We have owned a position in Axos Financial for 2 years, but the stock is off 37% from its high in early 2022. We think Axos is a good example of the opportunity in bank stocks right now. Axos has strong organic growth. It has low credit losses and will benefit from higher rates. No company specific issues have materialized in 2022 to explain the stock decline.

Here is our investment thesis on Axos Financial:

  1. Management – Greg Garrabrants has been the CEO since 2007 and has done a nice job of growing the bank. We think his strategy of targeting lending businesses with attractive returns and steadily building out multiple deposit franchises has created value. For example, Axos has built out several loan programs such as Small Balance Commercial Mortgages and Lender Finance. On the deposit side, Axos has diversified its deposit gathering from Consumer Direct to include Fiduciary Deposits and White Label Banking.
  2. Nationwide Direct Bank – Axos Financial is a nationwide direct bank. They have customers in every state, but they do not have branches. Previously, Axos operated under the name Bank of the Internet. The direct bank operation allows them to operate more efficiently than other banks with significant branch systems. Operating as a direct bank for two decades has positioned them well for the current trend of remote work and serving customers virtually.
  3. Organic Growth Focus – For the most part, Axos has grown organically throughout its history. However, from time to time, the company has made small acquisitions to acquire new capabilities, such as the securities clearing business, which they use as growth platforms. We believe organic growth is more valuable than acquisition growth.
  4. Securities Clearing – Over the last several years, Axos has made a couple bolt-on acquisitions that have positioned it to grow in serving Investment Advisors and smaller Broker-Dealers. Axos purchased Apex Clearing to start serving smaller Broker-Dealers. This deal gives Axos access to low-cost deposits in the form of excess cash held by the Broker-Dealer’s customers in their brokerage accounts. Then, last year, Axos purchased E*Trade’s Investment Advisor (“RIA”) servicing business from Morgan Stanley. We think there is a good opportunity for Axos to fill a market need in servicing RIA’s. After Schwab acquired Ameritrade, there are fewer options, especially for smaller RIA’s, to custody their customers’ assets. This acquisition of E*Trade’s RIA relationships gives Axos critical mass to grow this business.
  5. Low Valuation – Axos trades at 8x earnings. As recently as January, the bank traded at 14x earnings. We attribute the lower valuation to the general sell-off in regional bank shares since the Russian invasion of Ukraine rather than any Axos specific issue.

 

Other stock market investors see risks to Axos Financial’s shares:

  1. Less Asset Sensitive – Axos has a significant percentage of hybrid fixed-rate loans with initial terms of 3 to 5 years. So, in the current rising rate environment, Axos is less asset sensitive than peers who have a higher percentage of floating rate loans. However, compared to 2015, Axos’ balance sheet is more sensitive to rising interest rates than it had been. Axos has more floating rate commercial loans than it did in 2015. Also, Axos has more low-cost commercial deposits it will not have to reprice to retain. We still think Axos will benefit from higher interest rates, but the benefit will come over a period of several years, instead of in late 2022 and early 2023.
  2. Executive Compensation – The CEO has an innovative compensation structure. His compensation increases if the stock outperforms its benchmark. This can lead to remarkably high payouts if the stock does well. If the stock underperforms, he will not receive a bonus. We are not thrilled with this arrangement, but we tolerate it because we believe the opportunity in Axos is outsized.

 

We like Axos Financial. We think the stock is interesting at the current level. The management team has a strong record of consistent, organic growth. The bank’s current valuation is low, especially compared to recent history. We think the bank has ample opportunity for continued growth. We view Axos as an example of a bank holding in our portfolio that demonstrates low valuation, solid organic growth, and low likelihood of material credit losses in the medium-term. We have a dozen or more holdings with similar characteristics.

 

We own positions in both Enact Holdings and its parent company, Genworth Financial. Enact is one of six mortgage insurance companies. Mortgage insurance is purchased by borrowers to protect lenders if the borrower defaults on their mortgage. The government mortgage agencies (“GSEs”) require mortgage insurance when the borrower has a down payment of less than 20% of the home’s purchase price. Usually, first-time homeowners are the largest users of mortgage insurance since they often have the most difficult time accumulating enough savings for a 20% down payment. We believe the demand for mortgage insurance will be strong, but the mortgage insurance companies’ stocks are priced as though future earnings will not grow.

Here are our investment theses on Enact Holdings and Genworth Financial:

Enact Holdings

  1. Ignored stock – Enact’s stock is ignored because of its low float. Enact held an initial public offering in September 2021. Genworth retained ownership of 81.6% of Enact’s shares. 9% was sold in a private placement to another money manager, so only 10% of Enact’s shares are free to trade by public investors. This prevents larger investors from taking a significant position in Enact.
  2. Low valuation – Enact trades for 85% of tangible book value and 6x earnings. It is the least expensive stock of the publicly traded mortgage insurers, and we believe the entire group is cheap. The valuations are especially attractive given there are likely very few losses in their existing portfolios, and mortgage insurers have used strong underwriting criteria since the Great Financial Crisis (“GFC”).
  3. Strong housing market – The Millennial Generation is in their peak home-buying years. We believe insurance volume will be robust for all mortgage insurers. Strong housing prices mean that the existing portfolios of the mortgage insurers will experience low losses.
  4. Dividends in the near future – We expect Enact to begin paying dividends to shareholders in late 2022. Because Enact generates more capital than it needs for growth, we believe Enact’s board will set the dividend payout rate at 40% of earnings. This would translate to a stock yield of about 6%, which we think will be attractive to potential shareholders.
  5. Parent oversight – Genworth owns 81.6% of Enact stock, and we believe there are benefits from Genworth’s oversight of Enact. As the only cash-flowing asset owned by Genworth, we think Genworth will encourage Enact to pay dividends to shareholders. Although we don’t expect Enact management to make any poor acquisitions, we believe Genworth serves as an effective blocker of any poor capital management decisions. We acknowledge that Genworth limited their control over Enact by reducing the number of Board seats they control, but we think Enact’s board is aware of Genworth’s preferences for significant capital return through dividends.
  6. Industry growth – The mortgage insurance industry is growing between 6-10% annually. With rising home prices, borrowers will have an even tougher time accumulating money for a down payment, so they will turn to mortgage insurance. Also, the Millennial generation is at its peak years for buying a first home. First-time home buyers are the largest users of mortgage insurance. We believe the mortgage insurance industry will continue to enjoy strong volume growth in the coming years.

Other stock market investors see risks to Enact’s shares:

  1. Price competition – Some investors point to the potential price competition among mortgage insurance companies. Mortgage lenders choose the mortgage insurer for a borrower. The mortgage insurance industry is very price competitive. Recently, mortgage insurers have been disciplined in their pricing, and we believe investors will react favorably as pricing shows more stabilization this year.
  2. Risk to home price declines – We believe many investors still have fresh visions of home price declines from 2006 to 2010 in their minds. Although home prices have increased substantially, we think the current housing market is fundamentally stronger than 15 years ago.

Our two main reasons for this constructive view of the housing market are as follows:

1) Almost 100% of current mortgages were underwritten with fully documented loans.

2) We have a shortage of homes because we did not build enough houses in the 12 years since the Great Financial Crisis. We don’t believe home prices are at-risk in the near-term. We hold this view despite the potential for higher interest rates.

  1. Potential spin-off from Genworth – Many investors are concerned about pressure on Enact’s share price if Genworth distributes its Enact shares to Genworth shareholders. We are not concerned about this possibility because Genworth needs to retain its Enact shares to get the tax-sharing payments from Enact. Genworth has accumulated tax losses and files a consolidated tax return with Enact, so when Enact accrues for taxes and sends that money to Genworth, Genworth can keep the cash because of its past losses.

 

Genworth Financial

 

We also own shares of Enact’s parent company Genworth Financial. We think Genworth is more attractive than Enact. Here is our investment thesis on Genworth:

 

  1. Leveraged return on Enact – Genworth’s main asset is the 132 million shares of Enact it still holds. Genworth also has about $1 billion of net debt at its holding company, so it is a leveraged version of Enact. If Enact stock increases in value, Genworth should increase a greater percentage due to the leverage at Genworth’s holding company.

 

  1. Two other assets held – Genworth has two other assets that we believe are not reflected in Genworth’s stock price. Currently, Genworth trades for approximately the value of its stake in Enact less its net debt. The two other assets Genworth owns are:

 

  1. Tax-sharing arrangement – Genworth has a tax-sharing arrangement with its subsidiaries. Since Genworth has past losses, it does not pay federal income taxes. Regulators allow Genworth’s subsidiaries to send tax payments to the holding company for liabilities created by the subsidiaries’ current income. However, the holding company can retain these cash tax payments because it has the tax shield from past losses. This tax-sharing arrangement allows Genworth to get cash out of the subsidiaries without asking regulators to allow dividend payments. In 2021, Genworth received $375 million in tax-sharing payments from its subsidiaries. We conservatively estimate Genworth could receive $200 million per year for the next five years. This amount would equal $2 per share, which is significant considering Genworth’s stock is only priced at $4.

 

  1. Life insurance subsidiary – Genworth also owns a life insurance subsidiary. The life insurance subsidiary is a large company on its own, but we assign zero value to this subsidiary because of potential losses in its long-term care insurance business. However, we observe that Genworth’s management team has done a very good job raising rates on its long-term care policies to counteract increasing policy costs. There is some possibility that 10 years from now, management’s actions could salvage some value from this subsidiary. If this subsidiary has any value, it could be so large that it would be meaningful to the stock price. For example, if the subsidiary is eventually worth half of its current $11 billion of book value (or $5.5 billion) then this subsidiary could be worth almost $11 per share. This potential scenario is far down the road, so currently we conservatively assign zero value to this asset in our valuation of Genworth.

 

  1. Share repurchases on the horizon – We expect Genworth to begin repurchasing its shares during 2022. Genworth has paid down its holding company debt to its target level of $1 billion. As Genworth receives cash at its holding company from its tax-sharing arrangements with its subsidiaries and dividends from Enact, we believe Genworth will announce its intention to repurchase shares as early as the Q1 earnings announcement in early May. Since we believe Genworth’s shares are trading below intrinsic value due to the attractive valuation of Enact and Genworth’s other two assets, we believe these potential share repurchases will create additional value.

 

  1. Optionality with Enact stake – While most investors think Genworth will spin-off its stake in Enact, we think it is more likely that Genworth will buy-in the Enact shares. Genworth’s financial position has improved rapidly in the last year. As Genworth uses its cash flow from the tax-sharing arrangements and dividends from Enact to repurchase its shares, we think a possible scenario is for Genworth’s shares to outperform Enact’s. Right now, we believe Genworth is cheap relative to Enact, but if this were to flip, where Genworth was relatively more expensive than Enact, we think it will make sense for Genworth to buy-in the Enact shares it sold in September 2021.

 

We believe Enact and Genworth are both interesting stocks at their current valuations. We believe Genworth has a higher upside due to being a leveraged version of Enact, and because of its other two assets to which the market is not assigning any value.

 

We like Realogy Holdings (“Realogy” or “RLGY””). Realogy is the parent company of Coldwell Banker and Century 21. We believe the Coldwell Banker name has significant brand value among residential real estate owners. Realogy trades at only 4.4x EBITDA. We think stock market investors are overly concerned about disruption of residential real estate brokerage.

  1. Street estimates are too conservative – We believe Wall Street estimates for Realogy in the next 2 years are too conservative because they assume that Q2 2021 was the peak dollar volume period for housing We believe the housing market will remain strong in 2022 and 2023 as prices continue to increase and the number of housing transactions stays stable or increases marginally.
  2. Pandemic beneficiary – Realogy has benefited from the current pandemic-induced housing As the professional class has re-evaluated how they work and how often they commute to the office, many decided to change their living situations. Some have moved to the suburbs in search of more space. Others have moved to remote locations to work from home in low-cost areas or in vacation spots. Realogy has another firm specific benefit.

In the previous 5 years, Realogy’s brokerages had lagged due to a concentration to New York city and the suburbs where home prices and activity had lagged. Since the Great Financial Crisis (“GFC”) until the pandemic, homes prices in the New York suburbs had been stagnant. The main reason for the stagnation was the decline in high-paying Wall Street jobs. Wall Street was not creating a new generation that could move to Darian, CT or Summit, NJ to buy over-priced homes from the previous generation of Wall Streeters. With the pandemic prompting people to move to the suburbs, Realogy has benefitted from the resurgence of activity.

  1. Demographic beneficiary – The Millennial Generation is in their peak home-buying years. This generation was delayed in their household formation due to the However, biology waits for no one, and the current crop of 35-40 year-olds are buying homes.
  2. Compelling valuation – Realogy trades at 4x on a current Enterprise Value-to-EBITDA. If the company traded at 8x EV/EBITDA, then the stock price would be $49 or 175% higher than the current price. Given the company’s leading position as a residential real estate broker, we do not believe 8x EBITDA is too optimistic. In early 2014, Realogy traded at 12x EBITDA.
  3. Deleveraged – Realogy’s management has focused on paying down its debt. This has made the balance sheet as strong as it has been since it became Realogy’s current debt-to-EBITDA ratio is 2.3x, which was down from greater than 5x in 2019. We believe Realogy is close to redirecting cash flows from debt paydown to stock repurchases. We believe this change in capital allocation will be a catalyst for the stock.
  4. Debt refinancing in 2022 – Realogy can refinance $1.1 billion of debt during 2022 and save $30 million or $0.26 per share
  5. Potential acquisition target by private equity – We would note that Realogy was previously owned by private equity firm We believe that a private equity firm could purchase Realogy again if the company’s valuation remains at this compelling level.

 

Other stock market investors don’t love Realogy for a couple of reasons:

 

  1. 6% Real estate commissions aren’t sustainable – Many investors have a short thesis that real estate commissions are at We’ve all paid 6% brokerage commissions when selling a house and have been frustrated by this high level. These investors point to new real estate brokers with business models that reduce commissions to consumers. We point to brokers retaining market share even in ultra-hot housing markets like the Fall of 2020 as reason that real estate broker commissions are more sticky than consensus.

 

  1. Competitive intensity among real estate brokers for agents – Other investors point to competition among real estate brokerages for agents will lead to agents capturing a higher percentage of the We’ve seen this recently in Realogy’s results, but we think there is a limit to how much brokers are willing to pay out to their agents. One large competitor is Berkshire Hathaway Home Services (“BHHS”). Although BHHS is backed by Warren Buffett’s Berkshire Hathaway, we like them as a competitor. Buffett has a long history of not competing on price and tends to run his subsidiaries for cash flow with limited appetite for reinvestment. Plus, his ownership of a traditional real estate brokerage validates the attractiveness of the business. Second, Realogy competes with a relatively new traditional brokerage, Compass. Compass was founded about 15 years ago, received venture funding from Softbank, and completed its IPO earlier in 2021. Compass has a market capitalization of $5.3B compared to Realogy’s $2.1B. Compared to Compass (“COMP”), Realogy trades at 1/3 the Price-to-Sales ratio with operating margins of 12% compared to Compass’ -5% margins. Our contacts in the business have told us that Compass has pulled back on its pricing.

We think owning Realogy’s stock at its low valuation of 4.4x EBITDA is very attractive. We believe there are several potential catalysts that will help the stock re-rate to a higher valuation. First, Realogy has two high coupon debt issues that are callable in 2022. Second, after refinancing these two debt issues, we expect Realogy’s management will start to repurchase common shares during 2022. Finally, we expect Realogy will continue to report strong earnings due to the strong housing market.

Robert Kraft:

This podcast is for informational purposes only and is not an offer or solicitation of an offer to buy or sell securities. SNN Network, SNN Inc, and the Planet MicroCap Podcast, and the representatives are not licensed brokers, broker/dealers, market makers, investment bankers, investment advisors, analysts, or underwriters. We do not recommend any companies discussed, we may buy and sell securities in any company mentioned, and may profit in the event those securities rise in value. We recommend you consult with a professional investment advisor broker or legal counsel before purchasing or selling any securities referenced in this podcast.

Robert Kraft:

Welcome to the Planet MicroCap Podcast. I’m your host Robert Kraft, and thank you all so much for the support and for tuning in. You can follow Planet MicroCap on twitter, @BobbyKKraft, that’s B-O-B-B-Y K-R-A-F-T, you’re listening to episode 193. If you have any questions or comments, please feel free to tweet at me or shoot me an email at rkraft@snnwired.com. And when you do get a chance, if you like what you hear, please rate and review Planet MicroCap on iTunes, it really helps provide feedback for me, and spread the MicroCap message.

Robert Kraft:

Now we announced last week, so I thought we’d, uh, put out a l- another little reminder here, um, we are hosting our next virtual event, the SNN Canada Virtual Event, happening December 7 through 9, 2021. Uh, we at SNN Network, we’re teaming up with Paul Andreola and the team at Small Cap Discoveries to highlight our neighbors through the North Canada. So, uh, the website to go and register for that is canada.snn.network. You can expect three days of keynotes, educational panels, company presentations, and one-on-ones. Uh, we’re- uh, we’re very excited for the lineup that we’re gonna be showcasing for you all at this event, so be sure to register and get all the updates as they, uh, come. So again, to register, please go to canada.snn.network, and click the register button.

Robert Kraft:

Now for this episode of the Planet MicroCap Podcast, I spoke with Derek Pilecki. He is the Portfolio Manager at Gator Capital Management. After a great recommendation by friend of the show, Rich Howe from Stock Spinoff Investing, Derek and I found time to connect and discuss all things financials. Uh, we chat about regional banks, Puerto Rico, consumer finance, and what it’s like starting a hedge fund in the middle of the global financial crisis. Since launching Gator Capital, his funds performance has been nothing but stellar, a 21.52% annual compound return, and I really enjoyed finding out why. So thank you again for tuning in to episode 193 of the Planet MicroCap Podcast, and please enjoy my conversation with Derek Pilecki.

Robert Kraft:

Welcome back, everybody, to the Planet MicroCap Podcast. I’m your host Robert Kraft, you can follow me on twitter, @BobbyKKraft, that’s B-O-B-B-Y K-K-R-A-F-T. And today’s guest is, uh… We- we- we succumbed to the, uh, Twitter peer pressure, and we… I really… We had to pull each other’s leg to make this happen, you know. Uh, I’m su- I’m just a shy podcast host, he’s just a- a- a shy Twitter guy as well, but, you know, we’ve made it work, so, I- I’m really excited to, uh, welcome on today, Derek Pilecki. He is the Portfolio Manager at Gator Capital Management. Derek, thank you so much for joining me today, how are you doing?

Derek Pilecki:

Hey, Bobby, I’m doing well. Thanks for having me on the podcast, happy to be here.

Robert Kraft:

Yeah, I- it’s great to have you on, and I really appreciate you taking the time today. So let’s dig right in. You know, uh, a- a- m- as my… I usually ask every guest on here, uh, unless I’ve interviewed them before, you know, I- I’d love to know where your passion for investing began.

Derek Pilecki:

Yeah, I mean, I- I- I started investing right in college, uh, and I- I used college as a way to learn as much about investing as I could. So I mean, I read the Wall Street Journal every day, I would go to the library every day and read the Wall Street Journal cover to cover, bought, bought a few stocks. Um, you know, I graduated from college in 1992, so it was like, right before the internet started. So, you know, a lot of- lot of the learning was paper-based.

Derek Pilecki:

I guess where I really developed my passion for investing was I- I worked at Fannie Mae right out of college, the mortgage company, and I did a lot of reading at night about investing. Like, it was a great… I mean, I have a different view of Fannie Mae than the rest of the world. I got… I think it’s- I- it was a great first job in finance for me, and I read a- as much as I could about that markets at home every night. And, um, you know, I- I read Roger Lowenstein’s, uh, biography on Buffett; The Making of American Capitalists, and when I read that, I was like, I wanna- I wanna manage a portfolio.

Derek Pilecki:

But I knew, you know, I was 24, 25 at the time, I knew I needed to get training, and it was gonna be a long journey to open up, um, a fund, or you know, become a portfolio manager. So like, that kind of just sparked my- my path towards trying to become a professional investor.

Robert Kraft:

Absolutely. So I mean, I- I gotta go back to when you were, you know, still in college, and going to read, you know, the Wall Street Journal, uh, cover to cover. I mean, what inspired you to do that even- even prior to then going and working at Fannie Mae?

Derek Pilecki:

Uh, I mean, I think… I mean, I- I learned about the- the stock market from my grandfather when, uh… You know, I would r… Growing up, I was a baseball fan, right? And so I… Like, S- Sunday morning, and I’d read the… They’d publish everybody’s batting average, and it was only s- like, you know, through the week, they published like, the top 15 batters in each league, and, you know, I’d study them. And then on Sundays, it was a big day because they’d publish all the- the entire league, and, um…

Derek Pilecki:

But then Monday would come around and all of a sudden, there’s these, the business page was right next to the sports page, I was like, “Well, what are these numbers? Like, I love numbers, how- there’s not batting averages, I don’t know- recognize any of these players.” My grandfather explained, “No, these are companies and…” You know, he used Exxon as an example, like, this is in the 80s, like, oil… Before the oil crash of the 80s, like, Exxon was the biggest company like, in the country, or biggest market capital.

Derek Pilecki:

And he- he explained like, “This is the stock price, it changes every day,” and, you know, “Here’s volume.” And- and he just explained what the pages were. And it was a little… You know, it was a lot for me to understand at the time, but I just tried to, tried to learn a l- as much as I could about investing, and in r- in business, um, as that, that is the start.

Robert Kraft:

Well, you know, I’m- I’m- I’m also a huge baseball fan. So before we continue, I gotta ask who your team is? Of course, I- you can see my team pretty much, right? Yeah, all you have to see is the two, and you know who it is? R- w- so who’s your team?

Derek Pilecki:

I- well, you know, I’ve lived in Tampa for 18 years, so I’ve adopted the Rays. I was born in Philadelphia, so when I was a kid, the Phillies were my team, right? So I, uh, you know, Mike Schmidt’s my baseball hero, and I went to his Hall of Fame induction ceremony, but, uh, you know, but it… The Rays are hard not to root for, right? I mean, they’re the huge underdogs, the American League East is a tough division. And, uh, you know, really impressed with how they man- you know, navigate the- the season year to year, with, uh, less resources than the Red Sox and Yankees, so…

Robert Kraft:

Uh- uh, listen, I gotta tell you, I- I think you might be the first Rays fan I’ve ever met. Um, so I- I… Kudos, I figured it was mostly just Yankee fans in the stands, uh, or…

Derek Pilecki:

(laughs).

Robert Kraft:

… the other teams stands in the [inaudible 00:07:27]. So this is d- debunking that myth for me, so I- I again, apologize to all you Rays fans, and enj- j- enjoy your success, and okay, you’re doing great.

Derek Pilecki:

(laughs)

Robert Kraft:

All right. But, uh, but yeah, so that- that’s a b- this is- this is big news for me.

Derek Pilecki:

Yeah, wh- w- we’re going to the game tomorrow, gotta, you know… Our magic number is, I think it’s seven now, so we gotta get… Hopefully, by the time you, you publish this podcast, that we’ve clinched the American League East this year. So it’s exciting, doesn’t happen all the time, so gotta enjoy it while it’s happening.

Robert Kraft:

Sure. All right. So let’s get back to finance investing.

Derek Pilecki:

Sure.

Robert Kraft:

So, okay, so catch us up. So, um, tell us a little about- about from when you were at Fannie Mae to then, uh, when you launched Gator Capital?

Derek Pilecki:

Yeah. So, you know, I decided at Fannie Mae that I wanted to make, become an investor professionally and yeah, I guess. At Fannie Mae had the role of I was an analyst in our asset liability management. So like we are, my group would forecast net interest income for the firm and do budgets and, um, measure, do market measures of risk. And my job was to load all the assets and liabilities of the company into a computer so that we could do a m- model run and this is like circa 1995. And it would take like 10 hours to do one interest rate scenario. So like, if I didn’t load everything in perfectly, I wasted 10 hours computer time.

Derek Pilecki:

So like I knew that balance sheet at a [inaudible 00:08:47] level and it was a great lesson in fixed income, right, that Fannie owns a bunch of mortgages and mortgage backed securities and CMOs, and then they, they, um, fund their liabilities by selling agency debt, callable bonds, structured notes, and then a lot of the structure notes, they swap back to live or float or so. It was just a great education and finance for me, but you know, I didn’t want to run a bond portfolio, I want to run the equity portfolio like at night, we’d all stand around the Bloomberg and pitch stocks to each other, right?

Derek Pilecki:

And we’re not pitching, oh, I really like the, the Fanny sixes here like you, you, you pitch like I like Cisco or like, you know, Bank of America. So, um, you’ve just developed you know, I knew I needed to move to equity research and I didn’t think I could do that directly from Fannie Mae. So I went back to business school Chicago, and used that as the, the pivot to equity research. And so, um, you know, I love Chicago. I was in the class of 2000 to Chicago.

Derek Pilecki:

So there’s some pretty good and professional investors that were in my class like Dan Kozlowski, who was at Janis for a while, was there. Josh Spencer, who runs the tech fund at T. Rowe Price is there. Matt Freeman who runs the fidelity value fund was in my class. And so like, I felt like we were lucky that we had some top notch investors in that class of Chicago was a great learning experience.

Derek Pilecki:

And then, um, how I got a job at the buy side and had a small firm in Chicago, I, I, um, I transitioned to another firm in Rochester, a deep value firm in Rochester, New York called clover capital. And I loved that job but I was in the job for a couple years and a classmate of mine from Chicago called me up and said, “Hey, I’m, I’ve been working at GSam, you know, Goldman Asset Management and our, our bank analysts just retired and we own a bunch of Fannie Mae stock, will you please come interview because he knew I had worked at Fannie Mae.

Derek Pilecki:

And so I, I was like, you know, “I like my job.” He’s like, “Come on, it’s, you know, this is a good job.” And so I, I went interviewed for the Goldman bank analyst job on the buy side. And, you know, it was, I got the, got the offer because they owned Fannie and they needed help of managing that position. So, you know, I trained, I moved to Florida to work for GSam. GSam had bought this money manager that had been part of Raymond James, and so moved to Tampa in 2002. And, um, you know, worked for GSam for five years.

Derek Pilecki:

And you know, it was a, it was unfortunate, Fannie and Freddie ran into trouble almost coincidentally with me starting at GSam, seemed like it was not fun managing those positions for, for GSam. They, they Freddie had its earnings issues and then Fannie had its, it’s accounting issues, and then we ran into the housing crisis. And so, you know, I wasn’t having a great time at GSam. In 2008, I was like, “I- I want to go run my own portfolio rather than being an analyst.” I felt like I worked for a couple firms, gotten a good professional training and it was time to, to go start Gator. So I launched Gator in mid 2008.

Robert Kraft:

Very cool. All right. So before we get to Gator Investment Philosophy, you know, other than when you were doing all your own research yourself, you know, what would you say was the biggest lessons you learned that prior to founding Gator Capital in 2008?

Derek Pilecki:

Yeah. Um, so I’ve always been drawn to the value [inaudible 00:12:18] I kind of think you… It’s… Your investing style fits your personality, right? And so I’m always looking for bargains or, um, I don’t want to overpay for things. And you know, in a market like right now that, that’s a painful d- disposition to have, because the most expensive stocks go up the most right now. And so I don’t think that’s a permanent state of affairs. Like I think the market right now is very much like 1999.

Derek Pilecki:

So he just says that as a background, I’ve, you know, I was just naturally drawn to being a value investor. I think Fannie Mae is a, was a value investor in the bond market. They were always looking for value. I worked at a deep value firm, um, you know, I guess I- I did a lot of a lot of reading, I was drawn to the buffet, all the books that have been written about buffet, I attended a few, um, annual meetings.

Derek Pilecki:

And, uh, you know, I’ve been wanting to expand beyond just value investing to, you know, GARP investing or growth investing. And g- the Goldman team I worked for was more GARP investors. And so covering financials for, you know, a growth team just gives you a little bit different perspective. I guess one of the things I, that really opened my eyes was, when I got the clover, which was this deep value firm. I was like, “Okay, this guy’s going to do great fundamental research, this is going to be a great lesson.”

Derek Pilecki:

And within like the first few weeks of getting there, they’re like, we’ve put a technical analysis overlay on our fundamental investing to try to improve our entry point. And so I was like, “Whoa,” like that, that was not what I was expecting. And so we you know, was well reason, like, uh, I guess, you know, the value market… This is might seem like ancient history to a lot of people but that 1998 value stocks were terrible, right? They, um, they, it just the, the mid 90s, bull market value stocks did great. And then kind of like 97, they peaked out.

Derek Pilecki:

And while growth stocks continue to do well through the rest of the decade, ’98, ’99, 2000 or ’98, ’99 really value stocks were really a tough place to be. And, um, I think, I think that was a tough for that… Even though I wasn’t at that firm during that time period. Their lesson was, there’s a lot of stocks that they’d like, they got cheap and they kept getting cheaper and they got into stocks too early kind of, you know, a value investor buys too early, and they sell too early, right and they, and they were trying to improve those entry and exit points.

Derek Pilecki:

And so they said, a lot of times what, if you look at a stock chart, the stock chart might look ugly, it’s at a value that you want to buy, but it might get cheaper and you just have to wait and pick, better pick your price. And then on the, on the exit side, you know, they weren’t, they used to have firm price targets of, okay once, when this bank gets the 13 times earnings, it’s too expensive. Banks can’t trade at 13 times earnings. But sometimes banks trade up to 18 times earnings, so they, they tried to use some technical analysis to, to improve their, their sell points too. So I think that was a, that was an unexpected learning that I had working at a value firm that over relies on technical analysis so.

Robert Kraft:

Very cool. All right, so now we’re here at Gator Capital, you know, would love to little learn. And you’ve already alluded to this a little bit as well. But what would you say is, is the firm’s and yours in turn, uh, your investing framework? And, and what, what would you say is your focus, uh, uh, and, and why?

Derek Pilecki:

Yeah. So, you know, at Gator we focus on fi- the financial sector because that’s where my expertise is. So, um, you know, I think that the financial sector is one of the few sectors where you really need to have specialization. So, um, you know I think energy and biotech and financials, you need specialists to cover those sectors or invest in those sectors for people like it’s hard for generalists to come, just kinda show up and say, “Oh, this stock’s cheaper.”

Derek Pilecki:

Um, and so I’ve really focused on going deep within the sector and really, you know, there’s, you know, it was about a thousand publicly traded financials. 600 of them are micro cap banks. And so the other 400 are larger banks, um, capital markets firms, insurance rates, um, exchanges. And so I, you know, I really focused on knowing those companies and, you know, I can’t say that all 400 companies I know called, but I’ve pretty much read the annual reports for most of those companies.

Derek Pilecki:

Um, and so I, I use a value perspective and so I’m trying to buy stocks that I think are misunderstood and they’re cheap. And that misunderstanding by the market is going to get corrected somehow that people are too negative for some reason. And, um, and a lot of times that valuation, you know, will, will change when people come to realize that concern is a pass is, is passing. I think, um, I think we’re seeing that th- the, w- the financial sector has been this way for a long time, but so many generalists lost money in the financial sector during the financial crisis that they’ve ignored the sector.

Derek Pilecki:

And, you know, I’ve talked to tons and tons of funds that are like, “Oh, well we’re a generalist fund, but we don’t do much to financials or we’re a generalist fund and we really like Wells Fargo.” I’m like, “Yeah, that’s great.” Like Wells Fargo is, is pretty cheap and it’s a good turnaround, but there’s a lot of other more interesting stocks in the sector. And so I think that just it’s for around for doing some work and under applying some knowledge.

Robert Kraft:

I literally was just going to ask you, you know, what, what would you say is, has been the most misunderstood aspect about the financial sector right now? Um, but it sounds like that’s one of the things is that most generalists just ignored it since the financial crisis in 2007, 2008. I mean, is there any, is there anything else that’s, that’s been largely gone misunderstood about the space?

Derek Pilecki:

I think, you know, so people look at longterm returns of different sectors and the financials had a great long-term return up until the financial crisis. And then there was major big cap stocks that were either went to zero or were down 90%. So AIG, Citi group, Fannie, Freddie, WAMU, uh, Wachovia, um, you know, just huge impairments of value and a lot… Bear Stearns, Lehman, you know, so, so many large cap financials went down. If you look at the overall returns of the sector it lags a lot of the other sectors and people just think it’s not a really good sector.

Derek Pilecki:

Well, I think of that as a once in a lifetime type episode. And, you know, it happened during the great depression, the financial stocks got impaired. Maybe you could argue during the S&L crisis in the ’89, ’90 timeframe that got impaired, but then, you know, ’08 was a huge, huge deal. And with the, the change in Dodd-Frank laws, like there’s a lot more capital in the sector. And I think also the management teams really got scarred by that experience in a way.

Derek Pilecki:

So I don’t expect in the next cycle that the banks will have anything where near a severe cycle as they had in ’08. And so I think that’s going, you know, I could even look forward for… I think that might persist for the next 20 years. Like we’re not going to have an ’08 type scenario again, because the banks can’t legally, because they have a lot more capital and the management teams learned their lesson.

Derek Pilecki:

So I think, you know, it’s one of the, even though the banks are volatile, I think it’s one of the safest times zone banks in, you know, as far as if you think about an investing career. And I just think the generalists who ignore financials are missing that, missing that change.

Robert Kraft:

So, so then what are some of your criteria when you’re looking at potential investment in banks or any other business in the financial sector?

Derek Pilecki:

Yeah, well, I think it’s, um, well, I mean, I think there’s several things I think, uh, high returns on capital, um, and management teams that try to create value through capital management. So, you know, they’re buying back stock when it’s cheap. They’re not buying back stock when it’s expensive, they’re doing smart acquisitions if they can, or they’re n- avoiding dumb deals. And so I think that aspect is, is very important. And then, you know, I think there’s, um, there’s a lot of companies that have a little twist to the normal industry model that allows them to grow faster than the rest of the industry.

Derek Pilecki:

So like there’s tons of banks, right? And there’s a lot of generic banks that are not that interesting, but there’s some banks that have demonstrated they’re able to grow faster than others. And I think that’s, that’s super interesting, uh, and they tend to have higher returns because of that. So you can look at, um, companies like Silicon Valley bank shares or Western Alliance or Pinnacle Financial in Tennessee, they’ve all had, been great growth banks for a couple decades and I think that will continue, um, compared to some of the generic, you know, large regional banks that… You know, okay returns on capital, but not a lot of growth.

Derek Pilecki:

So just looking for the something, something twists that allows some twist to the business model that allows them to, to grow a little faster or produce higher returns on capital.

Robert Kraft:

Very good. And by the way, are you a shareholder in any of those three companies that you just mentioned?

Derek Pilecki:

Sure. Um, I- I do own Western Alliance and Pinnacle. Unfortunately I do not own Silicon Valley at the moment.

Robert Kraft:

All right, very good. So a- actually, in the Gator Capital, uh, investor deck that you sent over, uh, one of the slides has your own perspective investment themes in the portfolio. And you mentioned, uh, four categories here in Puerto Rico banks, consumer finance, small banks, and then a hard P&C insurance market. So, you know, why, why these, uh, these four spaces in particular, do you tend to focus on?

Derek Pilecki:

Yeah, so a lot of my investing is bottom up, um, an- analyzing companies for being misunderstood. Uh, valuations are cheap. I think the, the valuations will change. Um, and, uh, sometimes I’ll look at a sector and look at similar… Once I find a company that I like, like, um, Puerto Rican banks, I like LFG bank Corp. And so once I like that, I look at its competitors and those stocks look attractive to, and, uh, the, the stories are similar. Like the Puerto Rico banking market has consolidated back in 2007, there were 12 Puerto Rican banks for an island of like 5 million people and now there’s three.

Derek Pilecki:

And so that cons- it’s almost like an oligopoly there. And if you compare Puerto Rico to another island market like Hawaii, there’s only four banks in Hawaii, Bank of America and Wells Fargo exited Hawaii. So like it’s four local Hawaiian banks and they are in high returns and high margins, and they have high stock valuations.

Derek Pilecki:

Where in Puerto Rico it- it’s an oligopoly, they haven’t quite gotten their margins up because it’s a process. So I think their margins are expanding and I think the valuation will expand once the margins expand. So I think it’s, you know, we’re ge- Puerto Rico’s changing to an oligopoly market. And I think that’s, that’s interesting. I would say that maybe Puerto Rico doesn’t get the same valuation of Hawaii does longterm because it’s a territory versus a state.

Derek Pilecki:

But I think, you know, Puerto Rico has, is they’re US citizens and the banks are regulated by the FDIC. So the, they’re American banks, um, you know, and so it’s not like I, I said, oh, I think Puerto Rico bank, I just, I found a Puerto Rico bank and I was like-

Robert Kraft:

Great. (laughs)

Derek Pilecki:

… “Oh, the story’s good.” And so then I, I look around, so the same thing with the other sectors like consumer, consumer finance, we’ve long held, um, positions in consumer finance stocks. I think consumer finance, uh, companies grow faster than banks have higher returns, but they’re cheaper than banks. So I think that’s an evergreen opportunity. I think small banks in this rally that we’ve had in banks from last September through March of this year, it was really driven by the large cap banks and, uh, the small cap banks kind of got left in the dust.

Derek Pilecki:

And so I think there’s an opportunity right now with, with very small banks and part of that’s driven by the, the Russell reconstitution, the, um, you know, there are so many new IPO’s and SPACs that came out this year, that the minimum cutoff for the Russell 2000 inclusion every June has risen from 90 million to 245 million. And so there were 79 banks that got booted out of the Russell and a lot of those banks trade for book value seven or eight times earnings, and they’re operating just fine. They just had a big dumb index seller in June, and so I think there’s some interesting values in, in small banks. So the, you know, the, it’s the, um, kind of bubbles up from the bottom of, uh, you know, ways to describe the portfolio rather than being thematic investing.

Robert Kraft:

Got it. Okay. Yeah, no, I was just curious because, you know, send the investor text. So I, I didn’t know if that became your specialization where it’s, it’s kind of the flavor, it’s the flavor right now, you know, and then, uh, you know, at a certain point. So I wanted to actually zone in on one of the, I- I- believe it’s in consumer finance, so one, one, I, one of your current long ideas that’s in, uh, in the investor deck, Navient, uh, which is a student loan company.

Robert Kraft:

Um, so I’m just, I- I would love to hear your insights, not just on this idea in general, but just really the, the student loan, um, areas. Well, I mean, it gets a lot of headlines and, you know, loans are getting forgiven and stuff like that. So I’d love, love to hear your, your, your commentary there.

Derek Pilecki:

Yeah. So, I mean, I think the student lenders are very interesting because they’re hard to understand, like it’s a, y- there’s only three of them p- that are public traded, right it’s Nelnet, Sallie Mae, and, and Navient. And so to the, the amount of time that a analyst or portfolio manager would have to spend on them to come up to speed to have a view, I think they just trade cheap because it’s a lot of time to spend on just three small companies.

Derek Pilecki:

Um, I think the student loan market is super interesting, it’s changed a lot. So 90% of student loans are made by the federal government and 10% of loans are private loans. And so those loans are, um, they tend to be for the more expensive schools or for grad programs. And, you know, so like the first $17,000 you borrow for undergrad are government loans. And then if you have to borrow more than that, you go to a private lender and Sallie Mae dominates that market with 55% of the, of the market share.

Derek Pilecki:

So it, you know, it’s pretty stable pricing, pretty attractive margins. Um, Sallie Mae’s pricing is like, well, I work plus 600 like super wide margins. It’s risky, you’re lending to 18 and 19-year-olds for, they’re not going to start paying back till they’re 23. Um, but there’s a umbrella there, a pricing umbrella that allows Navient to come in and refinance some of the better loans away from Sallie Mae, um, Navient and Sallie Mae used to be the same c- part, part of the same company. And there was a spinoff back in, I think it was in 2014 and Navient took the existing portfolio and they were going to hold it and as there, that, those loans paid off, they used the capital to either buy new student loans or buy back stock.

Derek Pilecki:

And then Sally Mae took the loan origination platform and they, that was the growth story. And that, that played out, um, Navient has done a good job of refinancing liabilities, finding other, um, portfolios to buy. And so their, their earnings, although it was supposed to be like a decaying business, their earning’s actually grown over time. So, um, you know, I first got involved with Navient, um, r- right as COVID was hitting last year.

Derek Pilecki:

So like Navient was going to do three bucks and I bought the stock at 10, so traded for three times earnings and, uh, and COVID was hitting, it was a little scary for a while, but Navient traded down to five bucks, like with, within two weeks of owning it. And, uh, and so w- with the, the loan forgiveness and, you know, the amount of time that people have to, to, um, pay back their loans, uh, I thought, you know, worst case scenario Navient just gives everybody a s- six-month payment holiday and just t- tack the six months onto the end of the loan, um, student loans aren’t forgivable and bankrupt- and bankruptcy.

Derek Pilecki:

So I, I thought, uh, Navient would sail through just fine. Um, but you know, it was scary, their earnings are hard to understand because they have some derivatives, um, and market-to-market issues. But, um, you know, at five t- five bucks, if they’re in three bucks, it was at like a one and a half p- multiple is just kind of crazy cheap. Um, even coming into this year Navient will, still only was a 10. Um, now it’s, it’s doubled year to date or a little bit more than doubled year to date.

Derek Pilecki:

So I think it’s trading at eight times earnings and it, it’s, um, it had a, a standstill agreement with Sallie Mae. So for five years after it, uh, the spinoff Navient couldn’t go to colleges and originate student loans on campus. And that stand seller agreement expired, so now Navient’s starting to originate student loans on campus and their loan portfolio this year should flip from declining, uh, you know, through payoffs to actually growing. And so I think that will change investors perception about Navient and the multiple you should pay for, pay for their earnings so.

Robert Kraft:

Very good. I mean, so then coming out of that experience, looking at the student loan market, I mean, what… Because it’s actually I like, I have student loans, right. And the one thing that is, you know, we don’t have to make payments on because they’re all federal government loans, you know, that got suspended till next year. But I have friends that refinanced with private banks, they’ve been having to pay that back this entire time. I don’t even think they had any kind of forgiveness time. So I feel like that’s been the biggest misunderstood aspect when you think about, uh, the student loan space is that even in that 10% market of private loans, they haven’t had to stop you know.

Derek Pilecki:

Yeah they’re still paying, you know.

Robert Kraft:

They’re still paying, and that ’cause that interest is accruing, you know, versus the federal side. I mean, the interest isn’t accruing so you can either just pay lump sums or wait.

Derek Pilecki:

Yeah. And I, I think, you know, I think the student lenders for a long time have had this cloud over the, the college, will anybody take out a student loan or, you know, if they pay off all the student loans, what will happen to their portfolio as well? It’s kind of similar to what you’re talking about, if federal government decides to forgive a bunch of student loan debt, they’re not going to forgive the private loans, they’re going to forgive the loans that are government guaranteed.

Derek Pilecki:

And then, you know, if you look at, um, free college, you know, New York has had free college, but there’s, um, restrictions placed on people like you have to commit to living in New York for five years, you have to get a B average, your family can’t make more than $125,000. And, and so like that doesn’t… Not everybody qualifies for that. So you still have to get student loans or… And, and you also have to go to a New York state school.

Derek Pilecki:

So like if you wanted to go to Colgate instead of SUNY, Stony Brook, like you’re taking out student loans. And so like the student loan market won’t go to zero. Um, you know, I think, I think Sallie Mae, Navient’s loans in, in the New York s- school state system went down for one year and two years later they were higher than they were before the free college offer. And so like, it’s a scary headline, like, oh, free college, but student lending still, still persists.

Derek Pilecki:

I would say that I do… I am concerned that student, uh, tuition is stretched so far that I don’t know that schools will continue to raise tuition prices or be able to, or, you know, the number of schools that exist will decline. Um, you know, I do worry that we’re stretched on, on that aspect, but, you know, people will still go to grad school and, um, you know, there’s plenty of people who are willing to pay for education, but I think the student loan market will persist.

Robert Kraft:

You know, when you’re, when you’re talking to your LPs and, you know, March, 2020 happens and they see that you’re heavily, you concentrated in (laughs) in small banks and student loans and insurance. I mean, you know, what, what were those conversations like in, in March, 2020? I mean, was it stay the course or like, “Hey, you have every right to be worried,” no idea what we’re getting into right now. I mean that… What were those conversations like?

Derek Pilecki:

You know, you know I’ve been doing this for 13 years and I’ve been blessed with a LP base that is very in tune with my investing style. And so I think when we go through hiccups like that, they’re not expecting me to outperform on the downside. They’re expecting me to bounce with the market. And so, like, I, I don’t think people were upset or surprised by my March 2020 performance. And, you know, when I bounced through the summer, that’s what they expected. Like if I had not recovered quickly after March I think I would’ve gotten some angry phone calls, but I think I got some calls of, is this a good time to add money? I got a lot of people who are like, “Ah,” you know, that’s kinda what I expected.

Derek Pilecki:

So, um, you know, I was lucky I did not have any redemptions until August. And so it was, you know, I- I am very grateful for my LP base. I, yeah they, they’ve been with me for a long time on average and, you know, they did not panic at the bottom. So which made it a lot easier to, to manage, manage the money and try to find, pick the spots to outperform on the, on the recovery.

Robert Kraft:

Right. But a- but at the same time, I mean, how do you manage that, that headline risk? Because I mean, you’re in spaces that more so than most it’s the headline risk is just ev- it’s ever-present.

Derek Pilecki:

I mean, I think March, 2020 like I did not think consumer finance was going to be the ground zero for the stock market. Like there was a l- a run on the bank, there was a liquidity crisis and I didn’t, you know, we all, we all knew that the, the pandemic was coming and the case counts were getting higher. I didn’t think it would focus on mortgage rates and, and, um, consumer finance companies would be the biggest problems. And so that was the huge surprise, like, uh, you know, and then oil went down and, um, you know, I think the following Monday regional banks index was down 16% in one day, I mean, that was, that was kind of crazy.

Derek Pilecki:

It was, you know, I remember having conversations with my analysts, like is SunTrust or Truist gonna go bankrupt? And you know, of course they didn’t, you know, they didn’t come close, but, you know, just the way the stocks were trading, it was like, everybody thinks these companies are worthless and it was just a huge run on the bank. You know, people were looking for liquidity wherever they could. And I did not expect that to, to be that bad.

Robert Kraft:

Sure. Absolutely. So a- another question on the fund construction, I mean, would you say, it- it- the portfolio is more, uh, more concentrated, tends to be more diversified somewhere in the middle, you know, and how did you, how did you think about that?

Derek Pilecki:

I mean, I usually have 25 names on the long side, but I think, you know, I, I know a lot of investors have 10 or 15 names, but you know, all 25 of my names are in the one sector. So I feel like that’s pretty concentrated. Like it’s, um, they all trade in, in line. You know, insurance vary some from capital markets from banks, but, you know, in a crash, they all go down. And, um, and so like, I think it’s, I think it’s relatively concentrated. I recently, when I’ve been adding to small banks, I haven’t been buying as larger position sizes just to preserve liquidity in the portfolio.

Derek Pilecki:

So the number of names has crept up a little bit, but it’s, you know, I feel like the small banks are interchangeable to a large extent. So it’s, it’s the same trade whether I own, you know, if I have 30% of the portfolio of small banks, whether I have, you know, seven, four percent positions or 14, 2% positions, um, you know, it’s, it’s the same trade.

Robert Kraft:

Absolutely. Do you like talk to management. I mean, uh, you know, some of these smaller banks or smaller market caps, there’s a little bit more access to management teams. I mean, do you, do you like to, do you like to chat with them and get their perspective and, and do all that? Is that part of your due diligence process or, or no?

Derek Pilecki:

Oh, uh, absolutely. Like, I, I like that the management teams don’t change in my sector a lot. Like I like the maintenance, uh, research and, and financials is a little bit easier than consumer tech, right. I mean, you don’t have product cycles, it’s loans and checking accounts. Like you’re not, you’re not trying to look at the, the… Do channel checks, like how many checking accounts did you open this week, right or this month?

Derek Pilecki:

Um, so it’s a little more long-term from that standpoint, like once you know the management team, you know their track record and you know, where they’re focused on adding value, you can maintain that dialogue over a period of years and it doesn’t change quarter to quarter. Right? So I, I like meeting the management teams before I buy the stock. Um, I like, uh, you know, I’d like most of the management teams, I guess, one thing that I learned when we were at GSam, I felt like we really knew the management teams well. I, I felt like there was, um, there were times where, uh, y- you become friends with the management team and you don’t, you kind of lose a little bit of objectivity.

Derek Pilecki:

So like, I don’t like getting close to being buddies with m- management teams, but I respect them. And like, you know, I look, try to learn about their businesses from them, but, you know, I don’t want to know what they had for breakfast.

Robert Kraft:

Okay. Fair enough. I don’t think anybody wants to know what someone’s [inaudible 00:38:19] h- had for breakfast. I- I know you’re kidding but, but all right, I’m going to throw you a, this is kind of a, this could be like the dumbest question anybody’s ever asked somebody that focused financially. I’m like, I tend to ask dumb questions every once in a while. So-

Derek Pilecki:

Sure.

Robert Kraft:

… d- do you think about crypto at all, when you think about some of your, some of your bank… So h- how do you evaluate cryptocurrency? Do you see it as a risk? Do you see it as a long-term opportunity or tailwind for some of your positions in some of these banks that you own, or consumer finance or anything, you know, love to hear your take on that?

Derek Pilecki:

Yeah, so I like learning about crypto. Um, I think, I think recently, I think there’s been changes like I… For a long time I was a doubter about crypto because with the patriarch, you know, the, the federal government likes to know where, who has the money and where the money’s going. And so, like I just discounted the aspect of crypto that you can hide yourself from the government. Like, I just didn’t think that was going to fly with the regulators, but, you know, it, that’s changed in my view in the last 18 months, I think, um, you know, some important players like Coinbase are willing to report transactions to the federal government.

Derek Pilecki:

So I think that is in- that was what changed my mind about crypto. Like it’s going to be, be around for, for a while and it’s going to be important asset class. And, um, and so I think that’s opportunity for a lot of companies in my space. I think it’s, you know, we see it with a few banks that are, um, providing deposit accounts for stable coins. I think, uh, I think the business models of the, the, the Coinbase’s of the world are pretty interesting, you know, interactive brokers just announced you could trade coins, you know, Fidelity’s working along those lines. I think that’s an important, uh, revenue source, um, for a lot of the brokers. And so I think it’s, I think it’s very, very interesting development.

Robert Kraft:

I mean h- have you talked to some of the management teams and some of the positions that you have and be like, “Hey, are you… Is there plans, are you looking at it?” You know, what’s, what’s been some of the responses?

Derek Pilecki:

Yeah. I mean, it, it varies. So like, um, I own shares in Axos bank in San Diego. And, um, you know, I think, I think there are just a very good management team, very forward-thinking they, um, they try to grow the bank in a very thoughtful, organic manner and they just bought a clearing business and they’re gonna, um, grow that side of the business and they get some benefits on the bank side from the clearing business. And they’re providing services to broker dealers and RAAs, and they’re adding crypto trading capability to, you know, for their customers to be the broker dealers that trade on their platform.

Derek Pilecki:

So I, and I think within my portfolio, that’s the one area, one holding that’s really trying to take advantage of it. Um, you know, a lot of the regional banks or small banks, it’s just, it’s, it’s not, um, it’s not a factor yet. Um, you know, and I, I guess I’ve recently been doing some work on title insurance, which is one of the, um, biggest, you know, one of the biggest threats to title insurance is the blockchain, right? I mean, title insurance, you know, some people think it’s a scam, right? Meaning we all over pay for title when we want to buy a house.

Derek Pilecki:

Um, but you know, those companies throw off a lot of cash and they trade cheap. So, you know, is that business going to disintegrate because of cr- because of the blockchain? I don’t know, but you know, doing a lot of learning right now.

Robert Kraft:

Absolutely. Um, so my one last question on looking in, in the financial sector, I- I mean, what, what would you say are some of the overall opportunities? And then, I mean, we already kind of talked about some of the concerns, but what would you say are some of the overall opportunities now moving forward that gets you just gets you really excited about financials, uh, on a daily basis-

Derek Pilecki:

Yeah.

Robert Kraft:

… at least moving forward.

Derek Pilecki:

So I think there’s… I, I mentioned this earlier. I think the market is very much like 1999 where there’s some expensive stocks and some crazy frothy stocks. And then there’s a lot of businesses that are pretty reasonable valuations. And I think a lot of those val- good valuations are in, within the financial sector. I think, um, if you look at banks, generally they trade cheap relative to the rest of the market. Like they usually trade 85 or 90% of the market multiple, I think right now it’s like 58% of the market multiple. So banks are cheap relative to the market, cheaper than they usually are. Right? And I think that’s super interesting, especially since interest rates are zero. And if rates go to one or two percent, the banks earnings are going to take a stair-step higher. So you have cheap valuations on, uh, you know, under earning business models.

Derek Pilecki:

So like they start, you raise rates and then you get a, a reasonable valuation on the higher rates and banks should have pretty nice returns. So, I think that’s interesting. Um, you know, I, I see so many interesting areas with financials. It’s kind of picking like, which is going to move first. So like, I think everything related to housing has lagged, surprisingly, so mortgage insurance, some mortgage brokers, um, title insurance. I think those are all interesting businesses that are printing cash in this housing market and the stocks really haven’t moved. So I think that’s interesting.

Derek Pilecki:

I think, I think European banks are super interesting, you know, especially if rates go up in Europe, like those things trade super cheap. Like I own Barclays in that west group, you know, I think Barclays is 60% of tangible book and they’re buying back 5% of the stock. And if rates go up, (laughs) I mean their, their income statement’s going to explode higher. So it’s kinda trying to decide, okay, which of these cheap groups is going to realize the value first?

Derek Pilecki:

Um, you know, we talked about consumer finance and, and, um, Puerto Rican banks, uh, small banks, and then, uh, you know, insurance, we’re going through a hard market insurance. So hard market insurance is price, insurance prices are going up. So like if you’ve had a insurance policy, your rate probably renewed much higher this year versus last year. And, you know, we haven’t had a hard market since t- 2001, 2002, and it’s just an opportunity for the, um, the disciplined underwriters insurance to, to expand their business and, and put on more risk.

Derek Pilecki:

And so I think there’s a lot of interesting opportunities within financials that people just don’t, you know, it’s not in the general investment conversation.

Robert Kraft:

Very good. All right. Well, we’re at that part of the interview where I ask my favorite question to ask, and you’ve kind of touched on it already. So if there’s another story here, you know, I’d love to hear it. Uh, but what would you say is an investing experience that really changed your career either the most, or if you already told us the most, uh, then, uh, number two or, or three?

Derek Pilecki:

Yeah. So, I mean, I guess my, you know, so I launched my fund in July 1st of ’08. So 10 weeks before they shot Lehman brothers, I launched a financial services fund. Right and so like, and I had dreamed about this since I was 24, 25, I think on the second date with my wife, she knew that I was going to launch a hedge fund. You know, she didn’t, you know, it wasn’t going to happen then, but it was eventually going to happen. And so, you know, I- I’d saved, we lived very modestly when I worked at Goldman, saved up a bunch of money, launched the hedge fund and the crash happened and I got torched and I was like… I- I had hired an analyst. I moved them down to Tampa. I’m like, “Whoa, that dream of having a hedge fund just went, went by really quickly.”

Derek Pilecki:

And so, you know, I gave him two, two weeks severance said, “Go to New York and go get a job. I’m sorry, it didn’t work out.” And, but then October 1st ’08, I sat down at my desk at home and I was like, “Whoa, I had saved all this money and now I’m, you know, my balance sheets upside down. I need to make money today.” And, uh, I traded October 1st and I made like $5,000 and I made money almost every day in October ’08, when the market went down 16%, I just focused like today I’m making money. And it was one of those things where your back’s up against the wall and, uh, you’re going to make… You have to either succeed or fail.

Derek Pilecki:

And, you know, I was able to scratch out some gains. So I only finished ’08 down 14 or 15%. And, um, and then I, I kinda caught 09 very well. Like I was, um, I- I thought that the credit markets were going to heal and I thought that the, uh, they weren’t going to nationalize any more big banks, but I wasn’t certain. And so you, I was kind of neutral during the e- early ’09 and I, I made money the first couple of months of ’09 in a down market.

Derek Pilecki:

And then, uh, you know, this is going to sound crazy, um, my research is a little bit more deep than this, but, um, you know, when, uh, in the end of February of ’09 Citigroup got to its third bailout, like they did a preferred for common swap. And it was like, well, if Citigroup had such deal, they’re not going to, they’re going to give a better deal to Bank of America. So bank of America is not going to go, go under and Bank of America’s preferred’s were trading for like 30 cents in the dollar that morning. So I bought, you know, a 6% position in Bank of America preferred’s at 30 cents on the dollar and they finished ’09 at, at, um, at par, um, you know, Bill Ackman was talking about walking GGP through bankruptcy, the stock was at 60 cents when he actually… When, uh, GGP actually declared bankruptcy (laughs) the stock went to 42 cents and I bought, you know, 1% position at 42%, 42 cents and it finished a year at eight and a half dollars.

Derek Pilecki:

So it was like a 20 bagger. Um, and then, uh, and then the first Sunday in March, uh, Ben Bernanke was on 60 Minutes and he said, “Uh, we’re not going to nationalize any more big banks.” And I turned to my wife and it’s like, “He just rang the bell. That’s the bottom.” That’s what the market needed here. And then the market bottom two days later.

Derek Pilecki:

And so when I heard him say that I went in and bought every large cap, formerly large cap bank that was trading under five bucks and just, you know, fifth, third, um, regions, SunTrust, whatever, just bought a bunch of them. And, uh, you know, kind of caught that. I sold them all too early. Right? I mean, but, but I mean, they were either doubles or triples within 60 days. So, you know, I caught ’09 correctly and so I think that transforming experience from like October 1st ’08 to like April 30th ’09 was, um, you know, it was painful for a lot of people, but I was able to, um, just focus on the very short term and make smart decisions and, um, make money and get a good start, you know, turn around the start of the hedge fund so.

Robert Kraft:

That’s a great story. I was hope… Listen, uh, for everybody listening, when he talked about how, how Derek started his fund at, when he did, I was going to get to that. So I’m glad that you told that story. I’m very happy to hear that. I mean, what a time, right? Like (laughs) I mean-

Derek Pilecki:

Yeah. [crosstalk 00:49:41].

Robert Kraft:

H- h- how much money went into, how much money went into scotch for those six months?

Derek Pilecki:

(laughs)

Robert Kraft:

Just a little bit, right?

Derek Pilecki:

I mean, there’ve been several periods of running a hedge, this hedge fund where I’ve not slept and I would say that was the first one. It’s like-

Robert Kraft:

That was the first one.

Derek Pilecki:

Yeah. There was not a lot of sleep going on during that time period, but, you know, it’s also invigorating and, and kind of life transforming.

Robert Kraft:

Yeah. I mean, when are, when are other times where you’re just like, you’re, you’re holding, you’re holding the bottle for a second, and just say, “Uh-oh.” I mean, is it when, uh, when, uh, you know, uh, I guess Brexit, I guess Brexit must’ve been a big one.

Derek Pilecki:

Yeah. So, you know, Brexit happened, you know, Brexit was kind of towards the end of the period. So like, um-

Robert Kraft:

Yeah.

Derek Pilecki:

… the previous summer when Puerto Rico said they weren’t going to honor their debts and I owned a bunch of, I own Puerto Rican banks and the bond insurers then that was pretty tough. And then I also owned the private equity firms and when the high yield market fell out of bed in the fall of ’15, the private equity firms didn’t do too well. So I mean that whole time period from, you know, middle of 15 through the middle of 16 was, was, uh, was a tough one.

Derek Pilecki:

The end of 18 was not fun, you know, obviously March of 2020, so, you know, it’s, it also changes like, oh ’08, ’09, it was stressful, but I didn’t really have investors in the fund. I was the only investor when ’15 and ’16 happened I had grown the fund to a pretty decent size, and I was, you just feel a lot more responsibility for your LPs money. And so, um, that, that’s super stressful when your people have placed their trust in you and you’re not making them money or you’re losing money that you, you don’t want to let people down and I take that very seriously.

Robert Kraft:

I mean, look, I- I’m sure they’re not that upset when you have a 21, uh, gray they’re 21.7%, uh, uh, annual, uh, w- was, I think that’s your compounded, uh, growth, uh, since you’re starting away, right?

Derek Pilecki:

Yes, it is.

Robert Kraft:

(laughs)

Derek Pilecki:

Yes.

Robert Kraft:

So I’m, I’m, I’m sure, I’m sure they’re, they’re, they’re happy now. So, you know, before I let you go here today, and again, thank you for spending time with me and, and, you know, telling us your story and your investing philosophy and framework. So, you know, um, what advice would you have for investors that might be looking at banks for the first time or just the financial sector in general? Wh- what are some, some things that you’d like them to know?

Derek Pilecki:

Yeah, I would say, um, yeah, I guess the things that I like about, I think banks are a tough, tough sector. Like I think the longterm banks are becoming more com- competitive and the intense, competitive intensity banking’s increasing. So, um, you know, interstate branch laws went away 25 years ago. I think it’s, I think it’s going to be hard going forward, but I think there’s some management teams that have outperformed over a long period of time. And I think they, that past success will continue going forward.

Derek Pilecki:

I also think that, um, you know, I th I think they, if you take a long-term view of banks, you can make more money. I think if you worry about what rates are doing today or the shape of the yield curve, I think that a lot of that’s noise. So if you see banks trading off because of the yield curve’s flattening, I- I- I would just ignore that, I focus on the banks, they grow their deposits and grow their loans and have high returns on equity. And I think you’ll, you’ll do well with that, with those, those metrics.

Robert Kraft:

Very good. Well, Derek, we’re there, man. Where, where can our audience go and find more information on you? Follow you as well as, uh, learn more about capital, uh, Gator Capital?

Derek Pilecki:

SO if you sign up for our newsletter on gatorcapital.com, we’re happy to send your research as we publish it. I also tweet, uh, sporadically on Twitter @gatorcapital, um, and you know, my phone number and email address are on our website. So, you know, if you want to reach out and talk to me, I’m always open to, to conversations with investors.

Robert Kraft:

Very good. And you know, I’m sure a lot of people have been wondering, but did you, did you go, you didn’t go to the University of Florida, right?

Derek Pilecki:

No, no. [crosstalk 00:53:58]

Robert Kraft:

Just, like we gotta make sure this is the most, this is the most important disclosure of the entire interview right now.

Derek Pilecki:

I did not go to UF. So if you went to Florida state, you can still invest with me. Right?

Robert Kraft:

(laughs)

Derek Pilecki:

You know, so when I was at Goldman, we used to make fun of the stupid hedge fund names. And then when I started a hedge fund, I was like, “Oh man, I need to pick one of these names.” And I was surprised, I wanted something regional sounding, which in hindsight might not as been good because it afforded base hedge fund people don’t love that. Like people in the Northeast don’t like that I’m in Florida. So, so this was probably in hindsight, this was probably wasn’t the smartest thing, but I didn’t want to call it Sunshine Capital or Palm Tree Capital and I was surprised nobody had taken Gator Capital.

Derek Pilecki:

So I had, um, you know, I actually got the domain name from a, uh, high school baseball coach in New Jersey who had, um, who it was a university of Delaware grad. And he called his investment club, Blue Hen Capital and he was like, “Hey, this is kind of cool. I bet a lot of hedge fund guys would name their, um, their, their fund after their, uh, college mascot.” And so he went in, he went and bought all the college mascots and capital.coms. And so I had to negotiate with him to get Gator Capital from him. So the guy who runs Wolverine Capital had bought, was the other sale he had made. And, uh, so I bought Gator Capital from him.

Robert Kraft:

That’s kind of brilliant. I hope we also got like gatorcap.com like the short version so that, you know, ’cause I’m sure everyone’s like, “Oh, well I’ll just get around with that.”

Derek Pilecki:

Yeah.

Robert Kraft:

Or, or gat-, or gatorcm.com. (laughs)

Derek Pilecki:

Uh, I should probably go to my GoDaddy account by those up right now.

Robert Kraft:

I appreciate it. Well, with that, Derek thanks so much for joining me today. This is a lot of fun. I really, again, appreciate you taking the time and I- I look forward to our next conversation.

Derek Pilecki:

That sounds great, Bobby, thanks for having me on. Good talking to you.

Robert Kraft:

This podcast is for informational purposes only and is not an offer or solicitation of an offer to buy or sell securities. SNN Network, SNN Inc, and the Planet MicroCap Podcast, and the representatives are not licensed brokers, broker/dealers, market makers, investment bankers, investment advisors, analysts, or underwriters. We do not recommend any companies discussed, we may buy and sell securities in any company mentioned, and may profit in the event those securities rise in value. We recommend you consult with a professional investment advisor broker or legal counsel before purchasing or selling any securities referenced in this podcast.

 

One of the new small bank positions that we purchased for the Fund is in Esquire Financial Holdings (“Esquire” or “ESQ”). Esquire is a bank headquartered on Long Island, focused on serving the banking market for attorneys. By the nature of their business, attorneys often have control of money in escrow accounts for the benefit of their clients. These escrow deposits are attractive to banks because they tend to be sticky and not rate sensitive. Attorneys also have borrowing needs that haven’t been well-served by traditional banks. In addition, Esquire has an attractive merchant acquiring business. Esquire has developed a good track record of earnings growth in the few years since its 2017 IPO.

We believe there is a disconnect between Esquire’s growth and its valuation. It trades at 8.4x 2022 consensus Wall Street estimated earnings, but the bank’s earnings per share (“EPS”) is growing at 20%. We believe the major reason for this disconnect stems from Esquire’s removal from the Russell 2000 index this past June. Index funds that track the Russell 2000 had to sell their Esquire shares. We believe prospective buyers of Esquire’s stock waited to buy until the Russell deletion date had passed. We think Esquire should trade at 15x or greater, which is in line with other high-growth banks.

We believe the most attractive part of the Esquire investment thesis is Esquire’s deposit franchise. Esquire’s deposits have a very low cost. Esquire also has more deposits than it needs.  It has a low loan-to-deposit ratio and sweeps more than $300 million of other customer funds off its balance sheet to other banks or money market mutual funds. Esquire gets these attractive deposits by:

These deposits are not rate-sensitive, as the attorneys place ease of use above the rate paid in choosing their banking relationships.

Esquire is growing its loan portfolio at an attractive rate because it is attacking several opportunities. First, Esquire is making loans to attorneys for two different purposes. One is to provide working capital to law firms for managing their cash flow. The second reason is to provide funding for law firm expenses in contingency cases. Law firms regularly have expenses in cases that they take on contingency, which are then reimbursed when the client’s case is settled.  However, attorneys cannot charge their clients a financing fee if they self-finance these up-front expenses. If the attorneys borrow money from a bank, they can get reimbursed for the interest paid to the bank when the client’s case is settled. Esquire doesn’t bear the contingency risk in these loans. Instead, the law firm’s overall cash flow is the security for these loans rather than the settlement proceeds from any particular case.

Esquire built a merchant acquiring business over the last 10-years, which generates a good amount of fee income and enhances the bank’s value. We are happy that Esquire’s management is focused on growing a fee income business. We are hopeful that the management team will expand into other fee-generating businesses such as trust & investments, insurance, and/or mortgage banking.

Esquire’s focus on the attorney market leads to wider margins than typical banks. As Esquire scales, we believe the wider margins will lead to higher returns and eventually a higher valuation. Esquire Bank has better net interest margins (“NIM”) than a typical bank. The bank’s focus on attorneys leads to higher than average loan yields and low deposit costs.

We admire the management team at Esquire. Andrew Sagliocca has been the CEO of Esquire for the past 13 years, but he is still relatively young for a bank CEO at 53 years old. Sagliocca previously worked at KPMG and North Fork Bank before joining Esquire as the CFO in 2007. We believe Sagliocca has focused the bank on an attractive niche. He understands how to create value as a banker. We look forward to how much value he can create at Esquire over the next 15 to 20 years.

The main risk with Esquire is the typical credit risk of any small bank. In addition to loans to law firms, Esquire also makes real estate loans in the New York City metro area. Through our research, we don’t have any outsized concerns about Esquire’s credit quality.

We think Esquire is a cheap small bank with attractive growth in a unique niche. We believe the bank has a long runway for growth and should have a valuation significantly higher than the current valuation.

 

We believe Canadian banks are attractive relative to US banks right now. Canadian banks are as cheap as they’ve been compared to US banks in the last 20 years. The Canadian banking system is an oligopoly of five national banks. This oligopoly in Canada has allowed the banks “North of the Border” to post higher returns with less cyclicality than their US peers.

US banks have had a huge run in the last six months due to investor optimism about potential economic strength as a result of the good news about coronavirus vaccines. Since we wrote about regional banks being a “once in a decade buying opportunity” in our Oct. 27th letter, the S&P Regional Banking ETF (“KRE”) is up 64%! Although we feel US banks still have upside, the opportunity in US banks from here on out is not as attractive as Canadian banks due to relative valuations. Canadian banks have slowly lost their valuation premiums over the past 10 years.

The table below shows the current valuations and 20-year annualized returns of the five largest Canadian banks versus 5 of the top 6 US banks. We excluded Citigroup because its poor performance and returns. As you can see, the Canadian banks generally have lower valuations even though they have all outperformed the US banks.

  2021 P/E[1] 2022 P/E P/TB 20-yr return[2]
Canadian banks:        
RY 11.9 11.4 2.47x 13.61%
TD 12.5 11.9 2.15x 12.43%
BNS 11.0 10.4 2.04x 12.48%
BMO 11.0 10.7 1.81x 11.06%
CM 10.4 10.1 1.48x 10.66%
US banks:        
JPM 11.8 12.6 2.28x 9.47%
BAC 13.4 12.8 1.88x 4.28%
WFC 12.6 12.5 1.30x 5.27%
USB 12.6 13.1 2.66x 7.75%
PNC 14.5 13.8 1.71x 7.96%

Source: Bloomberg

[1] For Canadian Banks, we use their fiscal years ending in October.

[2] 20-yr return calculated via Bloomberg from 3/31/2001 to 3/31/2021. For Canadian banks, we use the US-listed American Depository Receipts (“ADRs”).

We own a position in Royal Bank of Canada (“RBC”) and are completing our due diligence on several other Canadian banks.  Royal Bank is the #1 bank in Canada. It has a business mix similar to JP Morgan Chase (“JPM”) with strong retail and corporate banking businesses.  It also has a significant investment banking and asset management business. From here, we believe Canadian bank stocks will generate attractive returns for shareholders in the medium and long term.

 

Here is more detail on our investment thesis for Royal Bank of Canada:

 

  1. Bank with consistently high returns – RBC consistently posts Return on Tangible Common Equity (“ROTCE”) in the low 20%. In contrast, JPM has reported ROTCE between 12% and 19% over the last six years. We think this reflects the higher margins of the Canadian banking system.
  2. Leading bank in Canada – RBC is the leading bank in Canada. It has the highest returns, the highest market share, and the highest valuation of the five major Canadian banks. We believe other stock market investors will favor RBC when Canadian banks regain favor.
  3. Low relative valuation to US Banks – Canadian banks have had premium valuations compared to US banks for a few decades due to their higher and more consistent returns. Over the last 10 years, this valuation premium has almost disappeared. The chart below shows the price-to-tangible book ratio (“P/TB”) of RBC compared to JPM’s. As you can see, in 2011 RBC traded at 3x P/TB while JPM traded at 1x. Now, both banks trade at 2.5x P/TB.The following chart shows a similar picture with the forward price-to-earnings ratio (“P/E”) of both banks. RBC has consistently traded at a 10 to 12x P/E, but JPM’s P/E ratio has climbed from 7x in 2011 to 14x today. JPM actually trades at a premium to RBC on an earnings basis.
  4. Strong growth at City National – RBC’s US Subsidiary, City National Bank, is growing very quickly. RBC purchased City National in 2015. City National was an LA-based bank focused on high-net-worth customers. At the time of the purchase, City National had already expanded and gained traction in San Francisco and New York. Now, City National has branches in Washington, DC, Atlanta, Miami, Dallas, Minneapolis, San Diego, and Las Vegas. City National has a banking strategy similar to that of First Republic and is growing at a comparable rate. We would note that First Republic trades at 26x 2021 estimated earnings.
  5. Solid management team – Chief Executive Officer, Dave McKay, has led the bank for the last seven years. He has been at RBC for his entire career and has run several of the business units as he climbed the corporate ladder. Rod Bolger has been Chief Financial Officer for almost five years and has worked at RBC for 10 years. Prior to joining RBC, Bolger worked at Bank of America and Citigroup. We think both men are good bankers and good stewards of shareholder capital.
  6. Consistent capital management – RBC has had a consistent policy of reinvesting for organic growth, paying a dividend, and using excess capital to repurchase shares. None of the five major Canadian banks have cut their dividend payouts since World War II. At 3.7%, RBC’s dividend yield is higher than any major US bank.
  7. Potential for a stronger Canadian dollar – The Canadian dollar loosely tracks the price of oil. It seems when crude oil is below $60 per barrel, the Canadian dollar trades at 70 cents compared to the US Dollar. When crude oil approaches $100 per barrel, the Canadian dollar trades closer to parity with the US dollar. We do not have a strong view on crude oil prices. Still, we would note that we seem headed toward a strong economic recovery from the pandemic, and crude oil prices generally reflect the level of economic activity.For the last eight years, we have seen investors shorting Canadian banks due to the housing markets in Toronto and Vancouver. We believe this short thesis is stale and hasn’t come to fruition. We believe different dynamics drive the Canadian housing market than the US housing market in 2008. We do not see the banks engaging in risky lending practices. The substantial problem in the US market in 2008 was due to risky loans with low or no documentation and loans to subprime borrowers. We don’t see evidence of either of these practices in Canada. We admit that the residential property markets in Toronto and Vancouver appear very expensive, but we believe the pricing reflects the strong demand for housing in global cities with land-constrained markets. We think both Toronto and Vancouver will benefit from immigration policies in the US making it difficult for high-quality immigrants to enter. We compare Toronto and Vancouver to New York and San Francisco and see similar pricing. We would point out that both New York and San Francisco fared relatively well during the 2008 US housing crash. Also, we do not see concerning house pricing trends in the rest of Canada.

    We do believe there are real risks in the RBC story:

    1. Energy Exposure – The Canadian economy is more natural resource dependent than the US economy. Oil and gas production accounts for a significant proportion of the economy. This presents two risks to RBC: 1) direct credit risk to energy companies, and 2) Canadian dollar risk due to the Canadian dollar’s high correlation to the price of oil. As the world moves away from fossil fuels, Canada’s economy will have to transition as well. In the short-term, this is less of a concern due to the economic strength supporting the price of oil.
    2. M&A – We would prefer RBC to not make a large acquisition in the US, but we are realistic that they may. We would say their M&A track record is mixed. First, their roll-up of US retail stockbrokers in the 1990s has worked very well. Also, their 2015 acquisition of City National Bank has performed well. However, during the 2000s, RBC bought Centura Bank in North Carolina, Eagle Bancshares in Georgia, and Alabama National BanCorporation. RBC was not able to improve the returns of those three US bank acquisitions and sold the operation to PNC in 2012. RBC lost at least $1 billion over 11 years from these acquisitions. We’re hopeful that RBC’s management team has learned its lesson and won’t try to acquire another generic US bank. We would rather they continue to organically grow the old City National franchise, which focuses on high-net-worth customers in major US cities.
    3. Vaccine distribution in Canada – A short-term risk is that vaccine distribution in Canada is going more slowly than in the US. So, the Canadian economy might recover more slowly than the US economy. We believe this risk is small because we think stock market investors will look through this issue. However, we are concerned about further lock-downs in Canada, like the recent second shut-down in Ontario.

    Given the large rally in US bank stocks, we are moving out of some US banks and into Canadian banks. We have long admired the banking oligopoly in Canada, but we had stayed away due to the hefty premium that the Canadian banks had over the US banks. That premium is largely gone now. We think the Canadian banks will regain their premium valuation over the US banks. We see parallels between buying the Canadian banks now and our call to buy “Growth banks” like SIVB and WAL in 2019.  Growth banks had lost their premium valuation because they were asset-sensitive. They have since regained their premium valuation. We think the same thing will happen for the Canadian banks.

JP Morgan Chase (“JPM” or “Chase”) is missing a strategic opportunity by not making an acquisition in the UK. Instead, JPM is entering the consumer banking market in the United Kingdom by creating a start-up digital bank. I believe this is a waste of time and resources for the bank. This digital bank will take decades to impact JPM’s bottom line. Instead, JP Morgan Chase should take advantage of the low valuations among UK banks and acquire Barclays PLC. Acquiring Barclays would immediately give JPM the #2 position in the UK banking market and provide significant financial benefits.

Chase’s entry in the UK market with a digital-only bank doesn’t make sense for a variety of reasons:

1) There are several digital challenger banks in the United Kingdom already. The top seven banks in the UK control 92% of the market. UK banking regulators have been encouraging challenger banks to enter the market. Chase will face significant competition trying to capture consumers who are willing to leave the existing High Street banks.

2) None of the challenger banks have demonstrated sizable returns to date. Why bother with an investment where none of the existing players have earned excess returns?

3) JPM’s start-up digital bank in the UK will take years to positively impact the bank’s financial performance. JP Morgan Chase will make about $30 billion this year. For Chase’s new UK digital bank to represent 10% of the bank, it would require $300 billion growth in deposits and demand $15 billion in bank capital.

4) Chase’s brand in the UK market is unlikely to have the power it does in the US. The Chase brand is powerful in the US. Chase has had a long association with the Rockefeller family. In the U.S., Chase has national lending businesses such as credit cards, mortgage, and auto. So, even if Chase does not have bank branches in their city, many consumers are existing customers of Chase or are at least aware of the Chase brand. When Chase enters a new US city (like Washington DC) with branches to build deposits and small business lending, it generates strong growth because of the strong Chase brand. This same dynamic won’t exist in the UK because Chase’s brand is weaker in the UK. Although JP Morgan Chase has operated an investment bank in the UK for decades, Chase does not have the same presence in national lending businesses that it does in the US.

5) JPM doesn’t have the same need to enter the UK consumer banking market that Goldman Sachs did when it started Marcus UK a few years ago. JP Morgan has one of the best deposit franchises among US banks. In contrast, Goldman is mostly funded with wholesale liabilities at substantially higher rates. Goldman was able to enter the UK banking market with only a high-yield savings account offering. The deposits Goldman raised in the UK replaced higher-cost wholesale funding. JP Morgan Chase doesn’t have this same need for low-cost funding.

Instead of entering the UK with a digital bank offering, JP Morgan Chase should buy Barclays PLC.

1) Buying Barclays will immediately give JPM the #2 position in UK retail banking. Retail banking is a scale business due to technology costs and advertising efficiency. By immediately getting the #2 market share position in the UK, JPM will save decades of clawing for growth from its new digital bank in the UK.

2) Barclays’s stock is so cheap that acquiring the UK bank will provide JPMorgan Chase HUGE Financial Benefits. Even if JPM paid a 30% premium to Barclays’ current market price, JPM would reap gigantic financial benefits by acquiring Barclays. JPM trades at 13.5x 2022 estimated earnings per share (“EPS”) and 2.38x tangible book value. Barclays trades at 8.2x 2022 EPS and 0.68x tangible book value. We estimate that estimates for JPM’s 2022 EPS would increase from $11.43 to $12.00, and tangible book value would increase from $65.30 to $72.85. This estimate only assumes a 10% cost savings on Barclays’ expense base, which is very conservative.

3) Jes Staley, a former JPM executive, has been remaking Barclays since he became CEO in late 2015. He closed or sold operations in 12 countries. This has narrowed Barclays’ operations to mainly the UK and the US. Since Barclays has been restructuring for 5+ years under Staley, JPM would not have to exit many non-core businesses. Jaime Dimon knows Staley well as the two worked together for nine years.

4) JP Morgan is prevented from acquiring additional deposits in the US because the bank already has more than 10% market share for deposits nationally. JPM would be able to divest Barclays’ US deposits easily and still have the capacity to fund Barclays’ US credit card business.

5) JP Morgan would consolidate the US credit card market by acquiring Barclays, which is the 9th largest credit card issuer in the US. Barclays has important credit card partnerships with American Airlines, Uber, JetBlue, and Wyndham.

6) JP Morgan would also eliminate a competing Wall Street investment bank. Dimon has been resistant to buying another investment bank. Since most institutional customers and corporations do business with every firm on Wall Street, when two investment banks combine, their customers tend to do less business with the combined firm than the sum of what they did with each firm previously. I believe the big prize of acquiring Barclays is to get the #2 position in the UK retail banking business for below book value. I believe Barclays’s investment bank has been a drag on its returns and its valuation. If the Barclays investment bank shrinks as part of JPM acquiring it, I believe it would not result in a loss of value. There are at least two positives from combining the JPM and Barclays investment banks: 1) if the combined investment bank shrinks as a percentage of the overall bank’s revenue, investors may place a higher valuation on the overall bank, and 2) removing a large competitor will reduce the competitive intensity of the business. Within Fixed Income, Currency, and Commodities (“FICC”), JPM had a 19% market share in 2019, and Barclays had a 7% market share.

The main problem with my proposed plan is Barclays has to be a willing seller. Many stakeholders who may veto the deal: Barclays’s management, Barclays’s Board of Directors, and the UK government. However, I believe each of these stakeholders can be won over because of the strategic logic of the acquisition.

My proposal of JPM acquiring Barclays ignores a second objective of JPM’s digital bank in the UK, which is to create a de novo model in the UK for JPM to use as a template to enter banking markets in other countries. This is an attractive long-term benefit of starting a digital bank in the UK; however, I believe the short-term financial benefits strongly outweigh the potential benefits of perfecting a digital bank model to replicate in other countries. Also, my idea doesn’t preclude JPM from entering other countries with digital banks. It would make more sense for JPM to take this approach in countries where the banks are highly valued.

Even if JP Morgan Chase doesn’t acquire Barclays PLC, its entry into the UK via a digital start-up is a waste of resources. The most important wasted resource will be management attention. Even if the UK digital bank is successful, it will take decades to positively impact JPM’s financials.

Arlington Investment (“AAIC”) is a mortgage real estate investment trust. AAIC’s liquidation value (or book value) is $5.90, and the stock is trading for $3.66.  We don’t think it will return to $5.90 in the near term, but we believe the stock can get to $5.60 (or 90% of the estimated Q4 book value) in 6 to 12 months, which is +53% higher than the current price.

The management at AAIC has made strategic changes to increase their liquidation value.  During the third quarter, they bought back stock at a discount to increase the liquidation value from $5.63 to $5.92. When they report the 4th quarter, we expect they will announce they continued to repurchase stock.  We estimate the liquidation value will rise to $6.10-$6.20. The company is involved in the mortgage market, so it is not a franchise company like Disney or Microsoft that you can own forever. This is just a trade from $3.66 to $5.60. We think the downside is minimal because management reduced risk earlier in the year. The company does not have much leverage.  On recent conference calls, management has expressed a conservative stance about investing the company’s capital.

Insiders at AAIC purchased shares on the open market at the end of September and again in early January. We believe AAIC has attractive potential return without much downside.

BBX Capital (“BBX”) is a company controlled by the Levan family in Ft. Lauderdale. The company has been through several iterations. At various times, it has owned a bank, a home builder, and a timeshare business. The current iteration was formed this past Fall after spinning-off its timeshare business, Bluegreen Vacation Holdings (“BVH”). The remaining businesses in BBX Capital are several real estate ventures located throughout Florida, a building products company focused on windows and doors, and a struggling candy business.

We believe BBX Capital is extraordinarily cheap due to the spin-off, its new listing on the OTC market, the super-voting shares held by insiders, and the complicated nature of the remaining businesses.

BBX’s recent share price is $5.35. The company has net working capital + note receivable from BVH less outstanding liabilities equal to $6.74 per share. In addition, BBX’s real estate investments have another $6.22 per share of value. This conservative valuation of the company is $12.96 per share, which we find compelling compared to the $5.35 stock price.

This valuation is conservative because

We believe BBX Capital’s stock price can approach $12.96 over the medium term. We look at the management team’s track record of transactions to enhance value over the last 10 years. We believe management will announce another transaction to enhance the value of BBX Capital. Our guess is they will announce a share repurchase program.

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