This transcript was prepared using transcription services provided by Rev.com. The transcript may contain errors, omissions, misspellings, or misinterpretations of spoken content. It should not be considered a verbatim or fully reliable record of the discussion.
Derek Pilecki:
I used to run 25 names on the long side. That number's crept up to about 40 names. Not all your ideas work. And so the ones that don't work don't hurt me as much. I think positions can become less risky at higher prices because the market's already starting to see the same things you're seeing. Markets tend to underreact to good news and it'll give you time to get into a name. You'll have more confidence and more confirmation of your thesis. I think repetition is a great way to develop edge. The more stocks you look at, the more stocks you buy or trades you put on, you develop skillsets and it's a muscle and you build that muscle over time. I've always been very focused on returns and not AUM. A life goal is not to run a billion dollar fund. My life goal is that have the track record comparable to where it's been.
The business is going to get bigger. I can make money in the markets and it will just compound. Stan Druckenmiller talks about this. When he's on a cold streak, he trades small, and then when he's on a hot streak, he parlays it and goes big. Investors that I've seen in the past that have not done well consistently over a long period of time, they don't stick to the basics because it gets boring.
Ethan Kho:
Derek, thanks so much for coming on the pod.
Derek Pilecki:
Hey, Ethan, good to be here. Thanks for having me.
Ethan Kho:
I think it's crazy how you're trading financials and the past five years, you've averaged over 20% a year annualized. What's your secret? How do you do it?
Derek Pilecki:
Yeah, I mean, it's funny. Everybody thinks financials is a sleepy back water and it's just my little dusty corner of the market. And there's opportunities that present themselves. I think a lot of people ignore financials. Every generation, the whole industry goes to zero. Savings and loan crisis, great financial crisis. And I just think there's a lot of smart investors who ignore financials because they think they're too complicated. So been able to ... In the last five years, there's been several things going on that have been pretty interesting opportunities. During COVID, the financials really lagged the rest of the market. And not until the Pfizer vaccine was announced that the financials really ripped high. And then we had the huge opportunity with First Republic and Silicon Valley failing. I was on the right side of that, underweight banks going into that episode and did a ton of work, making sure the regional banking model was stable and that customers weren't leaving, depositors weren't leaving the banks and took a huge overweight position in the banks in 23 and they rallied in the back half of 23 and 24.
And then I picked off three really interesting stocks in the last few years that were multi-baggers, Robinhood, Anywhere Real Estate and Société Générale. And so those were all big returns in a short period of time. So the combination of all those things have led to the higher returns.
Ethan Kho:
So you're looking at situations where there's a lot of positive change happening within businesses and the market hasn't exactly reflected that. I guess within that, I'm curious, how do you determine ... Rather, how do you figure out what is actually happening within a business versus just a narrative playing out? And I'll give an example. I guess with Robinhood, how do you determine the innovation on the brokerage business model, all the different tailwinds? Actually thinking about that information, how do you separate that from the perhaps noise around prediction markets and products that may appear cool on the surface, but could be. Now I'm saying could be, but could be perceived as just gambling products.
Derek Pilecki:
I agree with you on the prediction markets. I'm almost completely out of my Robinhood position now. And a big reason for that is the prediction markets. I worry that prediction markets are not a stable business. There's enough regulatory risk there that I'm uncomfortable. I don't want to pay for that to take on that risk. Are prediction markets just a way to circumvent online gaming laws in certain states or 18 to 20 year olds can't open up casino accounts, online casino accounts, but they can open up Robinhood accounts. So it was a way for younger people to be able to do online betting. I'm uncomfortable with that. I think on Robinhood specifically, I bought the stock in late 23 and there had been a big positive change. The business had turned profitable. It was not profitable when it came public. It had turned profitable. They had reigned in expenses.
They had been showing nice growth and the growth kind of compounds. The customers continue to add money. And I thought they had done a nice job of introducing new products and they had a clear roadmap for new product introductions. So I thought that would all accelerate growth. And it wasn't that hard to see with the product introductions that customer growth could accelerate. I would say that I definitely got lucky that they approved the Bitcoin ETF six weeks after I bought the position. So I bought it right as there was a huge run in crypto and popularity of buying the Bitcoin ETF. And so there was some fortunate timing on that. That was not part of my thesis. I didn't buy Robinhood because I thought that approval was imminent, but just good luck on that.
Ethan Kho:
And so when you have a thesis for a stock, and so we're talking about Robinhood now, but it can be a fanny stock. How concentrated are you when you have conviction?
Derek Pilecki:
I've changed my view on concentration a little bit. I used to run 25 names on the long side, and that number has crept up to about 40 names. And I seem to like ... And my returns have actually gone up with more names, which is a little bit backwards. And so I think it's because when not all your names, not all your ideas work. And so the ones that don't work don't hurt me as much as the one. And so if I put in average business size is now 3% instead of 5%. The ones that don't work don't hurt as much as they used to. And sometimes everybody says," Oh, I don't want to be invested in your 25th best idea. "It's really hard to rank your ideas. I do rank my ideas, but rarely is my best idea my best performance stock. Maybe I'm not that good at ranking or maybe there's just some normal dispersion about ideas and maybe your 30th best idea has a great return.
And so new positions normally go in to the portfolio around 4%.
I do not add to positions often. Occasionally I'll add to positions. I like to add to positions when I'm actually up on the position rather than when I'm down on the position. And I think positions can become less risky at higher prices because the market's already starting to see the same things you're seeing. If the position's down, the market's not seeing what you've seen. So you either have to say," The market's wrong and I'm right, " or the market's going to come around to my way of seeing things or I'm wrong. And a lot of times when the position's moved against you, you're wrong. And so I try not to add to positions when I'm down.
Ethan Kho:
So that's a, I guess, rule you've set for yourself. And I think that there are many fund managers who'll do this. They'll say," This is my process. These are my rules. "I think famously Soros and Druckenmiller, they would like to add, they'd go ultra levered only once they were up big for the year. And I guess I have a question regarding making rules for yourself in the fund management business. How strict are you? Because at the end of the day, you are fundamental, you are making discretionary decisions when you're managing money. I will never cross this line. How do you think about it?
Derek Pilecki:
No, I mean, I don't have super strict rules like that. I have guidelines, but every time I violate those guidelines, I seem like I lose money, so I should be more strict. But it's just the way ... There's just rules of thumb that add to your winners, let your winners run. All those sayings, there's a real reason why they exist and why they've endured for all these years because there's truth behind them. And it's not 100% of the time, but it's more often than not. But I'm not super rigid on implementing my rules.
Ethan Kho:
Within your process, how does your idea generation part work? So Robinhood, great idea. If you let that run, amazing. How did you go from ... Because I'm sure you're always analyzing the sector, but what are the things you look for or the ingredients that form a great idea in your eyes?
Derek Pilecki:
Yeah. I mean, I think it's a name that is less trafficked or it's not talked about. It's not controversial. And if I can come up with the investment thesis that it'll be a double in three years, that's kind of my hurdle rate. That's kind of mid 20s IRR, double in three years. And you can come across a lot of names like that. And so it also adds a little bit of discipline because you don't burn up a lot of capital on mediocre ideas. You're only putting money into things that you think can really have a lot of upside. And so kind of just keep a running list of things that are interesting. And there's a lot of things that are in process. Maybe the stock price isn't low enough yet to get you a double, or maybe you need to see some more development of the idea play out before it starts.
I guess one thing we talked about was buying stocks that are up or stocks that aren't reflecting good news. I think markets tend to underreact to good news. And so sometimes you can just be patient and even though good things are happening, the market won't believe it and really embrace it and it'll give you time to get into a name. You might not bottom ticket, but you'll have more confidence and more confirmation of your thesis by paying up for it a little bit.
Ethan Kho:
So you're very often looking at the names and identifying, "Hey, this one in three years can double." And as that one starts to rally and you've been watching it and you've been watching it on a daily, that is typically when you choose to buy?
Derek Pilecki:
I'd say so. That's the best entry points where you think there's a lot upside, the stock starts working and then you start to participate as it moves higher because other investors are seeing the same thing you're thinking and the stock price is giving you confirmation of what you're seeing is real.
Ethan Kho:
I see. And correct me if I'm wrong, but in the money that you manage, your entire liquid net worth is in your fund?
Derek Pilecki:
It is, yes. Yeah. I mean, I just think it's a great way to compound. I make all the decisions, so I just think it's a great way to compound my own money.
Ethan Kho:
I don't know if this is a foolish question, but why only trade financials if all your money is in the fund? Surely over the years, there's been some temptation to look at tech and AI and all these different things. And you're a sharp investor. I'm sure you see what's happening and have a view on it. You've never decided, "Hey, maybe we should touch that.
Derek Pilecki:
" I also manage a mutual fund and we have a handful of non-financial stocks in there, Meta, Dell, but really I have expertise in financials. I don't think people should pay me to buy healthcare stocks. I feel like I have edge in the sector, and so just want to play the game where I have an edge, right? That's how I think about it.
Ethan Kho:
And on edge, how do you continuously advance your own edge within the space? I know you're continuously looking at opportunities, but are there processes that you abide by, ways to develop your acumen or pattern recognition? I
Derek Pilecki:
Mean, I think repetition is a great way to develop edge. The more stocks you look at, the more stocks you buy or trades you put on, you develop skillsets and it's a muscle and you build that muscle over time. I think it's meeting with management teams. I was at a conference last week and met with 10 banks. That's great repetition to talk to the CEOs about what's going to drive their business forward. How do they view the value of their stock? How do they create value? I think that it's just consistency of meeting with 100 or 120 companies a year and going through earning season. It's just continuously looking at the same things over and over to develop that edge. Also, I think I have a very different view of the financial sector than other people. I think the financial sector has fundamentally changed for at least the rest of my career.
It'll eventually, in future decades, it'll go back to the way it was. But we're in this period where we've had massive regulation from the Dodd-Frank bill after the financial crisis. And I think the management teams have been so scarred by the great financial crisis that we're not having normal underwriting cycles like we had before. And all these management teams had near death experiences in 2008 and 2009, and we're very far away. It's like my grandparents grew up doing the Great Depression and they were thrifty, and it wasn't just my grandparents, it was all their peers. And I feel like the great financial crisis was the equivalent of the Great Depression for this generation. So I think we're 18 years since the great financial crisis. And if you think we normally have a financial event every 20 years where we would be right on the doorstep, I don't think we are.
I think the banks have a lot of liquidity. I think they have a lot of capital. I think the system is very liquid. So I think that view is not widely held. I mean, we hear all this stuff about what Jamie Diamond said the other day where he's seen a lot of things about it's 2008 again with private credit. I'm sure that there's some private credit funds that have made bad loans, but we're not nearly as levered as we were in 2008. The banks are very liquid. I don't think we are on the precipice of another crisis right now.
Ethan Kho:
Why do you think you have a differentiated view?
Derek Pilecki:
I mean, I think there's a lot of people who just don't like financials or they lost so much money on big cap financials in 2008. They just have sworn them off and said, "I don't need to bother with this sector." And I think that's the generalist portfolio manager view of, "I hate the sector. I'll own it if it's working, but otherwise I don't want to be involved."
Ethan Kho:
And what do you think that most other financial PMs trading financials, what do you think you get right that they get very, very, very wrong?
Derek Pilecki:
I mean, I don't know with our thought processes necessarily. I think there's some very good businesses within the financials and I try to focus on them and I think there's a lot of mediocre businesses and financials and I ignore those businesses. There's a lot of generic regional banks that just have ROEs that are uninteresting and that they're trying to grow through M&A. And I think there's large swaths of the sector you can just ignore because they're run by CEOs who are not interested in creating shareholder value. They're interested in having bigger banks. And so I think that's, I stay focused on the high ROE companies of management companies that are trying to compound their tangible book value growth. And that's what I focus on.
Ethan Kho:
I want to paint a picture that suppose you were to be wrong and that the private credit crisis ends up being destruction, right? Because I just had the thought of how a top PM or fund manager would navigate a situation like that and having not positioned themselves accordingly, right? What would you be thinking? I guess let's hope you're not wrong, not even for your sake only, but for the world at large, it wouldn't be great for us to have another financial crisis, right? But if you were to be wrong, how would you think about that situation?
Derek Pilecki:
Yeah, I mean, I think the banks have provided a lot of back leverage to private credit. So Wells Fargo has the most loans outstanding to non-bank financial companies and they've underwritten that business supposedly to a zero loss. They don't expect to take any losses on any of that business. No. Is that wrong? Have they provided more leverage than they've said or is there double leverage that we can't see from the outside? Or are the companies that these private credit lenders have funded, even though they've funded at low loan to value ratios, are the recovery's going to be zero because a SaaS company that fails has no collateral. So it just goes that even the senior loans are worth zero. Those are the areas where those seem like extraordinary assumptions, but that's where I would worry.
Ethan Kho:
And let's say you dig into that and it seems good from the outset, like the fundamentals are sound, but let's say the market moves against you. The way in which you've outlined your process to me is that you like to buy on the way up, right? Would you be, I guess, doubling down or every single ... As the market tanks and hoping for the come up, is that the mindset of a PM like yourself or are you cutting your losses and thinking there's something I've-between
Derek Pilecki:
I'm not really adding ... I don't do a great job of cutting risk and down markets, but I definitely don't compound risk by adding. So it's more just re-underwriting and saying, "Okay, is this a market perception?" The banks were down pretty hard last week, both on Monday and Friday last week, they were down on some of these fears. And so is that a market perception thing or is there real tangible evidence that I was wrong and if I'm wrong, then we have to make a change. But so far I haven't seen tangible evidence that I haven't talked to any bankers that are worried about taking losses in this area. All I've seen is rankings of banks with the most loans to non-bank financials. I haven't seen where any banks have had to set outside loan reserves for losses in this area, but I'm not looking to add to Western Alliance or Axos Bank here just because they're down.
I respect the market, and so the market collectively is smarter than me, and so I have to pay attention to that and I'm not going to ... It's too fresh of a situation to add to them here.
Ethan Kho:
If you're looking at sectors in general, and so not your process within the financial sector, but the financial sector as a whole, compared to other sectors, I guess a top-down view of things, would you be long? Do you think the sector overall will perform well? Or do you think someone in your seat who capitalizes on, say, dispersion and different opportunities within the sector is much better off?
Derek Pilecki:
I mean, I think there's a lot of dispersion right now in the sector. There's a lot of things going on with what we just talked about with private credit, and then you layer in AI with ... AI's caused some fears in the financial advisor space. And so I think that's very interesting. It's also caused some fears in the insurance space, especially insurance brokers. And so I think there's a lot of dispersion going on here. I think this is the opportunity set that's interesting for people in my sea of which of those fears are real and which models are going to get disrupted the soonest, especially they move a lot of the info businesses like S&P and Moody's and Visa and MasterCard into the financial sector. And so that some of those stocks have been down extremely hard, FactSet and VeraRisk and Morningstar. And so those are super interesting situations, like very multi businesses that very asset light, not capital intensive businesses that usually trade at high multiples and the multiples have been crushed.
So I think it's a very interesting time here. I think it's too soon they've gone down too much too quickly. I think one of those names could be an opportunity for me later this year, early next year as things kind of settle down and maybe those businesses won't get disrupted by AI, but the multiples will remain low and just let the stocks heal a little bit and the shareholder base will turn over and potentially present opportunities going forward.
Ethan Kho:
Yeah. I guess if we're looking at a situation like that, the question you asked was maybe the multiples are going to remain low even if the businesses themselves are not disrupted. How do you think about situations like that? I guess more generally, thinking about human behavior or the behavior of the market and forecasting that as part of the process as well as fundamentals, because I guess anything can happen regardless of you see the act, what is actually happening? Yeah. How do you navigate a situation where your positions are hammered if just the market doesn't like them, even if everything you said and researched played out exactly as you said it would?
Derek Pilecki:
I mean, I think you have to think about it in terms of who the shareholders are. And so take a stock like Morningstar or FactSet, like high multiple stocks, great, steady growth businesses, the charts are broken. The stocks have rolled over. There's a set of shareholders who will not buy those stocks with the way the charts look right now. Maybe one of those companies has a V and bounces right back up. But my guess is that of all the companies that have gone down, there's going to be a few that don't V, and I'm thinking about those as potentially opportunities for me in the future. I think it's too difficult to figure out which ones are going to V, or at least I'm not going to be the one to figure that out right now. There's probably 10 of these companies that have all gone straight down.
Some of them are going to keep going down, so I don't want to try to catch a knife. And some are going to be, I probably can't figure out which one the market's getting comfortable. And the rest, they're going to have broken charts. And so the shareholder base has to turn over. And once those shareholders have exited, they're not coming back to the stock quickly.
The chart has to heal and the stock just has to mark time as the shareholder base turns over. And then as the chart kind of puts in a base, it'll reattract those former shareholders, but that might take six to 12 to 24 months. So that's how I think about it, of like, who were the former owners? Who sold it down? Are they coming back anytime soon? Probably not. And then you kind of have some time to wait. And in that waiting, you can see are there any effects of AI to Morningstar's business over the next three quarters? And maybe there's going to be no effect. And so a year from now, we can buy Morningstar stock at a similar price, but have more confidence than we do right now.
Ethan Kho:
Yeah. I mean, talking about AI now, I guess the elephant is in the room is the Citrini's article that moved the market. And first off, what struck me the most is the fact that this is a Substack and I'm seeing Bloomberg about it, seeing the market tank off the back of a Substack one day, obviously. But first of all, how does that work? And second of all, what were your thoughts on the AI Doomer whole narrative?
Derek Pilecki:
I think it's super interesting and it's a great discussion to have because the rapid pace of the improvements of the models is what's the most scary. Maybe the models today can't replace some of those functions, but they've made so much improvement in the last three months. What is it going to look like three, six, or 12 months from now? And so I think that is very hard for people to get their head wrapped around of how much improvement there's going to be over the next short amount of time. And so I think that's what's the most scary part of this. And so I come back to it. I think there are some businesses that were sold off like insurance brokerage. I have a hard time believing that AI is going to come in and companies, commercial companies, like big corporations are going to ditch their insurance brokers because they're going to use AI.
I think there's advice and market knowledge the insurance brokers have that AI is not going to be able to capture. And people, the trust that the big corporations have with their insurance broker is not going to be replaced by AI. So the same thing with financial advisors, like Raymond, James and Ameriprise were both down hard on these fears. People who use a financial advisor do it because they like that human interaction, the advice and the advice they get when the market's a little rocky. We've had Vanguard out here for 50 years offering single digit basis point portfolios. You can very much get a cheaper financial portfolio as an individual investor through other alternatives than a financial advisor. I mean, that's no secret. I think that advice and people want that human interaction, I don't think that's going to change. And so I think on those two particular businesses that sold off on AI fears, I understand there's a lot of white collar work that's going to be replaced by AI, but I think when the work is trust and not just busy work, I think those are much more sticky.
Ethan Kho:
And when you're looking at names, do you try to own names that have, I guess, human components embedded within their existing businesses?
Derek Pilecki:
Yeah. I mean, ideally I do, but everything has a price. I mean, so I do own some commodity businesses that don't have that. Would I pay 35 times for Moody's? Probably not. But would I pay 10 times for Ameriprise? Yeah, I would. And I pay five times for Jackson National, which is a variable annuity business that's just a capital intensive business. So everything has a price, but obviously you're willing to pay higher valuations for businesses that have that human interaction.
Ethan Kho:
Do you think that parts ... So you don't think that portions of the investment process can be outsourced to these models?
Derek Pilecki:
Oh, we're trying. We're trying to ... I mean, I use AI in my process now. I use it to help me review SEC 10Ks and look at risk factors and the changes in risk factors year over year. I can get through a lot more companies with my AI tool looking at the changes in risk factors. It's a lot easier to compare documents. When I met with the 10 company companies last week, I had an AI tool help me prepare some questions that I wrote some questions out that I wanted to ask and then I had the AI model say, "I'm meeting with this bank based off their last quarter earnings, what are 30 questions I should ask them?" And so I'm trying to accelerate my process and my analyst is using it too, and we're trying to figure out ways to use AI to look at more stocks.
We want to turn over more rocks and look at more opportunities. And hopefully AI will improve our process by letting us analyze more companies faster.
Ethan Kho:
What do you think of the potential damage that can be done, especially for people who haven't put the investing reps in outsourcing their thinking to these models when they haven't actually had a grasp of let's call it grunt work, call it deep field research. How do you think about that?
Derek Pilecki:
Yeah, man, I think that's definitely risk and it's like how much of your investment process are you going to outsource? Are you going to say, "Build me a portfolio?" Or are you going to say, "Hey, I'm meeting with this company, what were the hot issues on the last earnings call that I should probe and more deeply?" So I think it's, do you use it as the fill in a little gap or using the model for the entire process?
Ethan Kho:
What are the opportunities that you think can come about from people outsourcing parts of their process to AI?
Derek Pilecki:
I think there's less people looking at stocks nowadays than there were historically. I mean, a huge percentage at AUM is passive, so they're just not looking at stocks. And then there's a lot of quant models out there and they're not necessarily looking ... They're looking at some of the metrics, balance sheet metrics or earnings metrics or earnings estimates or price momentum, but are they going through risk factors? Are they going through footnotes and financial tables? And so can the active investors that remain like me or my competitors, can we look at more stocks because we're more efficient or more productive? And so that's how I think about it'll just allow us to look at more names.
Ethan Kho:
Is part of the reason you've expanded your number of name, you're holding account from 25 to 40 because you can look at those more names or did that just happen, but are you looking to expand your holdings even more?
Derek Pilecki:
I think I'm comfortable with around 40 or 45 names. I think what really got it to expand was after Silicon Valley and First Republic failed and I made the decision to buy a lot of regional banks. The regional banks trade fine, they might trade 75 or 100,000 shares a day. And even though I'm a relatively modestized fund, buying a four or 5% position in a stock that trades 75,000 shares a day might take me a couple weeks. And so instead of having four or five, 5% positions in these small banks, I decided to buy 15, 2% positions. And so that was the initial impetus to expand the number of names. And then I've just gotten more comfortable with owning more names as a result of that. And so I like having more names in the portfolio and there's more to do. And yeah, I've just gotten more comfortable with more names.
And all my names are in the financial sector. So even though I own 40 names, it's not like it's buying the market. I mean, they're all very similar. I have the same investment process. So a lot of times they move together. So those 15 regional banks are all the same trade. APE, one times tangible book, growing earnings 13% a year, buying back stock with the excess capital. That's all the same trade, but it's 15 names.
Ethan Kho:
Now, you're in the financial sector. Do you ever, I guess if you're raising money from allocators, say hedge out my exposures just to give this, have a product that's, I guess, high sharp, low vol. How do you think about that?
Derek Pilecki:
Yeah, I've thought about that. I'm a long biased investor. I hate when the market's up and I'm not up too. And so that concept's foreign to me is running market neutral to have high sharp. So I mean, I know that that's kind of where the market is, but that's just not where I'm comfortable. And I think about it in terms of I have a pretty aggressive portfolio as far as the names, there's a lot of high beta names in my portfolio. And the implication is if I have a high sharp, then somebody could invest in me on a leveraged basis and uncomfortable with that. So just because in a crash, market correlations are one and everything will go down. So I haven't been comfortable having people use leverage to invest in me.
Ethan Kho:
And do you think that, I guess since we're now talking about risk, is your mindset with regards to risk one, just that's very common sense based rather than trying to hedge out all the exposures, make sure the vol's within a certain range and then lever up tremendously. So you get, I don't know, 10% annualized vol. How do you think about risk, I guess? Yeah.
Derek Pilecki:
I mean, I think more in terms of permanent loss of capital rather than mark to market loss. So I think about it in those terms of whether the chances of this business will get impaired during the time I own it and I'll have to move on and make up that capital in another investment. So I don't think about it in terms of volatility. What I don't like about, you mentioned I higher returns, I have high volatility, so my sharp is 0.75, and I know that's not impressive to some people, and I've done a few things to try to lower my volatility without damaging my returns. And so I've moved my net exposure from 75 to 50. I have a couple of trading positions on the short side that on some high band names that I try to trade around to generate profits and down markets.
So I am trying to reduce my volatility without hurting my returns, but as far as going to a market neutral portfolio, I have not done that.
Ethan Kho:
Derek, I think your returns speak for themselves and you have an amazing product, right? What are your barriers to scale?
Derek Pilecki:
Huge scale. You mean what my capacity is?
Ethan Kho:
Yeah, I guess what's your capacity and how big you want to grow your business?
Derek Pilecki:
Yeah. I mean, I've always been very focused on returns and not AUM. And so I look at my track record on my 18th year of running the fund and I like what my track record's been. And if I can continue somewhere close to that through the end of my career, I'm going to do this for another 15 years. If I have 32 years of track record similar to where I am now, I think that puts me in rare company. And so that's the life goal. My life goal is not to run a billion dollar fund. My life goal is to have the track record comparable to where it's been. I think through natural compounding, the business is going to get bigger. I think I can make money in the markets and I think I'll continue to do that and it will just compound. Say I was, I think if I quadrupled the size of my business, so from 350 to 1.2 billion, of my top 20 names, I wouldn't own more than 5% of any of my ... Only three of my top 20 names would I own 5% of.
And so I feel like maybe 1.2 billion's too big. Maybe my capacity's a billion or 900 million, but I could triple from this size and still move my names around.
Ethan Kho:
Do you think too many managers try to optimize for scale and building a product that can raise as many dollars as much as possible from the allocators and just try to run it like a fee-based business? Do you think more people should run it like before of just putting up great returns year after year after year?
Derek Pilecki:
Yeah. I haven't talked to enough successful portfolio managers or successful funds to really understand what their thinking is. I mean, I've heard stories about managers changing their objectives once they get large enough size and that management fee stream is a big number, but I don't have firsthand experience or haven't had firsthand conversations with any managers like that. I think there's a lot of hungry people. I mean, hungry by people who want to do well and have high returns, I think there's plenty of people still trying to put up good returns. I mean, I think it's been a tough market. Outside of financials, the Mag7 are such great businesses. It's hard to compete against those businesses or to manage a portfolio and outperform those businesses. So I think it's been a really tough ... This bull market's been really tough for hedge fund managers because you've had such big companies produce such great cash flows.
So I think it's been a very tough market for a lot of managers.
Ethan Kho:
Yeah. I actually don't think that's something that's talked about enough that ... I mean, obviously everyone talks about how concentrated the indices we're getting and still are, and that these businesses have compounded at just phenomenal rates, but that I was ... I'm young, and I remember just maybe a couple months ago, I was thinking about it, how do you beat the market when the businesses that have the highest weighting in the market are doing exceptionally well? And so theoretically, the way to beat it is to size those up more, but then you're not really creating a differentiated product, right?
Derek Pilecki:
That's exactly right. Look at some of those businesses like Google, Microsoft, Meta. Those are amazing businesses. Meta, Instagram, just take my money. Instagram, I'm like, every other ad I want to buy the product. It's amazing. And so how do you compete? How do you buy other stocks other than those big stocks and outperform? I think it's really hard for the industry.
Ethan Kho:
I was talking to a fund manager, I think it was four weeks ago, and then I was saying, "Oh, do you think there's more opportunity for much smaller funds investing in very small caps and then capping the portfolio size at say hundreds of millions of dollars and then just holding a lot of different names, but then at small caps, you really can't hold that much of any." And he told me that he thinks it's a paradox, that people think that there's more edge in small caps and that the large caps, there's actually a lot of opportunity and there are certain narratives that proliferate and one can, I guess, profit off of those. What are your thoughts on that? Do you think there's more opportunity in smaller names or you think it's the same everywhere or similar everywhere?
Derek Pilecki:
I mean, in my sector, I see a lot of opportunity in small caps. I mean, when I look, we talk about the market being expensive. When I look with Justin Financials, the large cap financials are the most expensive financial stocks. And so go down to small midcaps, there's a lot of cheap stocks in small mid-cap financials. And so I don't know what it looks like. I just assume that it looks that way across other sectors of the market, but I know within financials, the best opportunities that I see is small mid-cap financials because the valuations are significantly cheaper.
And they can affect change in their businesses more. So if they have positive change, they really can get the stocks going. And so I think you can make a manager focus on small mid-caps can make a lot of money. The valuations are cheap, the Russell 2000 hasn't gone anywhere for years. I think there's a lot of cheap stocks that are small mid-cap. So I mean, that's not to say ... He's right, there is opportunity from time to time in large caps. And if you have a differentiative view or you have some edge in something, you can make money in large caps too. But I think that the valuations in small mid-caps is super interesting.
Ethan Kho:
You've been in managing money for quite some time, and I'm sure you have many friends in the industry who've done well, some have not done well, some not so well. What are the traits that you can see of managers that aren't just able to have one great year, but consistently have edge and do very well in the market as you have?
Derek Pilecki:
Managers that have a consistent process that understand their own emotions. And I mean, I think Stan Druckenmiller talks about this, that when he's on a cold streak, he trades small, and then when he's on a hot streak, he parlays it and goes big. And I think that understanding that about yourself and when do you make your best decisions? So right now, February was a tough month, right? Financials were down, especially at the end of the month. And so right now, I feel like I'm trading a little bit smaller. I'm not as active. I'm just trying to pick my spots of things to do. And so, and that'll build up over time of as I make a few right decisions, my confidence will grow again and I'll trade bigger. And so I think that's ... And I know that right now I'm just trying to focus on the portfolio and I'm not trying to stretch myself too thin on other commitments and stuff.
So you just figure out how you operate, what's your discipline.
I think the investors that I've seen in the past that have not done well consistently over a long period of time, I think they try to ... They don't stick to just the basics of ... And because it gets boring, right? You buy cheap stock, it goes up, you sell it, buy cheap stock, goes up, you sell it. There's no reward for degree of difficulty. It's not a diving competition where you get judged. It's just making money. And if you do it in a boring way, it's still the same money. And so I think some people try to get too cute and try to ... Instead of making money, they try to make the next great call. And so-
Ethan Kho:
Yeah. I guess you don't want to continue.
Derek Pilecki:
Boring, but I stick to financials and I buy cheap financials and I think that consistency has paid off some.
Ethan Kho:
I think that's underrated advice for anything, anything you do, like doing it really well and it will get boring and just continuing. I mean, I listened to The Founders Podcast by David Sendra and he'll talk about the Rockefeller and Carnegie and what they did exceptionally well. And I think this is something that everyone can take is just they had their business and they had maniacal focus. For you, how do you keep that focus? Do you ever get bored with financials? I
Derek Pilecki:
Love financials and I get super energized by managing money for my investors and wanting to do a good job for them and getting positive feedback from them and wanting that to continue. And I know the best way for that to continue is for me to keep looking at financials. But back to the previous conversation, I'm going to bring up a manager that is well known and he's very successful, more successful than I will ever be. But John Paulson, Big Short made billions of dollars. And then after the financial crisis, he had this big bet on gold and it was working in 2011. And then gold after 2011 kind of meandered for a few years and his returns didn't keep up. And he's a super impressive investor, very successful. But that was the example I was thinking about when trying to make the next big call.
And eventually gold was a spectacular investment over a long enough period, gold above 5,000 now. It's been a five faggot. It was right, but it was that period of time of 2011 to whenever 2014 that it was really problematic and hurt his fun. And so I think of that as like, he made the big short call, that was great. And then was he trying to be too smart and do the gold call next? And did he do in too big a size? Or I don't know exactly, but that's what I was thinking about when I made that comment about trying to make the next call rather than make money.
Ethan Kho:
After you have a great year, do you find that the next year you ... Does that do damage to your process? Is it neutral? Do you improve? I'm curious.
Derek Pilecki:
I mean, I think momentum's a real thing, right? And so I have a great year. I usually have a following ... January is usually pretty good because the market Q4 is usually a pretty bullish time period and it kind of carries through to January. And so I feel like a lot of times I'll have a great year and then all of a sudden it's January 20th and I'm up. And so it kind of continues. I do use the end of the year to think about tax law selling and trying to purposely think about in December, can I buy two or three names that didn't perform well this past year that is ready for a bounce because we're having tax laws selling in December. And then when that pressure alleviates around Christmas, it starts to bounce into January. And so I think that's something that I try to do every year to try to get off to a good start.
And time flows so rapidly. It's not like a year ends and I just sit around and reflect. We're just going. It's just a process and we're day to day. It's just market opens tomorrow and we'll do the same thing. So I don't reflect a ton on the previous year. And I think that the combination of buying some tax loss, selling names, and then momentum of my existing names generally gets the year off to a good start.
Ethan Kho:
I'd like to ask some advice, and this is for younger people. How do you know if money management's for you?
Derek Pilecki:
I think a lot of people come to me and say they want to get into the business, and I think the business is much harder than it was when I got started. It's harder for small funds. There are not as many seats. A lot of the seats are quant-based versus fundamental based. And so I think it's a more difficult industry. I think you have to love investing. You have to want to wake up and read the Wall Street Journal as soon as you wake up and you have to want to spend Saturday mornings researching stocks because the phone doesn't ring and you can get five hours of interrupted time to read earnings reports and conference call transcripts. If that's what you want to do, then go ahead and do it. But if you want to do it for money, I would not try to get in this industry because of money, because if you lose your job anytime after the age of 32, it's hard to get another job.
Once you're off the track, you're done and the business doesn't hire a mid-career analyst. And so I think there's a lot of people who get into the business and then in their 30s or 40s have to go find another career. And so I think it's risky from that standpoint. I don't think the ongoing forces of active to passive and quant are abating anytime soon. So I think there's going to be fewer seats in the future. So I think you just have to have a real conversation with yourself of, why do I want to do this business? Am I really passionate about reading about stocks and picking stocks? And am I okay? Am I ready to prepare myself if mid-career I get fired or something happens to my company and my seat goes away and I'll have to make a change mid-career? I think there's some things that people don't talk about.
I've had a lot of friends who lost their job in their late 30s or 40s and weren't able to find a new seat and they struggle. So while the rewards can be great on the upside, it can really mess with you mid-career, mid-life. You have a young family and you're trying to reinvent yourself, that's a real possibility.
Ethan Kho:
That's brutal.
Derek Pilecki:
Yeah.
Ethan Kho:
Absolutely brutal.
Derek Pilecki:
I mean, I think it's not just the buy side. I mean, I think that happens on the sell side too.
Ethan Kho:
I don't think that's something that's talked about enough. When people give early career advice for young people, it's often, what are you interested in? Are you just in stocks? And you can get by by just asking yourself a couple of questions of, "Yeah, I find that interesting." I think my businesses are interesting, but I don't think ... As you said, this is probably the most competitive industry there is. It's one of them, for sure. Fewer and fewer seats, pod shops getting bigger. Yeah. I guess final question, let's say I answer that question. I say, "I want to be in this industry for a long time. This is what I want to do. " What is the one thing that very few people actually do that leads to outsized career returns, let's say?
Derek Pilecki:
I mean, I think if you want ... I try to tell people this, if there's an opportunity with ... And this opportunity's been there for about 15 years, but since we have the internet, there's a way to break into an industry that what didn't exist in the 90s. You can write up stock ideas, you can research how to write up a stock idea, you can write up your own idea and you can post it to Seeking Alpha or create your own blog, post it to Twitter. And if you do that 10 times, you'll have a following and people will follow you, including professionals. There'll be professional money managers who will read your blog because you wrote up 10 small cap stocks because they own one or two of them and they want to read other ideas. They read your idea on this bank, and so they want to see what other banks you like because they agreed with you on this idea.
And so you can find a job that way by just writing up stock ideas and posting them to the internet, and that didn't exist in the 90s. And so you can break into this industry if you want to, if you're willing to do that work on your own and put yourself out there.
Ethan Kho:
I love it. Simple, actionable, and directly translates to what the job you'll actually be doing. Thank you for coming on Odds on Open, Derek. This has been a pleasure.
Derek Pilecki:
Yeah. Thanks for having me, Ethan. Good talking to you.
This video is for informational purposes only and is not intended to be a solicitation of, or offer for, investment advisory services or investment advice of any kind. Any sponsored videos or ads throughout are not in affiliation with Gator Capital Management and do not necessarily reflect the views or opinions of Gator Capital Management.
Past performance is not indicative or a guarantee of future results.
-1.jpeg?width=579&height=579&name=20141211_GCM_0027_edit_web%20(1)-1.jpeg)