2502 N. Rocky Point Drive, Suite 665
Tampa, Florida 33607
2502 N. Rocky Point Drive, Suite 665
Tampa, Florida 33607
Garrett Brooks:
Good afternoon everybody, and thank you for joining us. My name is Garrett Brooks with Slingshot Financial. We are a Colorado registered investment advisor and your institutional representative for Gator Capital Management. With me this afternoon, happy to have the man, the myth, the legend himself, Derek Pilecki, Managing Member of Gator Capital Management and Portfolio Manager of Gator Long Short. Gator Long Short …
Derek Pilecki:
Hey Garrett.
Garrett Brooks:
… if you remember – oh, hey Derek. How are you doing?
Derek Pilecki:
Thanks for having me on.
Garrett Brooks:
Thanks for joining. How are things in your world?
Derek Pilecki:
Things are good. We’re just wrapping up earning season. We’re coming, the end of Q3 earnings so, it’s been good. Conference season’s starting. I went to the [inaudible 00:00:52] conference last week and headed to the Piper Sandler conference next week, so getting to meet with a lot of current holdings and prospective holdings, so it’s been good.
Garrett Brooks:
Fantastic. And for those joining and just becoming familiar with Gator Capital and the Long Short strategy here, which we’ll get into deeper in a second, Derek is a financial sector specialist, has been his entire career and so we spoke on a call like this back in April/May, I think it was, and you had said to me you were squarely focused in your sector, what you knew and you felt that the market was serving you up a big fat pitch at that time. And clearly the volatility in the sector, still a lot of uncertainty there and I know that you are just finding a ton of opportunity both for the long and the short book in your portfolio, but was hoping that you said, just came out of earning season, you could share with us your thoughts, first on the economy and the broader equity markets in general and then how that’s translating into the financial sector where you are squarely focused and finding that opportunity.
Derek Pilecki:
Sure. I guess to start with the economy, I would say we’ve been in a while here coming out of the pandemic where things have been super confusing and there’s been a lot of crosscurrents and I think most people would’ve expected the economy to have weakened by the stamp by this point, but the consumer continues to show strength and the economy seems to hum along. I would say we still have yet to see the full effect of interest rate increases. A lot of people have fixed rate mortgages, so they’re not seeing their payments go up from the higher rates, but there’s some loans that are going to repriced higher or any new business is slowing down because they have to take out new loans. So we could still see a weaker economy going forward. I would say that there’s been a lot of dynamic changes in the economy due to COVID.
First it was a product cycle where people just sat at home and order products and then as we got to move back out around, services really took off and now people have to go back to work. So it seems like consumption’s going to go down, but people are going to work more. So just a lot of different things, unusual for … some things that we haven’t seen for 50 years with inflation ramping up and then ramping back down. So I think the economy’s in pretty good shape. I’m worried about certain sectors of the economy, especially the big ticket items like housing and cars, just where people would have to take out a loan to make those purchases. I’m also worried about the construction trades. I think a lot of construction projects that are in process are going to completion and construction trades are working on those, but then the new projects that should be getting started in 2024, late 2024, 2025, they’re not really penciling out from an economic return standpoint for developers.
So I’m worried about the construction segments of the economy, not new homes, more just commercial like office buildings or new hotels. There’s just not new commercial billings that are getting started, so I’m worried about that and I’m worried about the knock-on effects of that. We’re starting to see some indications of slowness like FedEx telling their pilots that they have to want them to go work for a regional airline because Christmas is not going to be as strong as they had thought.
And so we’re starting to see some little incidental evidence that the economy is going to slow, but so far I think whatever happens will be relatively shallow. I think we’ve gotten some good news out of the Fed that they’re done raising rates. I know they don’t exactly say they’re done raising rates, but I think if you read the tea leaves, they’re not going to raise rates. I don’t think inflation’s going to re-accelerate from here. I think financial conditions are tight enough that there’s no way inflation can accelerate, but that’s my general economic view.
From a market standpoint, we’ve had a relatively strong market this year, but it’s been concentrated in a few stocks. I think there’s a lot of stocks that are inexpensive here. I think valuations are pretty interesting. Normally stocks discount a recession and they’ll bottom before we actually see the recession. So I’m not saying I think that the economy’s going to be weak, so we should [inaudible 00:05:40] out of stocks. I’m saying more I think the recession is here, but it’s going to be shallow and stocks might be bottoming now and getting ready for a run. So that’s my near term market view.
Garrett Brooks:
Great. And then how about in the financials, specifically in the sector that you follow very closely. I guess, what sorts of things are you seeing? Obviously there’s still a lot of chatter, a lot of commentary. I think I like to consider them more narratives surrounding the sector. I know that there’s, in talking with you closely, there are certainly some misconceptions and what can you share with us from your seat and looking very closely at the individual names in the sector?
Derek Pilecki:
So looking at financials, I mean I look at all different types of financials. Obviously banks, but also insurance and capital markets and asset managers and REITs. Banks are pretty topical because we had a regional bank crisis earlier this year. I think there’s a couple issues with the banks that bank valuations are as cheap as they’ve been, so it seems like the whole sector trades at seven times next year’s earnings, so that’s full expense.com. It’s expectations getting worse next year. It seems like almost every bank trades for seven times earnings. Which is cheap relative to where they usually trade. They usually trade nine and a half to 12 and a half times earnings.
I think the market’s discounting two things, net interest margins are getting squeezed. I think that’s close to coming to an end as deposit costs have risen to become more competitive money market rates and then some fixed rate loans are finally starting to reprice and we’ll move higher. So margins should start to expand going forward. I think the other big bogyman for banks is credit; is if the economy weakens, are we going to have credit issues? So far I think the office building sector is really the only source of concern within credit and a lot of banks have three to 5% of their loan portfolio in offices. A lot of those offices are suburban or focus on the medical community where people have to use their office to see patients.
I think a lot of banks have some pretty big reserves against the office portion of their loan book. We’re not seeing other sectors show weakness yet, but there’s one or two banks that have one or two issues and maybe this is just the start of a credit issue. So we’ll see. I think that other sectors of financials, insurance pricing is headed higher and the insurance stocks are doing phenomenal. Capital markets is kind of hit or miss. There’s not really been a strong IPO market or a big M and A market, so big investment banks aren’t really hitting all cylinders as far as the fees, but there’s pretty good trading.
Asset managers have been okay. We still have some pretty secular shifts from active to passive, and so the average asset manager trades pretty inexpensively. I think there’s some opportunities there. I think there’s a couple asset managers that trade at six times EBITDA and have diversified businesses. They’re not in large cap value, which is easily replaced by an index. Like they’re in either small cap stocks or fixed income products. They don’t necessarily have good passive products to follow along. So I think there are select opportunities there, especially finance, there’s constantly opportunities in that sector. And then in the REITs, I’ve really been short office REITs. I think the office sector is a problem. I’m surprised the office REIT sector has held up as well as it has given that they’re facing negative occupancy growth and negative lease rates. And so I think that’s a prime area for some shorts in the REITs.
Garrett Brooks:
Sounds like lots of opportunity. Sounds like there lots of value to be had there.
Derek Pilecki:
I would even add to it, within banks, with everybody trading at seven times earnings, it’s almost like the sector is not differentiating between banks that are well positioned for higher rates and banks that are not positioned for higher rates. It’s almost like people just trade in and out of the KRE, the ETF and they’re not differentiating between, hey, these banks are the best positioned for higher rates and these banks are really messed up with a lot of low coupon loans and that they’re going to be eating those low coupon loans for years. And so I think it’s a pretty interesting sector from both longs and shorts right now. I would say predominantly I’m net long the banks, but I also have plenty of shorts amongst the banks that have fixed rate loans.
Garrett Brooks:
And to that point, I know for a fact that there are a number of people who are simply trading the ETFs to try and get they’re either trying to bottom fish or trying to short, but doing the sector broadly, and that’s one of the key points I know that we’ve talked about before, you’ve seen through your career that generally a lot of your peers who were financial sector specialists following the financial crisis in 08/09, kind of became more generalists or lost interest with focusing on the sector. And so that’s leading to less competition for you and others like you, but for you and finding those gems, the hidden opportunities in the sector because so many people are simply placing trades with the ETFs broadly.
Derek Pilecki:
So generally there’s about two dozen financial sector funds, whereas there’s almost 200 technology sector funds. I just think that there’s less people looking at the sector and so that leads to some opportunities, especially in the small mid-cap stocks. There’s less liquidity. The multi-strat funds can’t really participate in the lower, the smaller market cap companies, so I just think there’s less people looking at them. And there’s tons of small cap financials to look at.
Garrett Brooks:
We talked a little bit about some of the different sub-sectors, the industries that are in the portfolio. In terms of themes, what would you say is really driving some of the performance that you’re seeing and we’re enjoying as shareholders?
Derek Pilecki:
If I look at the third quarter, the top three performers during the quarter were Genworth Financial, Jackson National Life Insurance, and First Citizens Bank. Starting with First Citizens there, they were the acquirers of Silicon Valley from the FDIC, so they bought the remnants of Silicon Valley Bank and they got a fantastic deal. So in Q1 and Q2, the stock was very strong and then it continued in Q3 where a lot of the banks pulled back during August and September where Citizens kind of just held its own and the market’s starting to figure out that Citizens is undervalued. I think Citizens, it trades for about $1,400 a share, book value is like $12.50, $12.70. I think book value is going to accrete over the next three years to like $1,800 and I think it can trade at one and a half times book, so it could get up to $2,700 in a three-year timeframe, and so you could have almost a double on the stock in a three-year time. And I think that’s pretty interesting.
Genworth’s been a stock we’ve owned for about 18 months. It has two main businesses, a mortgage insurance business and a life insurance business. They IPOd 20% of their mortgage insurance business two years ago. It’s Enact Mortgage Holdings and Genworth continues to own 80%. If you do some of the parts on Genworth, they have some debt outstanding. So if you take their value of Enact minus their debt, Genworth still trades at a discount to its publicly holdings of the mortgage insurance subsidiary and that totally assigns a zero to the $5 billion life insurance company. The life insurance company might be a zero because they were in the long-term care policy business and long-term care policies have just been mispriced and there has been a big black hole. But Genworth’s done a good job of repricing those policies over the past 10 years and they’ve, just to give you an example of how big the problem was, they’ve raised prices $22 billion on those policies and the market’s still assigning a zero value to the life insurance company.
So they’ve massively repriced those policies. Now those people are just getting to their mid-eighties where they’re making claims on those policies, so their claims are going to increase over the next 10 to 15 to 20 years, but I’m thinking that there could be some value in that life insurance company subsidiary, but it might not be realized for several years. So Genworth has held up this quarter and some of that discounts closed. And then Jackson National is a variable annuity writer. They were spun off from the Prudential UK a couple years ago. It was a very small percentage of your Prudential holdings, so say you’re based in London, you own Prudential UK, and then say you owned $10,000 Prudential UK, you got a $500 spinoff listed in the US in Jackson National. And so those investors all just sold off their shares and the stocks traded very inexpensively.
Variable Annuity’s are very tough, opaque business, so it should trade at some discount. I just argue that discount’s too steep and so the company’s done a good job of returning capital to shareholders. And so those three examples of things that have worked during the quarter, those aren’t Wells Fargo, Bank of America, Berkshire Hathaway, Travelers or JP Morgan. I mean it’s not the XLF/ETF. It’s small mid-cap companies with differentiated stories, unique stories that you don’t normally hear about, and I think there’s dozens if not hundreds of those companies within the financial sector for me to pick and choose from.
Garrett Brooks:
And right there, that hits the nail on the head. How can you explain such really impressive performance amidst a lackluster year to down year really in the process there, bottom up portfolio deeply, deeply researched, concentrated on small to mid-cap financials and businesses that Derek knows very well and oftentimes sees some sort of a catalyst in insight for either multiple expansion or some sort of a deterioration in the stock price. So that’s fantastic. In terms of the near term, I know that we’ve talked and talked with some advisors and you are very optimistic for the portfolio in the near term for the foreseeable future. What are you seeing in terms of opportunities and maybe some risk that we should be aware of?
Derek Pilecki:
So, I think in the near term, I think we’re in a good seasonality part of the year that the fourth quarter tends to be good. We started to see a little bit of a rally last week. I would expect positive market events over the next couple months. I think of this time as very similar to 1994/1995, where the Fed raised rates substantially in 1994 and then when they paused at the beginning of 1995. I think they did one last rate hike in March of ’95, but the market just ripped higher, especially financials. And so if the Fed’s pausing here, and that’s right, and the valuation of financials, I think there can be a substantial re-rating higher.
That being said, the recession is lurking out there and what is it going to look like? There has to be a lot of treasury issuance. The Central Bank, Chinese and Japanese investors and commercial banks are not buyers of treasuries right now, and they historically have been big buyers, so you’re going to have to have money managers buy all these treasuries, The Treasury’s going to issue, so that could be a risk. Then also if there’s surprise credit problems, more than what I think, and I outlined my concern about office buildings and loans on office buildings, but if there’s other segments of the economy that we can, I think they could some credit problems that would be a potential risk.
I do also want to just mention, obviously not all our picks work out great. We had the three biggest detractors in Q3 were Vornado Realty Trust, Axos Financial and Arlington Investment. So Arlington investment was a mortgage rate that was getting acquired, that was announced in Q2 and then the acquirer went down a little bit in Q3, so Arlington went down in sympathy.
Axos is a online bank based in San Diego. They have a super entrepreneurial CEO. It has been a short seller report around their involvement in crypto. I think it’s not an issue. I think the bank’s addressed the issue, but it underperformed slightly in Q3 and Vornado is an office REIT that had a terrible first part of the year and they bounced in Q3. I think it probably got oversold in May and just bounced a little bit on us in Q3. So I just want to be balanced about presenting stocks that work that don’t work in our portfolio.
Garrett Brooks:
Of course. So you’re saying not every single pitch is a home run, right?
Derek Pilecki:
Not every single one, right. Yes. I don’t bat a thousand.
Garrett Brooks:
Fair enough, fair enough. We would have serious questions, I think, if somebody sat here and said that everything that they’ve ever touched turned to gold. But with that being said, if anybody online here has questions, go ahead and pop them into the chat and we’ll address them as in the order that they come through. While we open that up and give people the chance to do that, I did have a question somebody asked me to ask of you, I should say, yesterday. And you touched on it a little bit earlier on, in terms of valuations, what’s being priced in and what’s not. This individual seemed to think that that long short financials would have a tough time and be seeing headwinds over the next three to four quarters, and I’d love to just get your initial reaction to that statement because I know it’s a fair sentiment and would love to hear what your thoughts are on that.
Derek Pilecki:
I think there are headwinds facing the sector, right? I think margins compressing and I think credit, and I think we got a little bit of an answer with the Fed pausing rates. I think the margins can bottom, if not this quarter, Q4 or Q1. And I think when margins bottom, that that’ll be taken off the table. And then credit, it’s always out there, right? And it seems like it’s closer than it’s been, but we are not seeing terrible credit quality amongst the banks. We just had the all time best credit quality over the past four quarters. Things are starting to tick a little bit higher. How bad will it get? It’s going to be a long process.
I think the banks are well run. I think the regulators are on top of the banks. I think from a credit quality perspective, we could argue that they weren’t on top of things from an interest rate risk perspective with Silicon Valley, but I think on credit quality, they’re reviewing loan files and I think credit’s pretty good. We will see where office loans go and we’ll see if there’s any other hot button credit issues going forward. So I agree that there’s some headwinds. I think the valuation, we’re way below the normal range for banks as far as valuations, and I think it’s way too cheap.
And I think from the long short perspective I touched on a little bit. All the banks are trading in seven times earnings, whether they have underwater bond portfolios or they’re perfectly positioned for this interest rate environment. And so I think that’s where the opportunity is of you don’t necessarily have to be long banks here. You can be long the ones that are well positioned and short the ones that are not.
Garrett Brooks:
Everything’s priced the same.
Derek Pilecki:
Yep.
Garrett Brooks:
Okay. Actually a few questions in here, a few good ones here. First one is, and actually this is going to kind of dovetail with the second one, I think here, but how do you position defensively and what does that look like currently?
Derek Pilecki:
I think I’m relatively defensive, so I’m about 90% gross long and I’m about 50% growth shorts. The net’s 40. I think that’s at the low end of the range. Historically, I’ve been above 50% that long, but I do see some, I’m pretty bullish about the calendar in the valuations, but I think there’s some things that are expensive and there’s also some banks that are not well positioned for the environment, so we’re short those. So I feel like we’re relatively defensive here compared to where we are normally, despite my bullishness.
Garrett Brooks:
Right. Great. I had a feeling that’s what you would say. The second question was actually what is long versus short positioning? You just touched on that, so we’ll jump into the next one. This has to do with real estate and it’s, do you think the banks will take larger losses on real estate portfolios?
Derek Pilecki:
I do think that there’s going to be a lot of work around real estate issues. I think to the extent that loans that, if a loan had a five-year term and it was written in 2019 and they have to refi it in 2024, I think that there might be some refis that sponsors need to contribute cash to pay down the loan a little bit to make the numbers work. I think the real problem is 2021/22 vintage, so as we get to 26/27, the valuations from 21/22 are not going to fly in 26/27, so we have a few years to go before that happens, but I think that’s the real vintage of loans that own commercial real estate that people are going to keep an eye on and how does that get refied. So luckily we have two or three years before we get there.
Garrett Brooks:
Interesting. Very interesting. Okay, one more question here, easy one. Do you take interest rate bets?
Derek Pilecki:
I think it’s hard not to take interest rate bets within the sector. I think there’s a lot of interest rate risk amongst the different companies. I would say, right now, that I’m relatively well positioned for higher, for longer. I think if the economy weakens substantially and there’s massive rate cuts, I’m going to have to make some changes to the portfolio, especially on the short side. I think some of my shorts would respond pretty favorably to aggressive rate cuts. I don’t think, my view of the Federal Reserve is they don’t want to be the ones that let inflation get out of control, and so I think they’re going to err on not cutting very fast. I think we’re in a higher for longer type scenario, and so, there is interest rate risk within the portfolio, but that’s how I’m positioned.
Garrett Brooks:
Fair enough. I would agree with you, higher for longer. It’s all about Jay Powell’s legacy from here on out.
We actually, that is all of the questions in the queue here, so it looks like we addressed everybody’s question. Derek, thank you so much again for your time. Love these chats. I know that the people in the field, the wealth of managers, the portfolio managers, the research analysts that I talk with, also love hearing from you, specifically on the sector, and congratulations on a phenomenal year and keep it up. Like I’ve said full disclosure, I am a shareholder and so I’m loving this and I know that the people who join us and who are listening and there are probably a number of shareholders who are also quite pleased with what you’ve done.
Derek Pilecki:
Thanks for having me on again, Garrett. Enjoy these chats.
Garrett Brooks:
Great, great. All right. Thank you everyone. Thanks for joining and obviously if you have any questions, feel free to pop them into the chat. You can always contact me and look forward to seeing you next time. Take care.
Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.