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2502 N. Rocky Point Drive, Suite 665
Tampa, Florida 33607
Robert Kraft:
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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:
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.
We do believe there are real risks in the RBC story:
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.
Jonathan Bale:
Good morning everyone, and welcome to the Gator Capital Management Q4 2020 webinar. And thank you for joining us. Our Q4 2020 webinar will be presented by portfolio manager, Derek Pilecki. The webinar will last approximately 30 minutes, after which, we will open the floor for a question and answer session. If you have any questions you can submit any time during this session by clicking the Q&A icon on your screen. Due to time restraints, if your question is not answered, we will follow up with you individually after the webinar to answer your question. And as always, if you have any questions about Gator Capital Management, please do not hesitate to reach out.
For those who read our Q3 letter, you will know that Derek, highlighted the opportunity he sees in regional bank stocks. Today, Derek, will review his investment thesis on regional banks, and then drill down specifically into ConnectOne Bank call. And as I mentioned, we will then conclude with a question and answer session. Very quickly for compliance purposes, the views and opinions in this presentation are solely those of Gator Capital Management. Gator Capital Management has made every attempt to assure that the accuracy and reliability of this information provided, but it can not be guaranteed. And past performance is not a guarantee of future results. With that being said, I would now like to hand it over to Derek Pilecki, portfolio manager at Gator Capital Management.
Derek Pilecki:
Hey Jonathan. Thanks everyone for joining us today. I wanted to highlight what I think is a once in a decade opportunity in regional bank stocks. As you know, regional bank stocks have lags in definitely this year. Even with the rally over the last six weeks of upwards of 40%, the regional bank Index is still down 13% for the year, compared to the S&P 500 rising 14% year to date. This poor 2020 performance comes after regional banks of Arthur Hill lag the broader market over the previous three years. From 2017 through the end of 2019, regional banks returned only 11% total versus that the S&P 500 Index is return of 52%. This long-term underperformance regional bank stocks has created the opportunity that we see.
So I’m going to go through several parts of our investment thesis today. And first I wanted to start with valuation. This graph shows the median price, the tangible book value of all publicly traded banks for the past 30 years. As you can see, recently, the regional banks have been trading in a medium price, the tangible book value slightly above one times tangible book. This was as of the end of September. This has risen to about 1.25 times tangible book currently, that is still at the very low end of the range. In fact, the only time this index is traded at a more inexpensive level was in the six months after Saddam Hussein invaded Kuwait in the fall of 1990. This occurred at the time of the SNL crisis when commercial real state was crashing and banks were poorly managed. So these valuations were near all time cheapness of regional banks, even though the industry is in much, much better shape than it was in 1990.
We can see from this graph, the range has been 0.9% in tangible book up to three times tangible book. Three times tangible book occurred in a very different time frame. It occurred twice in 1997 at the height of the bank M&A wave. And then again, from late 2005 to mid 2006 at the height of the value returns in the mid two thousands. I would argue that it’s unlikely with the current interest rate environment that we ever returned to three times tangible book. But I think getting more to the center of this range, specifically getting to 1.6 to two times tangible book, is definitely reasonable given the return profiles of banks, the credit quality that they’re seeing, the profitability of the banks and the stability of their capital base. So I’m not arguing that we returned to all time highs evaluation, I’m just arguing that we’ll return to more of a median valuation in regional banks.
Another way to look at regional banks is to devalue them on a price to deposit premium. So most bank investors view the deposit franchise of individual banks as the most valuable aspect of the bank. There’s customer relationship and the sticky deposits of people who are willing to accept below-market returns to have the safety and the relationship with the bank. And on average, bank M&A occurs the average price that banks have been acquired for as a deposit premium of 14%. So the way you hack-related deposit premium is you look at the price, the premium above tangible book that the banks trading at divided by its deposits. So if bank was traded below tangible book, you say there is zero or a negative deposit premium. Of course, we know deposits have value. So it makes sense for them to trade above tangible book since the average price of banks been acquired is 14%.
Obviously with the pandemic and the economic shutdown, the regional banks sold off heavily in March. Until recently, they hadn’t rallied much because there’s been fears about credit. Credit picture has been murky over the past six months for two main reasons. First, the bank regulators and the banks were very generous with granting deferrals for borrowers who needed more flexibility due to the pandemic. And so, the banks were liberal with granting loan deferrals. Loan deferrals guide as high as 30% for some banks, if they just granted deferrals to any customer who wanted them. Other banks only granted deferrals after talking to customers why they needed the deferrals.
Also with the economic situation, it was hard to predict in March how the economy would play out. There was a huge shift in spending away from discretionary leisure travel towards home improvement and fitness. And so, there was some businesses, like any home improvement business, like the local tile store that have done very well, but wouldn’t have predicted that in March. So they took a loan deferral and it turned out they didn’t need them. Then there are other businesses like hotels that needed the loan deferrals and are still struggling.
The second issue with credit was the change in accounting methods that FASBI wanted to implement for several years called CECL, which in the past banks had put aside loan loss reserves for the next year’s estimated loan losses. Where CECL forces the banks to put out aside loan loss reserves for the entire lifetime of a loan. So for example, on a credit card loan which on average last seven years, you have to… When you make the loan, you have to make open the credit card account. You have to estimate how many losses you’re going to have from that account over a seven year timeframe. And so, the banks effectively front loads credit losses for the banks. And the banks also have to change the amount of loan losses they have for changes in economic environment. So Q1 was the first quarter that we had this new loan accounting standard, and it was also a huge degradation in their outlooks for the economy. So they had to massively increase their loan loss reserves in Q1 and Q2. So made it uncertain what their loan loss provisioning would be in Q3 and Q4. And since the economic forecast didn’t go down in Q3, loan provisions came way down. And so, the deferrals and the change in loan loss accounting really confused investors.
And so, bank stocks didn’t rally with the rest of the market through the summertime. Capital reserves are an interesting topic because capital is as strong as it’s been for the industry in many decades. The changes in the way that banks have held capital and their capital requirements have forced them to hold more capital. This has lowered returns, but has also increased the stability of the banks. Similarly, loan loss reserves are extremely high right now relative to charge off levels. And so, we think the banking industries is in good shape as far as the amount of capital reserves to get through whatever economic environment we were facing due to the pandemic.
The other thing that we’re encouraged about, most banks have increased their tangible book value through this time. So we’re viewing 2020 as more of an earnings event for the banks rather than the capital event. There are some headwinds that we’re not ignoring, mainly interest rates. So interest rates have come down sharply this year, and that’s a headwind for banks mainly because, their deposit costs have not declined as much as their loan declined. Mainly because of the zero bound, you can’t charge negative interest rates for checking an account. So the headwinds to the banks, and I think that’s one of the reasons…
Just to continue, I want to move on to cost cutting. Cost cutting is a huge opportunity for banks. We’ve had some announcements from several banks that they’re cutting 20% of their branches. Branch utilization has declined drastically with the pandemic, and we think the real estate footprints of almost every bank are too high. And so, we think there’s a massive opportunity for cost cutting. There also be cost cutting in the back office staff with the banks seamlessly transitioning to work from home. I think there’s massive opportunity to cut the real estate cost. The election and regulatory issues, I think there’s some fear that the Biden administration will increase regulation of the bank, one of the benefits of a Republican administration that there was a little bit of easing on the banks as far as the regulators and some regulations.
I don’t think that the first priority of the Biden administration is the focus on banking. I think it’ll be more on foreign policy. It’ll be on getting economic health to people and it might be around healthcare. I think doing anything to the banking system is way down on the list. So we think that is a less of a risk than the market does. We would say that the one outstanding regulatory issue is how the treat delinquent loans due to the pandemic. The current regulatory framework has been very generous to the banks. We think one day that’ll end and the banks won’t have advanced notice. But we think for now the regulatory risk is relatively low. And then one other thing I want to touch on was the low valuations banks. The decline of banks in March was so severe that it torched a lot of the bank specific investors.
And I think when I look around at my peers, we all know the bank stocks are cheap. But bank specific investors don’t have enough capital to invest in banks. And so, that has kept valuations lower. And I think it’ll take some time for the generalist to buy up the banks and get more clarity. We’re seeing it in recent weeks. So that’s my general thesis on the banks. Mainly, low returns for the past four years has created a low valuation mainly due to credit. Credit’s not going to be as bad as the market’s feared and banks haven’t rallied mainly because investors have been having trouble seeing through credit and also had redemptions from their investors.
Jonathan Bale:
Thank you Derek. And again, everyone I apologize for the technical difficulty. I think we’re good now. But again Derek, thank you. We’d love to get your thoughts on what you see are the biggest opportunities in regional bank stocks.
Derek Pilecki:
Yes. I think there’s four pretty interesting opportunities within regional banks. I think generally regional banks are going to do well. But there’s four specific areas where I’ve been focused. First one’s been the Puerto Rico banks. Puerto Rico consists of U.S. territory. Maybe doesn’t get as much attention from US-based investors. But Puerto Rico banks are regulated by the FDIC, under the same U.S. banking regulations. Puerto Rico has changed drastically in the last 15 years, as far as banking has gone. They’ve gone from 12 banks to three banks on islands. So there’s been massive consolidation. We’ve seen margin widen now on the Island.
And the other big change is the Puerto Rico economy is about to turn, could possibly turn to a growth mode. It’s been in recession for 15 years. There’s some… With all the hurricane damage and the rebuilding and money coming onto the Island from the CARES Act that we could have population growth level off or even grow. There could be some re-migration back to Puerto Rico from Florida and New York City. We also could benefit… Puerto Rico could also benefit from onshoring of healthcare production. They have a big footprint of pharmaceutical and medical device manufacturing on the Island. And so, to the extent that we onshore pharmaceutical and medical device manufacturing from China back to the U.S. Puerto Rico should get its fair share of a business.
And so, when I look at the Puerto Rico banks, the three of them are all trading below tangible book value. Two of them have recently done acquisitions that are massively creative to their earnings. And then, when I compare Puerto Rico to Hawaii, which is another island market. Hawaii’s market is consolidated like Puerto Rico has just become, and those banks traded premiums to the banking industry. I don’t expect Puerto Rico banks will trade at a premium because Puerto Rico is not a state. And I think that some investors will just always shy away from Puerto Rico, but I think they can trade at a median valuation within the banking industry.
The second area that we see of opportunities is growth regional banks. So if you go back to 2017, early 2018, there’s a group of regional banks that traded at a premium. And these tended to be good organic growers. They just grew faster than the rest of the banking market mainly because they were very disciplined about their hiring and they were taking market share by hiring loan officers from bigger banks. And these banks traded their premium to the group in late 2018, 2019. All these growth banks lost their premium to the group. And so, you can buy these banks. And I’m talking about like Western Alliance, Wintrust Financial, Access Financial, Signature Bank in New York. They’ve lost their premium valuation, but they’re still growing organically. And so, I think that’s an interesting area where you can get some growth banks for median bank prices.
The third area we look at is New York City area banks. So there’s been investors who have avoided or even shorted New York City banks because New York City was hard hit by the pandemic. And there’s also a thought that because New York City is so dependent on public transportation, it’d be slower to come back. And so, there’s some investors who are avoiding credit risk with New York City. I would say… I think there’s a difference in… New York is a pretty diverse region. I think the outer boroughs are very vibrant still. I think if you go to Midtown Manhattan, the office occupancy is still in the low double digits. But I don’t think a lot of the New York City area banks have loans against the skyscrapers in Midtown. I think most of those buildings, loans, mortgages find their way into commercial mortgage backed securities, and they’re not held by the New York area banks.
Also, when I look at the LTV, loan-to-value ratios of the loan portfolios of banks around New York City, they tend to be very conservative here. Most of the lending to multifamily owners in the outer boroughs. And so, we think there’s just an opportunity there. People have avoided New York City area banks and New York is going to come back and it’s not that dead by any means. And then the fourth area of banks that I would focus on are banks with repurchase programs. So there’s… Quickly, when the pandemic hit in March, the big banks agreed with regulators to turn off their repurchase programs, and most of the small banks followed suit. But as we’ve gone through Q3 and now there’s Q4, there has been a number of banks and a couple of dozen banks have announced that they’re restarting their repurchase programs.
Most of them are small couples, mid midcap banks have announced the resumptions too. But I think having that natural bid under the stock with the repurchase programs will help those stocks outperform. So those are the growth banks that we are…. Those are the little niches within regional banks that we would focus on.
Jonathan Bale:
Awesome. Thank you, Derek. And then can you drill down into an example of a regional bank that you like for us?
Derek Pilecki:
Yeah. So I want to talk about ConnectOne. So this ConnectOne is located in Northern New Jersey. It’s one of the New York… We’d classify it as a New York City area bank. It’s been a great organic growth story as well. And so, the bank was started in 2004. They grew organically. They’ve made some smart acquisitions along the way. We think they have a very dynamic CEO. His name is Frank Sorrentino. He started the bank and he’s run it since he started it. The acquisitions he’s made have been very interesting to expand the bank in a low cost manner. The credit is stable. ConnectOne deferrals have come down drastically. We’re assuming that credit losses will be minimal. They there’s a little bit of exposure and some hotel portfolios, but we think there’ll be able to work them out with minimal losses.
Last year, they made an acquisition of Bank of New Jersey, which had nine branches right inside ConnectOne’s footprint, and they closed their other branches and kept all the customers. So basically, it eliminated almost all the expenses of that acquisition. It’s going to be massively creative, and we haven’t been able to see the accretion because the pandemic hit before they could report the first quarter. So because of that, we think that their earnings estimates for 2021 for ConnectOne Lennar are way too low. I think the streets had 211. I think they can do 245. And so, at $17, they are in 245 next year. It’s trading at seven times earnings. I think a fair multiple for ConnectOne given its growth profile is 12 times, so that mean that’s 60% upside.
One of the benefits… Actually, the low interest rates are helping ConnectOne because they’re able to get rid of some of their higher costs funding. Unfortunately, ConnectOne has a lot more loans than deposits. Usually, we like banks that have 90% loan to deposit ratios. The big banks run crazy low loan deposit ratios because they’re just a wash in deposits. But with the amount of liquidity in the system right now, ConnectOne’s able to raise the posits and replace some high-cost borrowing. So that’s actually helping their interest margin, which is different from the typical bank in this environment.
And then, the other issue that we’ve mentioned is commercial real estate concentration. So the regulators are a little on edge about how much commercial real estate loans a bank has. I think ConnectOne is right at the edge there, although the regulators have not made a big push recently about this. And they’ve backed off a little bit by looking at what the credit experience has been of individual banks rather than just looking at the percentage of their loan portfolios in commercial real estate. So we just raised that as a potential issue. It’s not a current issue. It could become an issue if their credit experience doesn’t stay as strong as it’s been. So we like ConnectOne Bank. We think there’s some pretty good upside with a well ran organic grower.
Jonathan Bale:
Thank you, Derek. I do want to remind our listeners too that if you have a specific question, you can submit it in the Q&A icon at the bottom of your screen. You can do that at any time during this webinar. While you’re doing that, I do have a couple of questions for you Derek, that have been submitted already. The first one, are you worried about credit losses at banks if we have a second shutdown like we did in March?
Derek Pilecki:
Yeah. So that’s an interesting question. So if we have a second shutdown, I think it will be a targeted shutdown and it would be for a defined time period. I think it’ll be for a four to six week time frame. I think that the problem with what happened in March was we were uncertain of how long the shutdown would be. I think with the vaccine on the horizon and targeted shutdowns, I think that it’ll be easier for bank investors to get comfortable with the banks to be able to manage through things. I think the other thing that this experience this year has shown is that, a lot of the marginal businesses don’t qualify for bank loans already. So like the nail salon or the restaurant in the strip center, they don’t have bank loans necessarily. They might have some equipment rentals under a lease or something, but they’re not funding working capital through a bank loan. The retail shopping center does have a bank loan that they’ve been able to show they can fill that space relatively easily with a new nail salon or new restaurant.
So I think the regulators have pushed a lot of riskier credits out of the banking system since the great financial crisis. And that’s been the rise of private debt funds. And so, I think that the banks have shown that credit quality is pretty high. And if we go through a second shutdown, I think it’ll create some minor issues, but I don’t think it will be game-changing for the banks.
Jonathan Bale:
Perfect. Thank you, Derek. The next question is on ConnectOne specifically. Do you think ConnectOne trades at the lower multiple because it has changed from an organic growth store to more of a growth through acquisition story?
Derek Pilecki:
Yeah. So that’s interesting. I think their acquisitions have been smart. They acquired Center Bank in 2014, which was a larger bank, but the smaller bank management ran the combined company. And so, I thought that was a very good deal. And then obviously, the bank in New Jersey deals, a great cost cutting deal. So I think the acquisitions have been value-enhancing for ConnectOne. And I think they actually might disguise the underlying organic growth at ConnectOne. And so, I go back and forth in my own mind about whether I refer them to start making acquisitions and just grow organically. But so far, the acquisitions they’ve made have been positive and BV acquisitions. So it’s hard to turn those down.
Jonathan Bale:
Awesome. Thank you. We have a couple more submissions. Derek, why are you not more optimistic on the bank M&A aspect of your thesis?
Derek Pilecki:
Well, I think we definitely need more consolidation in the industry. I think right now, we’re on pause. We’ve had some announcements of bank M&A. Obviously, PNC made a big announcement yesterday. But I think typical M&A or broader M&A is going to wait until there’s even more clarity on credit. So I think that is one issue. And then, I think the second issue is banks are sold and not bought. So we have to have a place where management teams want to give up their paychecks to consolidate. I think we could get to the point with lower interest rates where the banks aren’t hitting their return targets and boards force them to do value improving moves.
I also think another roadblock to more M&A is stock price. So everybody wants to sell for their all time high stock price. And we’re so far below the stock prices of early 2018 that how many management teams or boards are willing to say, “Hey bro, we’re going to sell at this lower stock price so that we can ride up with the acquirers stock.” I just think there’s… Some of those social issues are hard to work through. But that being said, we’re definitely going to have an M&A. And there’s too much capacity in the banking industry. There’s too much benefits from scale. We are going to have M&A. I just think you can own the organic growers or the well-run banks and make just as much money as you do by fishing around for the people who are going to sell.
Jonathan Bale:
Awesome. Another one is here. How do you think about the threat fintechs when evaluating traditional banks?
Derek Pilecki:
Fintech? The fintech issue is a big deal. So there’s a big effort to try to disintermediate the intermediate banks. So a lot of the efforts are on the consumer side, and I think of that more of a big bank problem than a small bank problem. And most consumers bank at a big bank, even bigger branch coverage, bigger ATM network better, better apps. The small banks are really business banks. They’re really small business lending and small business deposit gathering. So I don’t see fintech disintermediating that and small businesses as much as they disintermediate the consumers.
On the consumer side, the big deposits… We’ve seen some consolidation… Well, not consolidation. More competition from the brokers. And so, Schwab and Fidelity are obvious competitors. They both offer bill pay and ATM’s. And Schwab offers mortgages. The wirehouses now offer check-in. And so, the high-end consumer have been competed away for less 15 or 20 years. In the middle or the low-end, we see some of the fintechs going after the very small deposit customers or balances. I don’t think that’s such a big deal. I think the real big deal is the big balance customers are the most profitable for the banks. And I just don’t see the fintechs getting to that customer.
We’ve seen a little bit with the online banks. Online banking has really grown and taking share from the industry. So we’ve seen it with Ally and Capital One and Synchrony and Sallie Mae and Goldman and Discover. All have very strong online banking presences. So I worry about the online threat more than I do the fintech threat.
Jonathan Bale:
Perfect. Thank you. We’ll just try and squeeze in one more here. Is there any update available on Ambac?
Derek Pilecki:
Yeah. So Ambac still has its lawsuit with Countrywide. It’s slated to go to trial in February. Bank of America has done its controlled. Bank of America, of course, owns Countrywide. So Bank of America has done its best to try to keep the lane that trial. There was a hearing on Friday, another effort to try to delay the February trial. Of course, we also have the pandemic to deal with. The trial was supposed to scheduled for July this year. That delayed due to the pandemic. So I think that the start of that trial is the real big catalyst for Ambac. So as long as that date holds, I think Ambac’s interest is here.
Jonathan Bale:
Perfect. Thank you. Well, we’ve gone over the 30 minute mark here. So I’m going to wrap this up. But Derek, thank you again for your time. And thank you everyone for taking the time to join us here. There’ll be a replay of this webinar and the presentation. So that will be accessible in the next couple of days. But as always, if anybody needs any additional information from us or would like to discuss a specific questions in more detail, please do not hesitate to reach out. Thank you again, Derek, and everyone for joining us. And have a great day. Thank you.
Flushing Financial (“FFIC”) is a bank with 20 branches on Long Island. Originally, FFIC was mutual thrift that converted to stock ownership in 1995. The bank has had a long history of strong credit quality, but investors have sold the stock due to COVID-19. We think the valuation is way too low given the bank’s long history of strong credit and incremental changes management is making to the business to improve returns.
We think FFIC is too cheap for a profitable bank with a history of low credit risk. From a 0.59x price-to-tangible book ratio, we believe FFIC can trade up to a 1.1x price-to-tangible book level. This is the level at which FFIC traded from 2013 to 2019. In fact, FFIC traded at 1.4x in 2017-18. If FFIC were to make substantially more progress in remixing its deposit base, we believe there is further upside to the valuation.
We are not arguing that CNOB and FFIC are the greatest companies in the world. We are using them as examples of the opportunities we see in the bank stocks. We think both CNOB and FFIC could double in the next three years. If they did double, they would be trading in-line with their median historical valuation.
We believe there are several dozen similar opportunities in bank stocks, so we have purchased positions in many of them. We have expanded the number of long positions in the Fund’s portfolio to include more of these ideas. Even though the number of positions has increased, we don’t believe the concentration of the portfolio has been reduced because many of these positions are very similar and will trade as a group.
The two benefits of increasing the number of positions are:
ConnectOne (“CNOB”) is a $7 billion bank with 28 branches mostly in northern New Jersey. ConnectOne has a strong management team led by CEO Frank Sorrentino. The bank has a history of strong organic growth. In recent years, it has become a skilled consolidator of other banks. With the pandemic, investors sold the stock due to general concerns regarding credit risk. We think the valuation is too low given the bank’s history of solid credit and strong growth.
ISSUES
We think CNOB is too cheap for a growing, profitable bank with a history of low credit risk. From an 0.85x price-to-tangible book ratio, we believe CNOB can trade up to a 1.6x price-to-tangible book level. This is the average level that CNOB traded from 2013 to 2019. In fact, CNOB traded up to 2.2x tangible book in 2017-2018.
Jonathan Bale:
Good morning everyone. Welcome to the Gator Capital Management Q3 2020 Webinar. And thank you for joining us. Our Q3 2020 Webinar will be presented by Managing Member and Portfolio Manager, Derek Pilecki. The webinar will last approximately 30 minutes, after which we will open the floor for a question and answer session. Do you have any questions, you can submit at any time during this session by clicking the Q&A icon on your screen.
Due to time, time restraints, if your question is not answered, we will follow-up with you individually after the webinar to answer your question. And as always, if you have any questions about Gator Capital Management, please do not hesitate to reach out. For those who read our Q2 letter, you will know that Derek highlighted Puerto Rican banks as part of his research spotlight. Today will Derek will review the general opportunity he sees in Puerto Rican banks and then drill down specifically into First Bank Puerto Rico. And as I mentioned, we will then conclude with a question and answer session.
Very quickly for compliance purposes, the views and opinions in this presentation are solely those of Gator Capital Management. Gator Capital Management has made every attempt to assure that the accuracy and reliability of this information provided, but it cannot be guaranteed. And past performance is not guarantee of future results.
With that being said, I would now like to hand it over to Derek Pilecki, Managing Member and Portfolio Manager of Gator Capital Management.
Derek Pilecki:
Thanks Jonathan. I wanted to go over my Puerto Rico bank thesis starting here on page three. I want to first focus on the consolidation within the Puerto Rico banking market. So, we have a couple of market share tables here. The first one on the left is the market share of Puerto Rico. And as of June 2019, you can see that there are six banks with reasonable market share within the Puerto Rico market.
Then two of the large foreign banks, Santander and Scotiabank decided to exit the island and announce sales of their Puerto Rican bank operations, the First Bancorp and the OFG Bancorp. This reduces the number of significant players on the island from six to four. I would argue that Citibank’s presence on the island is more retail focused with a slight focus towards multi-national companies operating on the island. So, that really leaves just the top three banks, Banco Popular, First Bank and OFG as being the only three commercial banks on the island.
So, you can see Puerto Rico’s one of the more highly concentrated markets, banking markets in the country. We also don’t see any De Novo players from the US entering the Puerto Rico market any time soon. With this market share concentration in Puerto Rico, we think there’s a very attractive banking market from the standpoint of equity holders. We, we expect strong margins due to less competition. And we think this, competitive dynamic is similar to what we see in Hawaii, which of course is another island type economy with high margins.
The second dynamic in the Puerto Rico banking market is Banco Popular’s pricing strategy on deposits. Until 2015, the cost of deposits on the island were higher than on the US mainland, mainly because Banco Popular’s deposit rate strategy kept deposit rates high, which caused the other banks on the island to have to pay up for deposits. This kept margins and returns low on the island. As we went through the interest rate cycle of 2015 to 2016 … Banco Popular seemed to change their strategy. And they didn’t raise rates along with set fund rate increases. This moved the pricing of deposits on the island from above peer to below peer and has increased returns of all of the Puerto Rican banks on the island. As long as Banco Popular continues to price deposits less aggressively, we think the banking market in Puerto Rico will have higher returns.
In addition to the attractive banking market on the island, we think the economic conditions on the island could improve. Puerto Rico’s pretty much been in recession since 2006, but there are a few things that make us more bullish on the Puerto Rico economy going forward. First is, they’re having a double shot of stimulus right now. As a US territory, Puerto Rico companies and citizens are eligible from the benefits of the CARES Act. Also, Puerto Rico’s government passed its own stimulus. So, we think of this as a double shot of stimulus on the island.
Then Puerto Rico could potentially benefit from onshoring of pharmaceutical and medical device manufacturing. So, there use to be a tax break called Section 936, which gave corporations a tax benefit if they had manufacturing in a US territory. So, a lot of pharmaceutical firms moved their US manufacturing to Puerto Rico. So, there was about 40 pharmaceutical and medical device manufacturing plants on the island. This tax break was taken away in 1996 with a ten year phase out. So, when it finally phased out in 2006, Puerto Rico’s economy went into recession. And it’s pretty much been in a recession since then.
At the beginning of the pandemic in March, a lot of, of PPE, pharmaceuticals and medical devices were manufactured in China and we were having trouble importing those items from China because the Chinese Government wanted to keep the, the production of those items for their own citizens’ use. So, there’s been a call for the US to onshore some of that manufacturing. And Puerto Rico’s a natural place for that manufacturing to occur.
Moving to page four, we think Puerto Rico’s handled the virus relatively well. If we ranked all the states and territories, Puerto Rico would rank 44th of the 54 states and territories as far as coronavirus cases per capita. Although, we’d note in recent weeks, they’ve had, they have seen an increase in, in virus spread. Puerto Rico benefited early on in the pandemic from a, a strict curfew where citizens couldn’t be on the streets passed 7:00 PM. As this curfew was lifted, we’ve seen the virus start to spread, but it’s still at a manageable level.
Another aspect of the Puerto Rico bank stories, we know that the Puerto Rico banks are, familiar with how the economy operates after shutdowns. They’ve had a couple shutdowns in the last five years, one mainly, most notably because of Hurricane Maria where the economy lost power and the utility wasn’t able to get power to a large majority of the island for several weeks. And then they recently had an earthquake. So, I think the, their response to the pandemic will, will follow along the, the lines from these natural disasters and they’ll be able to navigate these fine.
The last two points of the, the general Puerto Rico bank thesis is, we think regional banks in general are cheap. They’ve lagged the broader market. They’re still down 30% for the year. And we think as people get comfortable, that the credit losses in the banking systems aren’t, uh, going to pose an existential threat that regional banks will increase in value. And Puerto Rico banks will increase along with US banks.
And then, uh, if we look at Puerto Rico banks relative to the US banks, they’re very cheap. Whereas the US banks trade at 1.1 times tangible book, the Puerto Rico banks trade at about 60% of tangible book. And we think with the ongoing margin dynamics in the, in the Puerto Rico market, they shouldn’t trade at such a steep discount to the US banks. So, that wraps our, our, our thesis, general thesis of Puerto Rico.
Jonathan Bale:
Derek, thank you, Derek. That was, uh, that was fantastic. Um, if you could, uh, would love to, to get your thoughts on what, you know, you think are the biggest risks to, uh, Puerto Rican banks.
Derek Pilecki:
Yeah. I think, I, I’d say the two biggest risks for the Puerto Rico banks is, uh, or what we worry about is the economy, because the … We, we’re really, we don’t need the economy to be booming in Puerto Rico. We just need it to, to bounce along and, um, not shrink drastically. And so, one … you know, if a, a real weak economy could potentially impose higher credit losses in the banks. And we think that would be, would be difficult.
We think that between the stimulus and the potential onshoring, we think that there could be some net employment growth on the island. And I think that would be fine for the Puerto Rico banks. The other risk that we worry about that we can’t really predict is if there’s a change in the, the posit pricing dynamic like we saw from 2010 to 2014 where Popular just priced deposits at a irrationally high level.
And we do-, we don’t have any evidence to suggest that we would go back to that type of market, especially with the consolidation. But it’s just something we think about. We can’t explain why they priced where, where they did it during those years, but if they went back to that strategy, it wouldn’t be good for, for the Puerto Rican banks.
Jonathan Bale:
That’s great. Thank you. And could you, um, you know, drill down into a, into an example for us?
Derek Pilecki:
Yeah, sure. So, I, I’m going to highlight First Bancorp Puerto Rico. It’s the number two player on the island. So, you … we own all three. We own Banco Popular, OFG and, and First Bancorp. But First Bancorp has, uh, a couple dynamics that it, I think will make it particularly attractive. First is, the, they’re making a very financially compelling acquisition of Santander’s operations. So, prior to, um, prior to this acquisition, First Bancorp was the number two player on the island and Santander was number three. So, their acquisition of Santander consolidates the number two and three market players.
The deal is 35% accretive to earnings per share for First Bancorp. So, they’re, they’re paying a little above book value. And they’re paying in cash for, for the acquisition. So, it’s very creative, especially when you consider the cost savings that they’re getting it, get from the overlap. Um, you know, First Bancorp had been running with excess capital for a number of years in anticipation of this acquisition. So, we think it’s an excellent use of their capital. First Bancorp’s earnings per share estimates for 2021 are higher than their, what they earned in 2019, which is unusual for regional banks.
Our next point on First Bancorp is, we think the valuation is extremely low. The stock trades are five and half times next year’s earnings and only about .95 times tangible book. Twice in a, the past 10 years, First Bancorp’s traded up to 1.2 times tangible, once in June ’13 and again in March ’19. We expect First Bancorp to trade up to 1.2 times again. And we don’t think 1.2. is necessarily feeling on its valuation because of the potential improvement of profitability of banks in Puerto Rico due to the consolidation. We think that the combination of the acquisition and the low valuation makes First Bancorp particularly compelling.
Our third point, we’d point that the credit qualities much improved at First Bancorp, that the bank’s currently running a very high level loan loss reserves, about three and a half percent, even though charge-offs in Q2 were only about 43 basis points. Loan deferrals have come way down. Uh, they were cut in half during the first three weeks of July. We believe that many people took loan deferrals as just an an option. And during the cycle, you know, usually loan deferrals are the fourth or fifth risk management tool banks use. But in this cycle, loan deferrals were given out to anybody who used it.
And with the uncertainty of the pandemic, a lot of people and companies took the loan deferrals just to manage cash flow, not because they necessarily needed it. So, we’re seeing as loan deferral periods are ending that, uh, companies and people are resuming their loan payments. We think credit qualities, um, is going to turn out to be a surprisingly good at, at First Bank along with a lot of other regional banks.
Then we would also note that, you know, during the financial crisis, First Bancorp ran with about 10% non-performing loans. And now, right now, it’s down to about two percent. We think it’s a huge difference between the way First Bancorp operated going into the financial crisis compared to the way they operate now. The recession in Puerto Rico was just starting as The Great Financial Crisis hit. Also, uh, we think the regulators have been all over the Puerto Rico banks for the past 12 years. And so, the amount of bad loans still within the banks is, is very low.
Moving on to loan portfolio. It will, I think the, the loan portfolio at First Bancorp looks very similar to US peers. It’s a mix of CNI, commercial real estate and residential lending. Um, we think the, the Santander loan portfolio they’re acquiring actually is slightly lower risk than First Bancorp’s existing portfolios. So, I don’t think the acquisition of those is undue risk.
Flipping to the … page, page six, um, with the expense base. You know, uh, First Bancorp’s been managing expenses for aggressively for a number of years. And then they’re going to cut out about 35% of Santander’s expense base in this acquisition. So, we think, you know, they’ll be operating efficiently. And that’s a, that’s an opportunity. The deposit franchise is, at First Bancorp has improved. The much larger mix of non-interest bearing deposits. And then it’s going to improve even more with the Santander acquisition. Loan to deposit ratio will decline to 85%. And we think this high level of liquidity will give the bank a lot of flexibility going forward. And they’ll continue to raise deposits to fund loan growth going forward.
On the bottom left part of the slide, I just want to point out the branch map, what it looks like. So, this is the island of Puerto Rico, of course. And the green dots are First Bancorp’s branches. The gray darts are Santander’s branches. And so, there are, is a lot of overlap, especially around San Juan, which is a box, on the right-hand side. We think that this is where most of the expense savings are going to come from branch consolidation. And they’ll have a nice coverage of the whole island after this acquisition.
And then the final point on capital, First Bancorp’s been running a very conservative capital. They pay capital, Common Equity Tier One capital of above 20%. As of June 30th, the acquisition’s going to close here in the third quarter. So, they’re going to use a lot of that excess capital to pay cash for Santander. But even after the acquisition, they’re still going to have at least 10%, CET1 ratio. So, we expect them to generate capital post acquisition and use that capital to, to start buying back shares late in 2021 or early 2022.
Jonathan Bale:
Perfect. Thank you, Derek.
Derek Pilecki:
You, you can see here
Jonathan Bale:
Um … Go on. Sorry.
Derek Pilecki:
Oh, you, uh, I was just going to wrap up. And you can see with the chief valuation and the and the low acq-, the low valuation and the, the compelling acquisition. And we think First Bank’s one of our favorite names here.
Jonathan Bale:
Thank you, Derek. I do want to remind our listeners, that if you have a specific question, you can submit it in the Q&A co-, Q&A icon at the bottom of your screen. You can do that at any time during this, uh, during this webinar.
While you’re doing that, I do have a couple of questions for you, Derek, that have, uh, have been submitted already. The first one, “As a US-based investor, how do you get comfort with the regulation of Puerto Rican banks?”
Derek Pilecki:
Yeah. I, so, we … The, the Puerto Rico banks as a US territory, they’re regulated by the, the US bank regulators. So, the FDIC regulates all three banks. They conduct the, the bank examinations. I, I actually believe it’s the, they’re regulated out of the FDI-, their examiners come out of the New York office of the FDIC. So, um, the same examiners who cover the New York Metro banks also do the exams in Puerto Rico. So, that, that gives us most of the comfort, um, that we’re under the same … they’re operating under the same rules of the US banks.
Jonathan Bale:
Perfect. Thank you. Um, the next question is on, uh, First Bancorp Puerto Rico specifically. Uh, “I understand that First Bank Puerto Rico had some trouble during The Great Financial Crisis. How do you get comfort that they are better prepared?”
Derek Pilecki:
Yeah. So, I, I mentioned this briefly. I think that the … You know, they had a near death experience in, in the financial crisis where they had to, um, do a, a prefer for common exchange to raise capital. I, I think that their loan portfolio is just a world different than it was going into the financial crisis. I think it’s a, a much more granular portfolio. I think, um, think the … they’ve been managing through the 13 or 14 years of Puerto Rico recession. So, I think they’ve been managing under a, a, you know, a relatively stressful environment for more than a decade now.
And so, I don’t think there’s a lot of fluff in their loan portfolio. And, you know, I, I have comfort that the, um, you know … you know, we meet with Puer-, First Bancorp’s management about once a year. We’ve been meeting with them for about six years. We have comfort how they approach the lending business. And then the, you know, having the regulators in there. I don’t think, um, you know … I think that it’s been a … I think they’re a little harsher on the Puerto Rico banks because of what happened in the financial crisis than they are on US banks.
Jonathan Bale:
Great. Thank you. Um, we have some, uh, new question submissions. Uh, “Derek, what do you see, uh, biggest risks with the Santander acquisition?”
Derek Pilecki:
Yeah, I think it’s, it’s integration. And it’s going to … you know … As they integrate the Santander, does it, um, cause them to lose focus on taking care of their customers? Or are there good customers in, that Santander had that, um, will be easy to pick off from the other banks? I guess one of the good things about that is, OFG’s going through its own integration with the Scotiabank branches. So, they’re a little … They’re slightly distracted as well. Um, you know, and Banco Popular already has 60% market share. So, you know, it can be, you know, uh, anybody who banks on the island and has already had a look at, uh, what Popular has offered. So, you know, we’re not that concerned about that. But, you know, the, with any acquisition, there’s integration risk. Um-
Jonathan Bale:
Perfect. Thank you. Um, another question here. “What are the short term and long term ROA, ROEs of the Puerto Rican banks? What is the long term multiples, and what is your upside, downside?”
Derek Pilecki:
Sure. So, you know, it depends on what the ROA is to, with the multiple. Multiples tend to follow what ROA is. So, I think the ROAs of the, the Puerto Rican banks can get above, um, get above one. Can they get to one and a half percent? I think they can. Uh, you know, it hasn’t been proved out yet, because, you know, we haven’t had a long enough time period with, um, you know, less competition on the island.
Uh, you know, I don’t want to … You know, the Hawaii banks trade for a premium because the margins are so wide there. I think, I don’t, I’m not arguing that they will get, the Puerto Rican banks will get to a premium. I think they can trade in line with US banks peers, especially if they prove that margins are wider, um, than US peers, I think trading in line with US peers. Because I think there will be, always be a some persistent discount for being a territory rather than a state. But, um, you know, I think it’s … I don’t think it’s unreasonable for them to trade in line with US peers.
So, can … I think US peers are trading cheap right now, one times book, 1.1 times book. You know, can US peers trade up to 1.7 like they were in 2018? Possibly. Maybe we need higher interest rates to get them that, to that valuation. But, um, I think in line with US peers. And then US peers recovering some is where we can go. So, if the Puerto Rico banks trade at 60% intangible now, can they get to one and a half or 1.7 times? You know, ar-, basically arguing for almost a triple of their, their valuation. I, I don’t think that’s unreasonable under a long enough timeframe.
Jonathan Bale:
Okay, perfect. Uh, next question. We have some more submissions here. Um, “On the last webinar, you shared your outlook on Q2. Uh, what were the major contributors to your, uh, performance in Q2?”
Derek Pilecki:
Yeah, so in Q2, the, the mortgage names, uh, were helpful. So, PennyMac, uh, we owned both PennyMac companies. And we also owned a mortgage insurer, NMI Holdings, that had had a tough Q1. So, that balanced a little in Q2. And then the, the other area that helped in Q2 was the, the capital markets, firms like Morgan Stanley and Credit Suisse that, that with the, the send back stocking, the, the capital markets, the debt capital markets new issuance and trading buyings were just off the charts.
And so, neither Morgan Stanley nor Credit Suisse had especially … have a big credit risk. So, a lot of their, um, underwriting revenue and trading revenue dropped to the bottom line. Uh, and so those were the, the two areas, mortgagings and capital markets, um, helped in Q2.
Jonathan Bale:
Perfect. Thank you. Um, next question. “Do you expect CET1 to be at 10% post acquisition?”
Derek Pilecki:
I do. I do. So, I think, um, you know, based on my model, uh, I think it’s going to come in slightly above 10%, um, post acquisition.
Jonathan Bale:
Okay, perfect. And then, uh, the question following that was, “Remind me of what is the threshold for CET1.”
Derek Pilecki:
Yeah, so, uh … Usually you think banks have to, uh … I don’t see banks with CET1s below eight percent. Um, most banks have, regional banks have targets of, you know, anywhere from nine to 10%. Um, I think 10%, uh, is a reasonable target. Maybe it’s, uh, more on the conservative end, but right around 10% is where I would expect First Bancorp to operate.
Jonathan Bale:
Okay, perfect. Thank you. Um, I think we have time for a couple more questions. Um, it looks like we’ve got some here. Um, and it looks like we’ve got two here. I think you could, you could possibly, um, sort together. So, first one, “Banks have lagged the border market significantly this year. What scenario do you think banks will outperform moving forward?” And then the next question, which I think relates, “Over the weekend, it was revealed that Warren Buffett sold most of his banking positions. Uh, do you think banks are in a good position going forward?”
Derek Pilecki:
Yeah, so the performance of banks has been definitely frustrating this year. So, I mean, I think there’s a couple things going on there. One is, there is, you know … PSTD from The Great Financial Crisis where the banks lost a lot of value and didn’t recover it. It was, um, you know, it was a little asymmetric downside risk in the banks from the credit losses. And so, I think with the economic shutdown, there’s just a normal, um, lookback to what happened in the last cycle.
Um, I think another part of the, the risk here, or the reason why banks have underperformed is that when you look at companies that are doing well during the pandemic or the shutdown, it tends to be more national big firms that have, um, maybe a technology aspect to them and Main Streets, that area of the economy that’s really hurting. But it’s hard to short Main Street through the, the stock market.
And so, I think there’s some, some part of the investment community that looks to banks as a way to short Main Street, because they have, uh, you know, credit risks, the Main Street. And then, you know, the other reason is rates. You know, zero percent interest rates is a headwind for banks. So, you know, they still earn spreads, but it, you know, it’s just, they, they can’t reprice checking accounts below zero yet. Um, and I don’t expect them to.
So, uh, so I think those are the three reasons why banks have, have underperformed. I think where banks are going to outperform, I think there’s going to be two things that are going to happen. I think that as we come out of loan deferrals and payment rates on, on loans or lack of delinquent loans will surprise investors. So, it … I think that a lot of loans are going to come off deferral and start repaying again.
And then I think the, the banks are one of the best, um, best bets for the economy reopening or from, for a vaccine getting introduced. I think, you know, they’ll … they have the most opportunity to snap back from a normalization of the economy. So, you know, to the extent that we get a vaccine introduced that people feel comfortable with, I think the banks are one of the best ways to, to play that.
I think, um, you know, I think the Buffett sales are interesting. You know, I think of those, the, the companies that he sold as pretty inexpensive and well run. So, you know, one thing when I looked at his, when I look at his portfolio, I was always surprised how overweighted he was to banks. So, he didn’t sell all his banks, he, you know, actually added to Bank of America. So, I think, you know, it might just be a, a reconfiguring going to the bank he feels most comfortable with. And it also might be just a realization that he was too overweighted to banks.
So, um, I do think that there’s opportunity in banks, especially since they flagged so much this year without, uh, you know, without this being a capital event. The, uh … You know, I think the, the credit losses that the banks are going to experience are going to … you know, they have hurt earnings this year. It might last a little bit into next year, but we’re not seeing tangible book values go down because of the, the economic shutdown.
So, it’s not, you know, permanent in inf-, impairment of ca-, of value. It’s just, uh, one, uh, one year’s earnings gets wiped away. And ev-, and it’s not even that bad. It’s like 40% of one year’s earnings gets wiped away. So, um, so, I mean, I think there’s … for the, the stocks to be down 40% or 30% because of that, I, I think is, is a, it’s been overdone.
Jonathan Bale:
That’s perfect. Thank you, um, Derek. That was, uh, that was great. Well, we’re approaching, uh, the 30 minute mark. So, um, uh, I’m going to, I’m going wrap this up. Um, Derek, thanks for your time. And, uh, you know, thank you everyone for taking the time to join us. We wish you all good health and the best during this time.
Um, there will be a replay of this webinar as well as the, um, the presentation. So, that’ll be accessible in the next couple of days. Um, but as always, if anybody needs any additional information from us, or would like to discu-, discuss specific questions in more detail, um, please do not hesitate to reach out. Thank you again, Derek. And thank you everyone for joining us. Have a good day.