March 2023 has caused bank customers to search for higher yields on their excess cash. As you know, banks were slow to raise the interest rates they paid on deposits. During the low interest rate environment of the last 15 years, bank customers had gotten used to holding excess cash in their checking accounts because searching for  higher yields was not worth their time. With money market rates approaching 5%, depositors had started to change their behavior and were looking for higher yielding places to keep their cash. The bank failures in March accelerated this phenomenon and deposit costs across the banking industry increased.

 

Our fourth headwind is the uncertainty of new capital and liquidity regulations targeted at regional banks. In the current environment we believe buybacks are off the table for the industry. With the need for capital across the Financial sector, we believe it is unlikely that bankers are going to buy back much stock in this environment even given the low equity prices. However, we have identified a few banks that are down more than 20% that have small securities portfolios, meaning they don’t have any of the mark-to-market issues that SIVB had. These select regional banks have been strong performers historically.

 

Despite these four new negative issues for banks, we believe regional bank stock prices have overshot to the downside. We estimate these four issues will cause a 10% decline in earnings, which is not bad compared to a 30% decline in stock prices. We believe the banks will be able to overcome some of these negatives with wider spreads on loans going forward. We believe we must focus on the best management teams that have shown the ability to grow while maintaining discipline on expenses.

 

Some banks we have identified include Axos Financial, United Missouri Bank, Webster Financial, and Pinnacle Financial. These banks are strong performers and don’t have the same problems that SIVB and others had with their bond portfolios. These banks have strong deposit franchises and have posted strong loan growth for many years. We believe they will be able to balance the demands of the new banking environment and post strong results.

 

We see two main opportunities in the aftermath of the Bank Crisis of March 2023: 1) non-bank financials and 2) select regional banks.

The best near-term opportunity is non-bank financials. The whole financial sector was down 10% in March. For comparison, regional banks were down 29%. Several of our favorite non-bank financials were down more than 15% despite having little in common with regional banks. These non-bank financials don’t have bank deposits and are not facing increased regulatory scrutiny.

We believe that non-bank financials declined in sympathy alongside the regional banks because some market participants were using Financials sector exchange-traded funds (“ETFs”) to hedge or short the sector. The ETF selling put pressure on all of the stocks held by the ETF whether they were regional banks or not. Also, we believe some market participants who were large holders of regional banks had to trim their overall equity exposure and reduced their positions across all Financials as a result, including non-bank financials.

We like Virtus Investment Partners and OneMain Financial. Virtus is an investment manager trading at 6x earnings with zero net debt. The company has been using their cash flow to make acquisitions of smaller investment managers and to repurchase their own stock. Virtus was down 16% in March despite their assets under management increasing in both March and in Q1. OneMain Financial is a sub-prime lender and is not a bank. The company funds its balance sheet in the capital markets and is fully-funded with mostly fixed-rate liabilities. The stock was down 15% in March and trades at 6x earnings.

We would have included Genworth Financial and Sallie Mae in this group, but as of the writing of this letter, they have fully recovered.

We think the opportunity in non-bank financials is a temporary one. This opportunity is disappearing as non-bank financials get bid to higher prices. We think this opportunity will be largely gone by the time earnings season is over as investors realize the underlying strength of these businesses.

The bank run by depositors on Silicon Valley Bank (“SIVB”) was shocking. After the bank announced an equity offering and the sale of a portfolio of mortgage-backed securities (“MBS”) on March 8th, depositors withdrew $40 billion in a single day on March 9th and made requests to withdraw another $100 billion on March 10th. Since SIVB did not have enough cash to meet these depositor requests, bank regulators shut down the bank the morning of March 10th. SIVB went from having a $16 billion stock market valuation on the afternoon of March 8th, to getting closed and placed into FDIC receivership by the morning of March 10th.

 

SIVB was primarily focused on the venture capital community. Venture capital investors and their portfolio companies comprised the majority of their customer base. As a result, the deposit base was much more concentrated than that of an average regional bank. An estimated 95% of SIVB’s deposits were not insured by the FDIC. When the venture capital firms decided to withdraw their deposits from SIVB, they strongly suggested to the management teams of their portfolio companies that they also withdraw their deposits. The combination of a concentrated depositor base, rapid spread of information over social media, and the easy accessibility of bank transfers on mobile phone apps led to a rapid drain on deposits from SIVB.

 

Other banks, such as Signature Bank, PacWest Bank, and Western Alliance, also focused on serving venture capital clients. Venture capital firms and their portfolio companies reduced their deposits at these banks as well, as they were worried about taking haircuts on their uninsured deposits if these banks failed. At Signature Bank, there were too many deposit withdrawal requests, which prompted the regulator to close the bank over the weekend of March 10th. Both PacWest and Western Alliance’s stocks declined by over 60% during this time period, but they were able to meet depositors withdrawal requests.

 

We are disappointed by the demise of SIVB. We had admired the bank’s franchise for a long time. You may remember that we published our bullish investment thesis on SIVB in our April 2019 letter. We sold SIVB during the onset of the pandemic in 2020 because we thought there were better investment opportunities. We continued to track SIVB’s progress and were amazed by the strong deposit growth at the bank. We never repurchased a position because we were worried about the red-hot venture capital environment. We were short SIVB during the Fall of 2022, but we were not short SIVB during 2023.

 

We are frustrated about SIVB’s management taking unnecessary risks that ended up destroying the franchise. Because SIVB had such a great deposit franchise, the bank only made loans for about 50% of its deposits. A typical regional bank is more balanced and lends out 90% to 100% of its deposits. Additionally, SIVB should have invested its excess deposits in short-term bonds. SIVB’s management instead invested almost the entire securities portfolio in long-term agency Mortgage Backed Securities (“MBS”). As interest rates troughed during 2020 and 2021, SIVB’s management continued to reinvest the bond portfolio in lower coupon MBS. They ended 2021 with a portfolio made up almost entirely of 1.5% and 2.0% yielding loans at a time when interest rates were at multi-generational lows. When interest rates rose in 2022, the value of these long-term MBS declined by 20%, which caused the bank to be technically insolvent as far back as last September. This was evident from the bank’s Q3 earnings release. However, bank regulators did not declare SIVB insolvent last Fall because of an arcane accounting rule which allowed SIVB (and other banks) to ignore the mark-to-market losses on the portion of its bond portfolio allocated to its “Held to Maturity” account when calculating its GAAP equity and regulatory capital. Due to the flexibility allowed by this accounting treatment of ignoring mark-to-market losses, SIVB and other banks took imprudent risks and bought long-term, low yielding bonds.

 

SIVB is not the only bank to damage their franchise by buying long-term MBS with low coupons. We think Bank of America, Charles Schwab, and Zions Bancorporation have all impaired their franchises by taking on too much interest rate risk in their bond portfolios. Specifically, these banks purchased a large amount of low-coupon MBS. With the increase in interest rates, the homeowners paying on the underlying mortgages have strong incentives to stay in their homes and keep their low mortgage rates, thus extending the duration of the MBS to 10+ years. These banks will therefore have to hold onto these underearning MBS for a considerable amount of time. At the same time, short-term interest rates have risen and made bank customers much more aware of the potential to earn higher returns on their cash balances. Unsurprisingly, there has been an acceleration of customers seeking higher short-term yields. These banks may earn a negative spread by funding these low-coupon MBS with high-cost deposits and borrowings for years.

Garrett Brookes:

Good afternoon everyone, and thank you for joining us. My name’s Garrett Brooks with Slingshot Financial. Slingshot is a Colorado registered investment advisor. We also serve as a fee-based representative to institutions for specialized investment managers. And I’m very excited to have with us today our partners at Gator Capital Management. Joining me is Derek Pilecki, the founder of Gator Capital Management, the firm which he founded in 2008. He’s currently the portfolio manager for the firm’s long short equity, which is a financials focused strategy. Obviously, we’ll get more into that. But really excited to have Derek with us here today. He manages his portfolio in a variety of structures, both private and public. Slightly different fee structures for each and liquidity constraints. But the same kind of principles, philosophy drive the investment process for each.

He’s received numerous accolades over the years for top of its class or category. And I think in an environment like we’re in right now, where the easy money and the Fed tailwind is not quite in place anymore, I think you really have to think differently. You have to specialize and really understand how to pick your spots, and manage risk in order to outperform on a risk adjusted basis. And I think Gator’s strategy offers some great opportunities. So we’re going to get into that a little bit here in a second. I would say if you have any questions, go ahead and put them in the chat and we’ll answer them as they came in at the end. But to get things kicked off here. Hey, Derek, thanks for joining us.

Derek Pilecki:

Hey, Garrett, thanks for hosting the webinar.

Garrett Brookes:

Glad to. And again, glad you could be here with us. To get things started, would you mind telling us a little bit about your background, how you came to form Gator. And I guess some of the experiences along the way which have shaped your investment philosophy and process?

Derek Pilecki:

Yeah, so getting to the point of starting Gator, Gator’s going to celebrate its 15th anniversary this June. But it was a long process to get to start Gator. When I had my first finance job after college, it was working for Fannie Mae, the mortgage company. So I was in their asset liability strategy group and I was an analyst. I ran the company’s risk-based capital stress test. And back in the mid ’90s, Fannie was one of the most admired companies in the country. And it was a great learning ground to learn about the fixed income market. Fannie’s basically long mortgage backed securities and short agency notes. And they were on the cutting edge of structured notes. We’d issued structured notes and swap out at the whatever interest rate payment it was back to LIBOR minus 12 or whatever the street was offering.

And so, it was a great way to learn about the whole fixed income market. And while I was there, I was doing a lot of reading on my own about stocks in the stock market. I came across Roger Lowenstein’s biography of Buffet, The Making of an American Capitalist, and just fell in love with the idea of having a small hedge fund. But I knew in my mid ’20s, I wasn’t ready to do it. I needed to get a little bit more training. So I went on this process where I went back to business school. I went to the University of Chicago, got my MBA, and used business school as a transition period to move from fixed income into equity research. And so, I worked at a couple small value shops after business school and it really made sense for me to cover financial companies, because I had worked inside a big financial company, and knew about interest rate risk management, and the like.

So I started covering financials on the buy side and then a classmate of mine from Chicago, who had gone to Goldman Sachs Asset Management, recruited me. He called me off and was like, “Hey, our bank analyst is just retired. And we own a bunch of Fannie Mae, will you please come interview?” And so, I moved to that. The Goldman job was actually in Tampa. They had bought a manager that had been previously part of Raymond James. And so, I moved to Tampa in 2002, 20 years ago, and worked for GSAM for five years covering financials for their team. And that team managed about $25 billion in growth stocks. I was one of two financials analysts on that team. Great training ground. I would say their investment philosophy was like a Charlie Munger style, buy great by great franchises, own them forever.

And so, I had my value roots and then influenced by a manager who followed Charlie Munger. And so, in 2008, it wasn’t so fun being an analyst at an equity shop, a growth shop following credit sensitive financials. So I’m not the favorite child, so I used that as an opportunity to start Gator. And so, I launched Gator. So we started our financials long short strategy in 2008.

Garrett Brookes:

That’s great. That’s a heck of a time.

Derek Pilecki:

Yeah, it was a crazy start. Yeah, I launched 10 weeks before they short Lehman Brothers, so that was a crazy time. But there was also a ton of opportunity [inaudible 00:05:37]. So I was able to maximize.

Garrett Brookes:

Yeah, it’s certainly a good time to be able to short.

Derek Pilecki:

Yeah, but that rally in 2009 was really tough to shorten too.

Garrett Brookes:

Right. Yeah.

Derek Pilecki:

You had a view the credit markets would heal and they weren’t going to nationalize any more big banks. I was able to call the turn in ’09. And so, we just have continued to find opportunity in the financial sector since then. So one of the outcomes of the financial crisis is there’s a lot of generalist portfolio managers who don’t love financials. They lost a bunch of financials in ’08, and they kind of just ignore the sector, or they don’t really dig deep into it. And so, I was always surprised by the number of good franchises that trade at cheap valuations in my sector.

Garrett Brookes:

As just a result of less analyst coverage, less fund managers covering. And then it’s also, if I’m hearing you correctly, a fairly good amount of dispersion among the constituents in your universe. So you kind of stack opportunities there to grab some premium.

Derek Pilecki:

Yeah, I mean I always think the opportunity sets right now is as good as it’s ever been with these changing interest rates, and companies, and financials… People say, “Oh, financials are an interest rate play.” Well, not every financial company responds to interest rates the same way. You have a lender that’s making fixed rate multi-family loans, and they have hot CDs as their funding base. They’re not going to benefit from higher rates like a bank that has commercial floating rate loans, and a really strong core checking account deposit base. So I think there’s a bunch of dispersion amongst returns within my sector, which is good for a long-short manager.

Garrett Brookes:

Absolutely. Absolutely. So you formed Gator in 2008 and began with the private fund, as well as some separately managed accounts, individual portfolios. And from there then assumed management of a mutual fund, a legacy mutual fund. And this is in November of 2017.

Derek Pilecki:

Right.

Garrett Brookes:

And then over the course of a year, transitioned the portfolio to your strategy as it is now, which was complete I guess in Q1 of 2019, if I’m not mistaken.

Derek Pilecki:

Correct. So Michael Orkin retired and started our process in 2017 to identify as a successor manager. I won that process and started on an interim basis. Took it over in November, 2017. The proxy was official in February of 2018. And Michael had run the portfolio as a bear market fund that he had really protected well on the downside in the internet bubble and the financial crisis. But that’s just not my style of investing. So I agreed with the board in early 2019 to transition the portfolio to be more similar to how I run my main strategies. And so, now it reflects my investment style. And there’s heavy overlap between the mutual fund, Caldwell & Orkin Gator Capital long-short fund, and my private fund.

Garrett Brookes:

Great. And actually I just checked on Morningstar before we jumped on here, and you are top 5% for the three year, and well within the top decile for the five year amongst your peers. So there is a clear change when you institute your portfolio on the legacy fund and it really bears out.

Derek Pilecki:

Yeah, I mean I think there’s been a good opportunity over the last few years and we definitely have been able to create some value over the last five years, and looking forward to the next five years because I think there’s still a lot of opportunity out there.

Garrett Brookes:

Yeah, and I am too. So with that being said, do you mind talking a little bit about your investment process and idea generation? I know it’s a bottom up portfolio and would really like to hear your thoughts as a specialist on how you go about constructing the portfolio.

Derek Pilecki:

Yeah, so we’re looking for stocks that are misunderstood. So usually that means they have a low valuation because people are ignoring them. They have a view that they’re just dead or the earnings are going to evaporate. We take a look at the low valuation stocks is okay, if these earnings can maintain and the street changes its view of what the value of that earning stream is, then we can get a higher multiple. So a five PE stock goes to an APE stock, that’s a pretty big return. And we’re also looking for some kind of catalyst that’s going to make that change. So an example would be Genworth Financial. We bought this stock last year. We had owned Genworth from 2012-2014.

And back then, the real issue was the mortgage insurance subsidiary ,where they’re going to have to raise additional capital to fill a cap potential capital hole in mortgage insurance. And that stock played out well as it became clear that mortgage insurance was just going to be fine, housing marketing was clearly recovering. Well, the stock kind of blew up on long-term care insurance in late 2014, early 2015. Long-term care insurance is a really tough business. You’re selling policies to 60 year olds for when they potentially go in a nursing home at 85. And so, they’ve written these policies 25 years ago that people are just making claims on, and the claims were way higher than anybody expected. So they kind of went through a long period.

If you look at the stock chart from 2014 to 2022, the stock flatlined. And during that period there was an aborted attempt to buy a Chinese insurance company to acquire them. They weren’t able to get that past regulators. And so, the stock flatlined around three or $4 a share, and investors just lost interest. I mean their socks were moving all over the place and Genworth’s just sitting there.

But during this time we had been following, Genworth had been doing a good job of raising prices in their long-term care insurance business. And they also were able to get the mortgage insurance subsidiary separated from the life insurance business, and they actually did an IPO of the mortgage insurance subsidiaries now enact holdings, which 20% trades on the New York Stock Exchange and Genworth still owns an 80% stake. And so, Genworth was fixing its capital. And then on the Q4 call last year, they said, “Hey, we’re getting this cash in. We’re going to our debts get paid down to the level where we’re comfortable. We’re going to start using excess cash now to buy back stock. And we’re going to probably make an announcement on Q1 earnings.”

And stock didn’t really respond. And so, we bought a position, they announced it on Q1 earnings, stock still didn’t respond. It wasn’t until they actually started implementing the stock buyback in late 2022 that the stock started going up. So it’s an example of follow things for a long time. For a long time there was nothing to do in Genworth, but then when the catalyst came of we’re going to start the stock buyback, we took a position and move forward. So cheap stock trades for… I mean I think it trades for three times earnings now. I think there’s creating value.

There is potential that long-term care, they could salvage some value out of that business. To own the stock here, you don’t really need that. They’re probably going to spin off the mortgage insurance business. And so, just a hated stock, couple billion dollar market cap, people weren’t paying attention, and we were able to make some money in a pretty tough stock market last year. So that’s just an example of the type of things we do. I would say right now, only about 20% of the portfolio has a market cap above $10 billion. So we have a lot of small mid-cap companies in the portfolio.

Garrett Brookes:

Yeah, and that’s actually been a great spot to be so far year to date.

Derek Pilecki:

It has. And if you look at the style boxes on Morningstar, they classify us as a small cap value style box. And when I think about positioning our mutual fund in a portfolio, I mean I think it’s a replacement for small cap value. We’re not just hugging the index with a lot of unique stories within small cap land. I think small cap is a place where active management still pays it. You can extract alpha if you’re following companies. The streets pull back on research efforts as big firms have experienced outflows due to shift from active to passive that there’s less buy sign analysts on the street. So I just think that the opportunity in small caps is still robust.

Garrett Brookes:

And in the same spirit, you know came from one of the large firms, one of the gorillas really just before forming Gator, and then larger firms before that as well. Do you think that you have any additional advantage in having your own firm? And is there anything else that you’re able to do that you couldn’t do at some of the larger firms, I guess?

Derek Pilecki:

Yeah, I think large firms have resources and they have a lot of people to throw at problems. I think one of the main advantage of a small firm is the lack of bureaucracy. I mean, I don’t have my day filled with administrative meetings. I spend a large percentage of my time focused on investment research. I don’t spend the month of the July writing 360 degree reviews of 15 team members. I give feedback instantly to my small team of four. And we’re not spending hours in meetings rehashing things or trying to posture. I mean, I’m doing investment research. So I think I go through more names, I spend more time on names. And I think that’s a real advantage.

Garrett Brookes:

Yeah, absolutely. Well you mentioned just before a little bit about the profile of the mutual fund. And in the spirit of having some fun here and also disclosure, I also am an investor in Gator long-short. And so, we work together. I’m also an investor in the strategy, and I thought my style is probably not very different than some of the investment advisors on the call here, and the other folks that I talk to on a daily basis. And so, I thought it’d be fun to give you an idea of my insight and the [inaudible 00:17:17] portfolio in.

And so, I’ve always been… I’ve shared this with you and just about anybody I’ve talked with, I’m a big fan of alternative strategies. My own portfolio could best be described as a risk-based asset allocation model. I use both active and passive. I dedicate a specific allocation to alternative strategies. They’re all liquid in a public format. And in the fourth quarter of last year, preparing to rebalance for Q1 here, I had decided that I wanted to reduce my traditional exposure in favor of increasing the alternative strategies.

And so, along the way throughout last year with the increase in vol, I had basically pulled out of some of my opportunistic equity allocations, you could consider them satellites I guess. Just because the vol became unpalatable for me. And also to dovetailing on your point, I tend to favor for the foreseeable future here, small value in favor of small growth. And so, what I did was actually removed small growth beta, a small growth beta position, and with the proceeds from that combined with some of the sold out of opportunistic equity, invested in the Gator long-short strategy, and included that in my liquid alternatives allocation.

Derek Pilecki:

Yeah, I mean I think that makes a lot of sense. You remember back from the internet bubble when small growth blew up, it was years. It was like a good 10 years before small growth showed any relative performance. I mean value went on a multi-year run after the internet bubble and we could see the same thing here. You look at some of the values of small growth companies and it’s still pretty high. And so, I think that makes a lot of sense.

Garrett Brookes:

And I just think also with… Certainly we could say, you could argue that liquidity will be pulled out of the system. It’s certainly not being added as it has been for the past 10 years. And so, I think that some of the more speculative, higher flying names, large cap as well as small caps, it’s going to be a little bit tougher. And so, I think that the value space is where you’re able to really extract some excess return for the level of risk.

Derek Pilecki:

Yeah, I agree. I think that makes a lot of sense.

Garrett Brookes:

So now some of the fun parts. Where are you seeing opportunity? What do you like right now?

Derek Pilecki:

Yeah, so in the portfolio, I really like midcap banks. So there’s many mid-cap banks that are growing earnings, they’re growing loan growth. That they’re well run, I think the underwriting’s conservative, and they’re trading for six or seven times earnings. And so, last year was really interesting. Banks came out of the gate the first January, February, hey rates are going up, banks are going to outperform. They outperformed the S&P by like 12% in January and February alone. And then Russia invaded Ukraine and they gave up all that outperformance through the end of June. And then from June on they kind of tracked the broader market. So super disappointing year last year for banks, especially given that rates are higher.

But with higher rates, earnings are higher on average for banks. Not every bank but on average for banks. And so, right now we have the cheapest valuations I’ve ever seen with for banks or not ever, but going back to the mid ’90s cheap. And so, I just don’t think these mid-cap banks should trade it for six or seven times earning. And so, examples are Pac West, Western Alliance, East West Bancorp, Webster Financial. So really excited about this group of banks. And I think that there could be easily a scenario where these banks trade for 10, 11, or 12 times earnings. So going from six, seven times earnings to low double digits would get a nice return. And in the meantime they’re growing their business and low growth is attractive.

I guess the negatives that people point out is, “Oh, well there’s deposit funding, costs are ramping up.” And yes, that that’s happening, but at some point that will level off and they’ll earn their normal margin. And in the meantime they’ve compounded their growth through continuing to put up one growth in the high single low double-digit area. A tangentially to that, I really like Puerto Rico for the banking environment. So Puerto Rico is a US territory. Banks there regulated by the FDIC, they issue press releases, they attend the American banking conferences. They are US banks.

Puerto Rico only has three banks on the island. So it’s an oligopoly. And if you go back to the pre-financial crisis, there were 11 banks in Puerto Rico and it was super competitive. And so, if you look at another island banking market, Hawaii, there’s four banks in Hawaii. And each of those four banks earn wide margins, and they have high returns, and they have premium valuations. But the Puerto Rican banks trade in line to at a slight discount to US banks. So I think that we’ve already seen evidence that their margins are going up and their returns are increasing. I think it’s a matter of time before the multiples go to a premium. So really think Puerto Rico’s interesting.

I think there’s selective opportunity in asset managers. So the two groups asset managers. Alternative asset managers, private equity firms. And then traditional asset managers, they publicly traded. They manage mutual funds or vehicles that we’re familiar with. And so, I think I see opportunities in both groups. So in alternative asset managers, I really like Carlyle. Carlyle had a phenomenal 2020, 2021 as all the private equity managers did. In 2022, Carlyle took a step back. They botched their CEO transition. So the founders had appointed dual CEOs five years ago. One left to become governor of Virginia. The other one, they didn’t renew his contract, so the founders stepped back in and took over management of the company last year. And the stock got crushed because of it.

It was like the street took this view of like, “Oh, it’ll never be fixed. People will leave Carlyle without a CEO,” which is just nonsense, I think. I can think there’s investment professionals that are there at Carlyle, they’ve been there their whole lives. They’re not going to leave just because there’s a little bit in transition. Well, the new CEO finally got appointed yesterday. And he’s a former Goldman guy. I think he’ll bring some credibility to Carlyle. One of the knocks on Carlyle is they’re less profitable than the other the private equity shops. Carlyle had always managed their business where we run and operate the business on management fees. So we spend all our management fees trying to grow the business. And then we pay ourselves on the incentive fee. Well, when that was fine, when they’re privately traded partnership, but now that they’re publicly traded, and Blackstone, and KKR showing huge profitability on the management fee line item alone, Carlyle changed.

And so, they’ve shown a ton of operating leverage the last three years, that transition’s happening. I still think there’s some probably excess expenses in Carlyle’s expense base. I think the new CEO will come in and attack that and they’ll show even more operating leverage. So I really like Carlyle valuation came down to nine or 10 times fee related earnings, and then you get all the incentive income for free. So I just think that’s way too cheap. Normally people, they do some of the parts and they buy 15 or 18 times to management fees, and maybe a two or three multiple to incentive fee. So I think there’s a lot upside with Carlyle. Within the traditional asset managers, I like Vertice and I like Victory Capital. Both are acquisitive firms. They buy smaller managers, they consolidate the back office and the sales teams, they hold onto the assets they acquire, and they’re hugely creative deals.

And so, I think it’s a little bit of financial engineering. They’re able to get these small managers cheap because traditional asset managers are so out of favor because we have the shift from active to passive. But it just works in an acquisition strategy. So they both trade at six times the EBITDA. I think that’s too cheap. I think they’ll continue to make a creative acquisitions, and they’ve been smart with their capital management.

And then on the long side of the last thing that I like, is the selective life insurance companies. So I already mentioned Genworth, another one I like is Jackson National. It’s a classic spinoff type story. It was a subsidiary of Prudential UK, the British Insurance company, they decided to spin it off. Prudential UK, of course, trades in London. When they spun off the shares, the shares traded in US. So you had a bunch of UK investors all of a sudden end up with this tiny position, this unloved newly spun off US insurance company. So the valuation came on the first day of the spinoff, came out super cheap. Still trades at a cheap multiple. Management team’s been very aggressive with capital management, buying back shares, paying an attractive dividend. It’s an ugly business. Variable annuity platform is… There’s a lot of downside risk when the market goes south, but I think they’ve done a good job of managing the risk and managing their capital. So those are the ideas I like on the long side.

Garrett Brookes:

And I think you’re hammering home just how differentiated the different drivers of excess return within the financial space. Myself and other kind of macro level asset allocators, I think we tend to look at financials as a pure yield curve shape play or kind of a price momentum. And this really is kind of eye-opening that there are deeper value situations here and different ways to add some premium.

Derek Pilecki:

Yes.

Garrett Brookes:

How about… Oh, I’m sorry.

Derek Pilecki:

Oh, I was just going to say the view that you want to only buy financials when the yield curve steep, you miss all these stories. There’s a lot of stories that are not driven by interest rates.

Garrett Brookes:

Yeah. How about on the other side, the short side?

Derek Pilecki:

Well, I think the most glaring obvious thing is office. We have a problem with offices. I mean, people aren’t going to go back to work. If they go back to work, they’re not going every day. While there might be the investment bankers, and the advertising executives, and the attorneys need to be in the office, so they do their apprenticeship model. There’s a lot of people who are not going back to the office. Law firms that you should have 10 floors in midtown Manhattan, their back office people don’t need to be in-person, they’re going to work from home. They’re going to take seven floors when their lease renews.

And so, what we’ve seen is people are paying their leases when they expire, they’re going to take less space. That’s a problem for office owners. So the bull case on office rates is, oh well they trade a huge discount to NAV. Well an NAV implies private market values are real. I totally disagree with that. There’s a problem. We have too much office space in the US. It’s an acute problem in the central business districts, New York, Chicago, and San Francisco. The commutes are too long. People aren’t going to do make those commutes anymore. Excuse me.

Garrett Brookes:

Sure.

Derek Pilecki:

So I’m sure at every office street, I think it’s a huge opportunity on the short side.

Garrett Brookes:

Yeah, and that’s a great point because you do… That is what you hear. If you listen to the financial press, they’re already a discount to NAV. Well, that’s a great point. What is the NAV? And I think we’ve talked about this before and there’s just not a lot of transactions in office right now. So those are probably kind of due for markdowns, those NAVs.

Derek Pilecki:

Right.And we also see it from the bank lens. We talked to banks. Banks are starting to call out what their office exposure is, what the LTVs are, how big the portfolio is, how much is suburban versus central business district. They’re all talking about we’re not making new office loans. And when capital leaves a sector like we saw with oil and gas, when you cap service sector, stock valuations do not work. Stock prices do not work. And so, if they can’t get loans rolled over, it’s just not going to work.

Garrett Brookes:

That’s great. Thank you.

Derek Pilecki:

And I guess on the other short opportunity is there’s been a lot of new companies that have come public through SPAC or IPO over the last two or three years. And so, some of those business models are untested, some of them are flimsy. So I think a lot of them got crushed in 2022. But with this junk rally in early 2023, we’re revisiting some of those stories that we’re going to get a second bite at the apple wall. So I think that’s pretty interesting

Garrett Brookes:

That’s interesting. That’s a great point. This kind of risk on rally that we’re seeing has giving you a new entry point for the shorts.

Derek Pilecki:

Definitely.

Garrett Brookes:

Well, thank you. Thank you for the time. Like anybody has any questions here? I’m going to again open up this chat and field a couple as they came in. Looks like there’s just a couple in here. Okay. So I think what this one is getting at is, can you talk about what drives long versus short percentage or allocation in your strategy?

Derek Pilecki:

Yep. So right now the mutual fund is 90% gross long and we’re 30% gross short, so the net 60. I would say that’s pretty typical when I look back through the history of my strategies, can’t say that changing the net exposure has added a ton of alpha. Really the alpha has been from stock picking. And so, we focus on that. I would say it’s driven from a bottom up perspective of if we find more shorts, our net exposure will be less. We do not use leverage to the extent that we don’t make gross longs above a hundred percent.

So I think about this level is about what you would expect. Maybe it’ll go to 50, maybe it’ll go to 75 or 80, but in the 60 range is what I would expect the normal course would be. I think that there could be a scenario where if I got uncomfortable with underwriting in the banking system generally, where I thought that there was going to be real problem with credit losses, we could get our net exposure way down. I don’t anticipate that happening. I think everybody still has PTSD from the financial crisis and underwritings staying strong, that regulators are solo over the banks. The Dodd-Frank Bill has gotten a lot of the more risky lending outside of the banking system. And so, I don’t envision a scenario where banks will really loosen up underwriting in the near term.

Garrett Brookes:

That’s great. And you already answered the next one, which was about do you employ leverage? And so, we have one more here. This is a fun one. Do you think we will see more mergers in the asset management space?

Derek Pilecki:

I do think it’s going to be a consolidating industry. I think there’s a couple things driving it. I think there’s some headwinds with the shift from active to passive. I think we have some generational turnover, And so, people are going to be looking for exits. I think there will be continued consolidation in that space. Yes.

Garrett Brookes:

Great.

Derek Pilecki:

Yeah, we know how hard it is for small managers to get started, and consultants are really driving the market, and flows gravitate to the bigger managers. So I think there’s a real case for scale and asset management.

Garrett Brookes:

Yeah. Great. And I guess we can wrap it up here. It doesn’t look like there’s any more. Obviously, if anybody has questions, specific things that they’d like to talk about offline, feel free to reach out to me. You could also just quickly pop a message here into the chat and I’ll catch up with you at a convenient time. But any parting words here, Derek?

Derek Pilecki:

No I mean, I appreciate everybody’s attention. We’ve been running the mutual fund for five years. We’ve been running our broader strategy for 15 years. I think there’s a lot of opportunity and long short financials, especially in the small midcap area. So appreciate everybody’s time today.

Garrett Brookes:

Fantastic. And I think there’s a ton of opportunity as well. All right, everybody, thank you for joining us. And hope to talk to you again and join us for future programs here. Take care.

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