Tobias Carlisle:
And we're live. This is Value After Hours. I’m Tobias Carlisle joined as always by my co-host, Jake Taylor. Our special guest today is Derek Pilecki from Gator Capital. He is a small cap bank specialist. Welcome, Derek. How are you?
Jake Taylor:
Our bank is advised. Is this synonymous with value these days?
Tobias Carlisle:
Hey, thanks for having me on. Are banks synonymous with value these days?
Derek Pilecki:
I think so. Yeah. I mean, I think you think about the normal valuation range for banks. It's 10 to 14 times PE and they seem to be trading eight or nine times earnings. So it's below the bottom end of the range. I think banks are cheap. I think we're still living through the post Silicon Valley First Republic environment. And so banks, they're trading cheap still. And I think there's some reason people really haven't figured out that the yield curve has more juice in it, so the banks can earn higher returns and M&A environments improving and deregulation is happening. So I can see a scenario where they get back to their normal valuation range, but they're cheap now. Small cap banks are cheap. I
Tobias Carlisle:
Actually thought you were going to say you thought it was a hangover from the GFC, but you short circuit me there. But what do you think about the ... It's my impression that banks have still suffered a little bit from that GFC, that sort of undiscoverable risk in the balance sheets.
Derek Pilecki:
Yeah, I agree with that, but the small mid-cap banks really hit peak valuations in 2018. So there was a time period 2014 to 2018 where they traded at quite high multiples. And so if you think about a lost decade, I think small mid-cap regional banks just had a lost decade from 2018 to 2013, 2018.
Jake Taylor:
To 2028?
Derek Pilecki:
Yeah. Yeah, maybe we are two years away from it actually happening, but in the last couple years, they've acted a little bit better. But if you go 2018 to 2023, it was flat to down.
Jake Taylor:
Why are there so many banks in the US? It feels like relative to the rest of the world, there's a lot of banks.
Derek Pilecki:
Yeah, I think it's an artifact of the interstate branching laws. You couldn't open up banks across state lines. And even in Texas, you couldn't open up a bank branch across county lines. And so every little geography had its own bank. And so those interstate branching laws were taken down during the '90s, and that's when we really started seeing consolidation. So that's the artifact of every state protected their banks from getting acquired by other states banks.
Jake Taylor:
And that trend line is just down and to the right, the numbers, like this consolidation wave. Do you think it's just going to keep going?
Derek Pilecki:
It will. We're not going to be as consolidated as Canada or Australia. We're not going to get down to five banks, but we're at 4,000 banks. We'll get to 400 banks or something that ... It was 13,000 the year I graduated from college, so we're from 13,000 to 4,030 years, 35 years. So the trend line's down. What
Jake Taylor:
Does that mean from an investment perspective then?
Derek Pilecki:
It's hard. I don't think we're in an M&A environment where there's a lot of excess returns from M&A. It's not 1996 where we have NationsBank and First Union overpaying for banks to get market share. The market's been very disciplined. If an acquirer overpays for a bank, they're in the penalty box. So I feel like bank acquirers are pretty stingy with what they're willing to pay. So if you're going to invest in banks just because of M&A, you end up owning a lot of mediocre franchises for a pop at some time. So I prefer to invest in the banks that are more organic growers or after looking at what their acquisitions have been, if they've made particularly good acquisitions like a First Citizens when they bought Silicon Valley, that's an opportunity to participate in M&A. But I don't think it's really great to just sit around in a bunch of mediocre banks and wait for them to get taken out.
Tobias Carlisle:
Derek, can you explain your strategy to us, please?
Derek Pilecki:
Yeah, I think it's a deep value strategy. I only focus on the financial services sector. So it's banks, non-bank financials like brokers, insurance, non-bank lenders. And I'm looking for names that have cheap valuation and for some reason why the valuation I think is going to change. And so I have a little rule of thumb. If I can come up with an investment case, the stock will double in three years, I'll probably own it. And so that could be something that's trading at six times earnings. They're going to grow earnings 12% for three years, and the multiple is going to rerate the 10 times, and that gets me a double. And so just do that over and over. I think there's particular businesses in financials that are attractive, that are either balance sheet light or grow attractively. There's some good growth banks. I think one very interesting thing in financials right now is there's a lot of franchises that have good organic growth that you don't have to pay a premium for that growth.
And I think there's some reasons for that. I think people aren't normally thinking about financials and growth. I think some of the banks that used to have growth multiples, those growth multiples went away after First Republic and Silicon Valley failed. So I think you can find some interesting businesses right now that are growing low double digits that you don't have to pay up for that growth multiple. But I think of it as a deep value strategy.
Jake Taylor:
How do you think about the potential left tail of ... I mean, GFC obviously was brought a lot of things to bear, but when there's so much that you're depending upon, how good is the asset side? And there's that joke that there are less bankers than there are banks. How do you assess that and then try to chop off that left tail, I would imagine?
Derek Pilecki:
Well, I mean, I think I'm pretty positive about the environment as far as where we are in the economy. I mean, I think after the GFC and then especially Dodd-Frank, the banks have a lot more capital and a lot more liquidity than they did 2006. And so I think we're 18 years away since the great financial crisis. If you think we have a financial crisis every 20 years, it should be happening. And I think that's what makes the private credit talk right now scary because it's about the right timing. I don't think we're going to have a systemic problem with private credit. They run with a lot less leverage and they don't have to fire sale assets when they go bad. Banks, as soon as they have a bad loan, the regulators are on top of them of sell the note, foreclose the property and liquidate.
And so that kind of drives prices down and it's not the best outcome. And where private credit can manage to the best economic outcome and manage through that, there's not the same deposit funding that forces them to be sellers. So I generally think the banks are in pretty good shape. And I think about recessions, the deep recessions we've had recently have been the savings and loan crisis and the great financial crisis, and they've been because the bank stopped lending to Main Street. In 01, 02, in 2020, we had recessions that were pretty mild. The banks continued to lend, credit was available to Main Street. So I think if we have a pullback or a slowdown in the economy, the banks are pretty far away from turning off the spigot to Main Street. So I think we muddle through any slowdown. So I feel good. I think the obvious fallacy in my positive outlook for banks is Silicon Valley and First Republic's failures, but I think that was just interest rate mismanagement 101.
We learned during the 80s you can't lend long and fund short, and that's exactly what they did. And so I think of course you can have individual institutions fail. I think systemically, I think we're pretty far away from the system failing, but I try to be open-minded about that positive view, but that keeps me positive generally.
Jake Taylor:
One of the arguments that we've heard about AI potentially lowering switching costs for all businesses. If AI can go and I can see there's a better rate at another bank and it can go do the application for me, close my account, and I wake up the next day and my account's moved, all of which is to say, if you do have lower barriers to exit, does the funding then become a lot less sticky? And now all of a sudden everyone looks a little bit more like SVB might been where a tweet caused people to try to yank their money out. How do you think about that, or is that something that's come up recently?
Derek Pilecki:
I think there's some aspects of banks that make them mediocre businesses. They're commodity-like, like what you just described, and they're becoming more commodity-like. There's not as much loyalty and the switching costs are coming down. There's threats from fintechs. I think AI is just another one of those threats. And so I think money's getting hotter over time.
You can bank through Schwab and Fidelity or Merrill Lynch or Morgan Stanley. So I think that is just increasing the competitive intensity of banking through time. So I don't think it's going to be a switch. All of a sudden they're unstable. I just think at the margin, the competitive intensity is increasing. JPMorgan is a monster. I mean, they have branches on 50 states. They entered Boston, Philadelphia and DC. They didn't buy any banks under those three cities. They just opened up 20 branches in each of those cities and everybody already had a Chase card or a Chase auto loan and started opening checking accounts there. I mean, that's not a FinTech, that's one of their own, just ramping up the competitive intensity. I also think about it in terms of consumers really bank at the big banks because of the branch networks and the ATM networks, small, medium businesses who bank at small and mid-cap banks.
And I think small mid-cap businesses very much depend on the credit provided by their banks. And I don't think they're moving to the big banks or switching that easily because the credit is sticky and that's the lifeblood for these small mid-cap businesses.
So there's some ways I think about it, but banks are okay businesses. There's some very, very good bankers. There's some banks that run very efficiently and grow their organic loans and earn higher ease and then reinvest that capital and loan growth. And I think you think about banks, the best performing bank stocks are the same banks that grow tangible book value at the highest rates. So if you did a screen and said, show me all the banks that have compounded tangible book value the fastest over the past 20 years and then looked at the stock returns, those two lists would be almost identical. So you think that's how I think about how to find banks in the long-term high ROEs, reinvest in loan growth, don't do dilute of acquisitions. How
Tobias Carlisle:
Do you think about portfolio construction, Derek?
Derek Pilecki:
Yeah, so I use a little bit of leverage. So it's a hedge fund. I run an 130% gross long and 80% growth short, so the net's 50. I think of a new position. I own more names on the long side than I used to. I used to run 25 names. Now I run about 40 names. So average position's about 3%. I let positions get up to 10% if they outperform the ... So a new position usually goes in three or 4%, and I tend not to add to positions once I've owned them. Either they get bigger because they outperform or they get smaller because they underperform.
Before I started Gator, I worked at GSAM and I had this old PM who used to tell clients, "We want our stocks to go down so we can buy more cheaper." And that's garbage.That does not. Sounds good. Sounds good. It does not work because you end up buying all the wrong ideas and the ones that are outperforming, you're not adding to. So it's not to say I never add to names when they're down for my initial purchase price, but the bar is pretty high for me. I need to re-underwrite and say, okay, these are the reasons it's down. And generally I don't have an automatic buy. And I think that's a way to really destroy capital, to keep adding the names that aren't working. And I wouldn't say that I'm super good about taking stop losses and exiting names, but I don't compound the problem.
And then I use a little bit of leverage because I've added a lot of value on the long side. So I've added marginal value on the short side, but my longs have way outperformed the index, and so I want to have more money into my long ideas. So that little bit of leverage allows me to own more of my longs. And then the shorts allow me to stay in the game when we go through a period the last few weeks where the market's down. I'm not getting crushed and it dampens my volatility a little bit.
Tobias Carlisle:
How do you think about shorting?
Derek Pilecki:
I mean, I think there's a lot of mediocre banks or a lot of mediocre financial companies. So companies that are going through mergers that I think are not well-priced or that I think are very complex or companies that have had mediocre ROEs for a long period of time, I think about those as just I'm not going to get hurt from them ripping higher and they're just going to, it's almost like they're funding shorts. It's hard to do valuation shorts. I think valuation shorts tend to run in my face. I try to find names that have some headwind to them. So I'm short mortgage insurers right now, and I just think there's home price volatility. With interest rates high, there's some COVID boom real estate towns that are inventories are rising, and I think that's just going to be a headwind for the mortgage insurers. Mortgage insurers, it's not 2006.
I mean, they're not zeros or they don't have a bunch of subprime. I just think there's a headwind there. And so I don't think they're going to be up in line with the market, but shorting is very difficult.
Tobias Carlisle:
I had a question here. Sorry, it just slipped. The risk of loan modification and manipulation of loan quality were raised by Bill Moreland of bank reg data. Are you aware of Bill's arguments and do you have any thoughts on them?
Derek Pilecki:
I'm not aware of Bill's arguments, but- Okay. So my interpretation is that is the extend and pretend.
Tobias Carlisle:
Yes.
Derek Pilecki:
And so bankers, when the loan's not paid off in contractual terms, they have to add that to non-performers. If they give some waiver of extend the maturity date or waive payments. And so I mean, I think it shows up in the regulatory data as far as non-performing assets. And so I think the credit quality in the banking system the last few years has been all time best credit. And so I met with 10 banks last week at a conference, nobody's concerned about credit. And I had another bank tell me, when they did M&A, they used to go in and one out of every three banks would have underwriting quality that they would find acceptable that they would be willing to bid on. And now they said today, any bank they go into, they all have credit quality that meets their minimum standards. And so I think there's just been a huge improvement since the financial crisis of loan administration, loan files are all standardized.
The consultant industry has made a bunch of money by getting all the bank's loan portfolios, their credit administration up to snuff, and the underwriting quality is pretty consistent across the board. So I don't worry about the banks underwriting. The credit numbers have been very good. We have seen a few bumps in the last six months, TriColor, First Brands, they tend to be bigger deals, but small mid-cap businesses or small medium-sized businesses, the credit quality has been very good. And even in office, it hasn't been terrible in the small mid-cap banks. Some of the large regionals have had some office towers in Midwest cities that have presented some problems, but they have relatively small percentage of the loans in office. So I don't have a huge concern about credit.
Tobias Carlisle:
Who holds all the office?
Derek Pilecki:
I think it's a lot in CBS. It's securitized. And so I think those towers are pretty big tickets. And so I think a lot of it gets securitized.
Jake Taylor:
So it's sitting in your pension fund right now? Is that the-
Derek Pilecki:
Right. Oh, great. Or
Jake Taylor:
Endowment or somewhere. Does the private credit world, what has that done in the last 10 years as it seems like it's become a bigger thing?
Derek Pilecki:
Yeah, I mean, I think it's been both good and bad for banks. So the private credit grew because the banks shrunk their credit underwriting box after Dodd-Frank-
Jake Taylor:
So all the adverse selection went off to private credit land or is that what ...
Derek Pilecki:
Yeah, I mean, they're probably getting enough rate to offset it. And that's real. I mean, there was a real reason why private credit grew. Has it gone too far? Is there too much private credit? Maybe there's some not great operators, but generally there was a good reason. And I think it makes the banking system safer. I'd rather the banks provide wholesale leverage to those portfolios than own those portfolios directly.
Jake Taylor:
Until we have to bail out some of these private credit guys because they're
Derek Pilecki:
Systemically- Do they get? I don't know either. I mean, I guess one of the things that was concerning, one of the things I'm concerned about with banks is they're providing this wholesale leverage. How often do they reject private credit loans from entering the warehouse? And so that's a consistent question I asked the bankers of, you have this private credit fund that you're providing wholesale leverage to. Tell me about how often you review the credit quality of those loans.
Jake Taylor:
What's the answer that they usually say for something like that?
Derek Pilecki:
Usually they say we review it as it enters the ... We have a day or two to review the loan file before we provide that funding on it. That's
Jake Taylor:
Not a lot of time to do a lot of DD. No.
Tobias Carlisle:
If you go to Derek's Twitter account, you'll see his pin tweet is calling out SVB, asking how- Silicon Valley Bank, asking how it was still solvent four months before all hell broke loose. Walk us through what you saw there, Derek.
Derek Pilecki:
Yeah, so I mean, I had owned Silicon Valley and I had owned it when I worked for Goldman, and then I owned it at Gator. I owned it in 2019, 2020, and I missed the run up in 21. I had a venture market during COVID, which is boom, Silicon Valley went from 200 to 700. I missed that run. So I didn't have a position in the stock, but I was reading the earnings releases during 2022. I think it was third quarter, and I looked at it and they had had massive deposit growth during COVID, just all the venture market boomed. All these companies had raised venture capital and put it on deposit at Silicon Valley, and they took all that cash and bought MBS, and then rates had gone up by then. And I looked at the balance sheet and the earnings release, and I was like, whoa, this is ... You do mark to market.
They had all the numbers in the press release available for sale, held to maturity and what their losses were, and just did the calculation. I put it on Twitter, tangible equity minus preferred minus these two sources of losses, mark to markets, negative four billion. And I was just like, whoa, I'm shocked the stocks where it is. It was above book value. And so then I put that tweet out and it was out there and people pushed back and like, oh, deposits are staying in and the regulators will look through the losses. And then one of my friends/competitors who runs a bank fund, when they tried to raise money in March, he quote tweeted me and is like, "Yep, today's the day they figure out Silicon Valley's insolvent." So it was interesting, interesting
Tobias Carlisle:
Time. To what extent is that the fault of Silicon Valley Bank's management? And to what extent was that sort of systemic throughout all of the banks? Because to me from the outside, they sort of look like they're doing the right thing. They're putting a lot of it in treasuries. Treasuries. Yeah. And we've had this 40-year falling interest rates. There's a chart doing the rounds that says that they've been falling for 6,000 years or something like that. And
Jake Taylor:
We just hit the inflection at the bottom.
Tobias Carlisle:
20% of the world has negative yielding rates. And so it's not unreasonable to think, well, maybe rates are going to go negative in the States. Maybe you are safe putting it on the two-year. I think that was such an unreasonable amount. I think it's really their fault.
Derek Pilecki:
I think they buy 30-year mortgage-backed securities with a one and a half percent coupon. Even if the rates do go negative, they can always go positive in a big way at some time over those 30 years. So the safest thing ... And it was in checking accounts. The funding came in through checking accounts that are demand deposits. So you should really just be in treasuries, very short-term treasuries. And they had swept a lot of the deposits off balance sheet into money market accounts, and they could have done that too. So I think it's entirely Silicon Valley's management fault. I think the shocking thing is same thing happened at Schwab and the same thing happened at Bank of America. And Bank of America had a trillion dollars of MBS at one and a half percent coupon. I mean, that's shocking. And it just ... Buffett carried a lot of cash during that time too.
He didn't put it in MBS. He had it in turfery bills. That's the right thing to do. So I think it's completely on managements.
Tobias Carlisle:
Yeah, I think Jamie Diamond had a similar ...
Derek Pilecki:
Yeah, right. Diamond had very ... It was all duration. Cash at the Fed. And that's what you're supposed to do.
Jake Taylor:
What about- But I got to make my earnings numbers, Derek, what am I going to do with this? What is this yield for ants?
Derek Pilecki:
It's so frustrating. I mean, as a former long owner of Silicon Valley, it was a great franchise, and I was very angry that they destroyed that great franchise. And so it's super sad.
Jake Taylor:
In kind of a silly way too, because my understanding was that they had some interesting option-like characteristics to early stage companies that they would get. And you had a decent bank stapled with this interesting call options, and then you blow it up on the most mundane, stupid banking 101 thing, right?
Derek Pilecki:
Completely agree. I mean, they had a 60% market share of venture capital funded companies. They just had this near monopoly. It was this ecosystem in Silicon Valley ran through Silicon Valley Bank. They connected people and just it was a really hard time. KSweet
Jake Taylor:
Mortgages or whatever. Exactly.
Tobias Carlisle:
What about Blue Owl? That's in the news a little bit at the moment. Are you familiar with what's going on with Blue Ow? Can you perhaps explain that to us?
Jake Taylor:
I've never seen a Blue Owl in the- It's been a wild, have you? What's happening there?
Derek Pilecki:
Yeah, I mean, I think they've been aggressive in their lending, and so they've raised a bunch of money, put it to work, and they have a non-traded REIT where they need to provide some liquidity to it. So they've done a few things to try to prove that they have liquidity and that the loans are marked correctly and the market's not believing it. So that's the issue. Where are we? Have they been too aggressive in their extension of credit? And that's what the market's telling you. And they haven't been able to disprove it. This transaction recently where they sold loans at 99.7% apart, there's machinations underneath it. Was it a true sale? Was it to a real third party? People don't believe it. So until they answer those questions, I think there's going to be a cloud hanging over it.
Jake Taylor:
Well, how's you going to buy the Tampa Bay Lightning if you're less what you're really getting after it?
Tobias Carlisle:
Yeah. What about the BDCs? Do you follow BDCs at all?
Derek Pilecki:
I don't. I don't love the risk-reward ratio. If everything's fine, you make 12% and everything's not fine, you're down 40%. So I just don't love that setup. And it seems like they degrade book value through time through losses. And so I don't love BDCs. I think it's a retail product for people who hunt for yield, and I think it's prone to blow-ups. I mean, I think Aries runs a good BDC, so it's the blue chip, but there's a lot of other things to do in financials. I don't need to participate there.
Tobias Carlisle:
Obviously, you keep an eye on the large banks, but you don't tend to participate much in the larger banks because they're just too well-known to expose every single portfolio, fully valued.
Derek Pilecki:
I'm sure a bunch of ... The valuation is higher. Oh, you're better. Yeah. So I mean, JP Morgan's a great business 15 times and three times tangible value is not a good value. And so I think we're a weird thing where the small banks are trading at eight times earnings and the large banks are at 12 times earnings. And so that's usually backwards because you have M&A premium in the small banks and they can grow faster. And so I think part of the reason why the large banks are trading at high multiples is they've had some improvement in their capital rules, and so there's been expectation of more buybacks and
They're also been deemed too big to fail. So they're very stable businesses. They have very low loan to deposit ratios. But I also think we've had this move from active management to passive management. And we talk about the market being expensive and because of that and all the flows into the spy are going into the large cap companies, if you look just at financial sector, the highest valuations, the largest cap financials, Berkshire, JP Morgan, Visa, MasterCard, Progressive, American Express, Morgan Stanley, those are the most expensive financials and they also happen to be the biggest. So I mean, I've owned JPMorgan in the past when it was one time as tangible book value. And Jamie Diamond's the best banker in the world, so there's no reason not to own it at the right price, but today is not the right price. Me and Jamie sold a lot of stock himself personally.
They complain having to buy back their stock with their excess capital. They're telling you their stock is not attractive. So we're just at a weird time where the largest cap companies are the most expensive.
Tobias Carlisle:
Yeah, that's something I've been talking about a little bit on Twitter that since the pandemic, the large caps are more expensive than mid-caps and small caps, which is historically unusual if you go back over the last ... The last time that it happened was the late 1990s and the run up to the dotcom, and then it clearly in the early 2000s, that reversed pretty violently through to 2015 or so. And it's been trending back the other way since then, but that's a historical for the most part for the reasons due identify that small, medium tend to grow faster than large, and as a result, they tend to trade at a higher multiple.
Derek Pilecki:
Right. I mean, I thought that when we got out of zero interest rates that small big caps would outperform. I think there's some historical correlation between interest rates and small caps outperforming, but that didn't really happen or it happened episodically, but we still have this persistent overvaluation of the large caps. I think
Jake Taylor:
It's- Toby, what happened small or large at the end of the tail end of the Roman Empire?What was that?
Tobias Carlisle:
Well, interest rates are much higher and interest rates have been falling since. So it's been a ... When does that chart go back to the Wald City of Eric and Gilgamesh or something like that? Yeah, right. 6,000 BC. There's First Brands and TriColor, is there some cultural underwriting? What do you make of the issues that they have?
Jake Taylor:
The Bear Stearns hedge fund failure in early 2008 that was a harbinger.
Derek Pilecki:
Yeah. I mean, if we had this conversation last September, I would've been a lot more scared. And then we went through four months with no new issues, and then we had one last week where similar to First Brands. And so is there a systemic problem in collateral management and are the The big institutions not doing their work on collateral management. Three pieces of evidence saying that there has to be more work to be done there. So I don't know.
Jake Taylor:
But we need the answer. I mean,
Derek Pilecki:
That's the great thing about investing.
Jake Taylor:
It's a podcast. Just guess.
Derek Pilecki:
Yeah. I think investing under uncertainty is where you can really make a lot of money. Pattern recognition and mosaic, you don't have all the answers. And when you have all the answers, it's too late. So you have to make that guess and use that experience.
Tobias Carlisle:
One of the topics that I beat to death on this podcast is the yield curve. The inversion started in 22, got the deepest inversion we've got in the Fed data, Alfred data, which goes back to 1960 or something like that. I understand that it's not the deepest inversion ever, but it's the deepest one I can find in the data. And then we've had this very, very long inversion and we've sort of really stuttered coming out of it as it's normalized. It was basically flat for a year or so. And we've had this very recent where it's sort of normalizing now and then maybe even that it's sort of rapidly closed recently. So I don't know what to make of all of that, but how does that ... I mean, do you subscribe to Cam Harvey's thesis that that inversion or the normalization tends to precede a recession?
Or how do you think about that in terms of banks? Does that impact there? Because clearly they're playing parts of those yield curves. So when that inverts, that must hurt their earnings or just the direction of the rates?
Derek Pilecki:
Yeah, 23 and 24, that headwind really hurt the banks. The Fed just kept jacking up the Fed funds rate to five and a quarter and the 10 years stayed low, so that there was a real headwind there. The banks had very much had to pay up to keep deposits after Silicon Valley and First Republic failed. And so they were paying a premium and then they had the headwind of the inverted yield curve. And so with rate cuts in 24 and 25, the bank's been able to push back on, they're no longer paying that premium, that Silicon Valley First Republic premium and the more normalization's helping them. When I think about what shape of the yield curve, what spots on the yield curve, I think of the five-year to the three-month is the ratio that the banks focus on the most. A lot of their loans are based off the five-year plus 200 or whatever, and then their funding is around the three-month or related to what the three-month rate is.
I don't know that it pretends a recession just because we had this artificial Fed move at the short end. And so was that real or was that just fake, the Fed trying to recover its reputation from not fighting inflation hard enough? And so I don't know that if we get normalized here, that is a predictor of recession. Yeah. I mean, I guess the things that I watch most on recession watch is continuing unemployment claims and that's contemporaneous with ... When that starts spiking, I think that's contemporaneous with a recession. And so that's the number that every Thursday morning looking at how many continuing claims there are, and is that moving higher?
Tobias Carlisle:
I track a few of those series. I'm not sure if I track that series exactly, but one of them is it's definitely up year on year, but it's not spiking the way it has pre other recessions.
Derek Pilecki:
I agree with that.
Tobias Carlisle:
Yeah. What do you make of that?
Derek Pilecki:
It's all good though. I think it's a little bit of overhiring during COVID. And so the companies are working off that excess workforce that they acquired during COVID is what I tell myself. I don't know if that's right, but that's how I explain it to myself.
Tobias Carlisle:
I think that COVID bump is visible. Pick a- Cocoa prices. Yeah. Beef, lumber, take your pick of whatever. It all seems to have come through. And then since 22, we've been working our way out of that sort of excess capacity or all that pulled forward demand. And it does seem to be, it's screwing up a lot of different data series and ratios that I track. I don't know whether the signals are good or not, but I continue to track them. I don't know if you feel the same way. Yeah.
Derek Pilecki:
Yeah. I mean, the society has gone through a lot of change in a short period of time, change of habits and the way you live.
Tobias Carlisle:
What about European macro? I don't know if you want to discuss individual names or not, but just in terms of what's happening in Europe, what are your thoughts there? Because some of those banks have struggled for an extended period of time.
Derek Pilecki:
They sure have. I own a few nowadays. So I own a couple of the French banks and I've owned Barclays for a while. So I mean, I think GFC to 2023, the European banks were just flat to down and the valuations got extremely cheap. And there was also a change. We went away from negative interest rates, so we started getting a little bit of yield curve, and then there was also a change. And a lot of the management teams started getting shareholder value religion of we need to have a higher ROE. We need to not build umpires. We need to be more focused on creating value for shareholders. And so I think I owned Barclays for a while. I owned it for a long time. I was classic value investor way too early, owned it for five years. And finally in 2024, the stock worked.
And it worked because it was trading at 45% of tangible book value. And they said, ROE is going to go from 10% to 12%, and we're going to buy back a third of the market cap over the next three years. And so market finally woke up to that statement and said, okay, this shouldn't trade at 45% of tangible. And so at the end of 24, I looked around. I was like, okay, it took six years, but Barclays finally worked. Is there any other names that look similar to Barclays? And I came across the French banks and B&P looked like very similar to Barclays. I would say the French banks were classic empire builders. They had outposts around the globe, didn't care about ROE, just get bigger, bigger, bigger. But the BNP CEO, he sold Bank of the West and the US, brought the capital back to France, bought back a bunch of stock, bought an asset management business, which is a higher ROE business.
He said, ROE is going to go from eight to 11. So I bought B&P. And then as talking to people in my network about ideas, I talked to one friend and said, "I just bought B&P." And he's like, "How'd you pick B&P?" And I told him that story. And he's like, "Well, I agree with that, but you should also look at society general." And it was crazy. It was 35% intangible book value. CEO at the time was 50 years old. He had been in place for two years and he was selling units in Africa and bringing the capital back to France and talking about ROE is going to go from five to eight to 11. And so for 35% of tangible ... And they had beaten earnings three out of the last four quarters. And so the stock was already, you could already see the stock was starting to understand what he was doing.
So I bought B&P and Society of General. So that is not a macro call on Europe. I understand one of my LPs is a longtime hedge fund manager, and every time I talk to him about the French banks, he can't get past that it's French. He just is like, no, no. And so I'm like, ignore that. Ignore that if they're in France. The ROE is going the right direction. They're not building umpires anymore. And so I don't have a view on Europe's GDP. I think the banks underperformed for 15 years. There's a catalyst change in how management teams are thinking about shareholder value, and there's more to go on that. And maybe I got lucky that the dollars started falling at the exact same time I bought the French banks. So I mean, that was not forecast by me. It was just kind of grievy, but that's kind of how I ... I probably should have bought more European banks.
I probably should have bought a few Japanese banks, but that's what I did.
Tobias Carlisle:
I've been enjoying chatting so much. I've missed out a deadline for ... JT does his vegetables at the top of the hour. Sorry, folks, it's 11:09 on the Pacific on the West Coast. JT, take it away. Veggies.
Jake Taylor:
All right, sure. So picture this. You're 70 feet up in the jungle canopy of Borneo and this 200 pound orangutan crosses branches that you and I would fall if we were on it. And he pauses and tests the limb and shifts his weight. He's conserving his energy as he moves around. And so we're going to be talking about orangantangs today, and hopefully we can stick some to the landing on making it make sense. But a few little fun facts about orangutans as we get going. So they build a fresh sleeping nest basically every night. They weave these branches and leaves together, and then it's like they reset their home on a daily basis, which to me seeds wildly inefficient.
And their reproduction is famously slow. Mothers can go many years, even almost of a decade between bursts, which is not common for primates. And the whole species is kind of really paced for patients. So Charlie Munger used to have, he would have this saying of, he talked about, it was a joke basically about an orangutan eating a banana, and it was kind of tangentially related to intelligence. So he'd say that a smart person could have a productive conversation with an orangutan, and the orangutange just sitting there leisurely eating his banana, and the human is talking, and the uregate is obviously contributing nothing to the conversation. And yet the human walks away with a much clearer understanding than when he started. And it's because the talking is forcing kind of structure to it. It's hard to hide your own gaps when you have to actually put it into sentences for someone else.
And so you start to understand where your argument is soft, where there are clearer counter contradictions of what you're saying, and talking it out can really help. And so Munger was, he was poking fun at himself at this. He was implying that he was the orangutang and that quietly letting Munger talk his way to the right answer. Probably most of the time that answer was no. But if you go on Charlie's record, the real point is that under that joke is this idea that it doesn't necessarily require a shared understanding between both parties to have this kind of improvement. It requires exploration and kind of the right constraints. So humans already know a lot of what they should do, right? And yet we still don't do it. They smoke when they know that they're at risk to that. They chase bubbles when they know that the odds are not in their favor, but they're going to be special for some reason.
Mugger's rule of thumb was always that persuasion is a very weak force and incentives and guardrails are much stronger. And so if you want to want better outcomes, you redesign the environment so that the good move is the easier than the stupid move to do. And this actually maps pretty neatly to AI. And because AI is really almost following this kind of banana logic a lot. So it doesn't understand meaning like a human does. It doesn't have beliefs or any real stakes. It's got no skin in the game. It optimizes patterns against some objective. It's a banana kind of as a reward function. And it's still useful though. And exactly in mungers a range tang sense. It can improve outcomes without some internal profound enlightenment. And this whole talk of AGI, I might be kind of missing the point. If you put an AI model in your loop and suddenly you have a lot of sloppy thinking that maybe gets punished with a sloppy output.
And if you want that quality back, you're forced to define your terms better, specify constraints, name your assumptions, decide what good actually means that you can't hide anymore. And so that interaction is kind of a form of leverage. It's acting like these kind of cognitive guardrails that's keeping you moving the right direction and help you understand both what potential outcomes are available and then also help you narrow that search space down even. So that forcing of an articulation of your problem surfaces contradictions, and then it's actually quite adept at red teaming, whatever you're saying. So it just needs to sit there consistently enough that your own reasoning becomes sort of audible to you and coherent to you. But you have to be really careful because coherence is not the same thing as comprehension. Coherence is not truth. Elegant language is not reliability. It can be right for the wrong reasons, wrong with perfect confidence.
It suffers no consequences for a bad call. So you kind of have to let the AI help you explore, but never conclude. Use it to tighten your reasoning and not outsource your thinking. And since Munger, this is a Munger related segment, of course we have to do the obligatory inversion. And in this original explanation that we just had, AI is the primate who's mindlessly optimizing tokens for that banana treat while we're talking to it. And it's helping us get somewhere, but humans might actually be the more banana-driven organism here, at least most of the time. We optimize for status and ego, group approval, avoiding embarrassment, defending our own sunk costs, being seen as consistent even when it conflicts with accuracy. We're predictably irrational, to use Dan Orelli's term. And in plenty of real interactions, the machine is calmer than we are. It doesn't get defensive.
It doesn't need to win. It will rewrite and restate and recheck without any emotional friction, which good luck trying to do that with a human. And perhaps the better analogy is actually that we humans are the orangutangs in this thing. And by interacting with humans, the AI is getting better. Not because your single conversation is magically rewires the model in real time, but because the ecosystem, as we're all interacting with it, is a form of selection pressure. The prompts, the corrections, the preference signals, usage patterns, those become the training and evaluation signal for the future versions of AI. So we're shaping what's getting reinforced and how it could be improving, which means there's kind of an uncomfortable question here, which is, what are we training AI to become at this point? If we're rewarding speed and flattery and confidence sounding pros, we're training these systems to optimize exactly for that.
And we're creating really like a perfect machine to produce insane amounts of overconfidence bias in all of our decision making. But if we're rewarding rigor, explicit assumptions, sourcing, uncertainty when warranted, error correction, now we're training to get those behaviors. So AI doesn't need to understand your business or your portfolio or your strategy. It just needs to explode weakness in your assumptions and force you to think a little bit clearer. And likewise, humans don't need to become enlightened to use AI well. They need a system that makes the right behavior easier over the stupid one. And so wrapping this all up, make sure you're aware of who is the banana eating primate here? Is it you or the AI? And my aim is to use AI as the orangutan, make it the constraint that forces me to articulate, quantify, stress test, but keep the skin in the game on the human side.
The model can't pay for being wrong, so you're the one who has to be on the hook for it. So treat the outputs like drafts that earn their way into reality through verification and keeping that human in the loop.
Tobias Carlisle:
Good one, JT.
Jake Taylor:
Thanks.
Tobias Carlisle:
Derek, I'll let CapEx spend on data centers. Has that found its way onto any bank balance sheets anywhere?
Derek Pilecki:
Not in the small mid-cap banks. It's in some, I think some large banks, they've securitized some of those loans. And then I think in the shared national credit market, the big loans get chopped up and banks that invest in them as they would bonds. And so I think it's in that market some. It's
Tobias Carlisle:
Not a risk that you're tracking or what
Derek Pilecki:
You- No, it's not. I mean, I do think there's reason to be concerned about those loans. Meta's not putting that risk on their own balance sheet. They're happy to have somebody take that risk down. So they must know the- Like Blue Owl. They might not want to have that residual risk and it's better to be on somebody else's balance sheet. I think it's right to be-
Jake Taylor:
From an accounting perspective, how do you feel about that off balance sheet SPVs that they do? Obviously, okay, if Facebook is 25% owner of this SPV and Blue Al's the other 75%, it goes onto Blue Al's balance sheet, but yet Meta is signing things to effect saying that's a money good loan for this entire entity, and therefore they're really on the hook at the end of the day. Is our accounting a little bit suss right now around this?
Derek Pilecki:
I don't know if it's the accounting. I mean, I think it gives Meta some optionality down the road of, do those facilities have some residual value in the future? Or if they don't, they'll be the ones with the cash to be able to resolve it in a cheap way. Will they be able to buy back the debt at pennies on the dollar or for some discount bid? Is
Jake Taylor:
That the master plan? He's going to ...
Derek Pilecki:
I mean, I think it's an option, right? It's like-
Jake Taylor:
With Blue Al goes bust and he can buy off this other 75% for
Derek Pilecki:
Cheap. Does Blue Ow need liquidity at some point? Maybe.
Jake Taylor:
What is this? Mafia?
Derek Pilecki:
Just he's given himself options.
Tobias Carlisle:
What are the big levers for small and mid-cap regional banks in terms of rates? Is it the absolute level of rates or the shape of the yield curve or the direction of rates? Do you concern yourself with any of those or you're purely bottom up, it doesn't matter at all?
Derek Pilecki:
No, I think every bank's a little bit different. So I think generally lower short-term rates, if the Fed funds has two or three cuts this year, I think that's generally very bullish across the board for regional banks. There's some banks that are asset-sensitive, so they would prefer to have higher for longer. So it's a mix, but I think the median or the average small mid-cap bank wants a 3% Fed funds. But I think it also matters what the repricing is. So one of the things that I like most about small mid-cap banks right now is both sides of the balance sheet or the margins are getting better. So on the asset side, a lot of the loans they made in 2021 are five years. And so in 2026, they're going to reprice from four and a half to six and a quarter. So they get repricing on the asset side and then the liability side rates have been coming down.
So you get both the margins widening on both sides of the balance sheet. So I think that's really the driver for a lot of small mid-cap banks. And then to the extent that some banks are able to grow their loans, that compounding of loan growth is very valuable, putting that earnings to work into new ... It's almost like CapEx. Balance sheet growth is bank's CapEx to expand their earnings power.
Jake Taylor:
And then on the insurance side of things, any concerns about the big private equity firms that have bought life insurance companies for cheap source of funding and then put them into their own funds? And if things go a little south there, who's paying mom's annuity payment that was promised?
Derek Pilecki:
Yeah. So I mean, Apollo is a fascinating stock on that standpoint. When they first had their relationship with Athene, I was like, okay, that makes sense. Apollo's going to stuff Athene with all their garbage. And then they went a couple years later, they bought Athene. I was like, oh, I thought they were ... Why are they buying their garbage? That didn't make sense to me. And so maybe they weren't stuffing it with garbage, but I don't know. You just don't know. So it's helped me from the standpoint of I've owned some life insurance companies that had big variable annuity businesses that had very low valuations and private equity wanting to bid on life insurance companies has increased the valuations across the board of life insurance companies. And so it's been helpful from that standpoint, but it's hard to own those businesses. You just don't know how much balance sheet risk there.
Athene is a five or six multiple business. I'm not going to put a private equity multiple on all of Apollo when Athene is a big percentage of their earnings. And so I think Apollo's multiple is higher than I am comfortable with because of that. But I think you're right to be skeptical. I guess I own shares of Jackson National, which was a spinoff from Prudential UK about four or five years ago, and it came out super cheap. You had a UK listed life insurance company spun off a variable annuity writer in the US, and it was I think one and a half or 2% of the Prudential UK value. So all these UK shareholders got this stub position, this terrible life insurance business. Yeah, classic great flat spinoff. And he's trading for 18% of tangible book value. And so bought it, it's worked, it still trades at two-thirds of tangible book value.
And they had not done a deal and they just announced a deal with TPG. And so I was like, oh, okay, now am I the one holding Jackson National and they're about to get a bunch of TPG's stuff? And so I don't know. I have to monitor that and ask those questions.
Tobias Carlisle:
Do you track the Berkshire clones like Markel or Fairfax? Do you have any views on those two?
Derek Pilecki:
I mean, I think Fairfax is a great business. I think Remwatts is super smart. I think the valuation's starting to reflect it. I mean, the stocks had a good run, but I think he's created a lot of value. I think Markel has been more difficult from the insurance underwriting standpoint. The casualty insurance or casualty reinsurance has been a tough business the last few years. I think there's universal questioning about reserves and casualty books from 2015 to 2020, I think are the years that it looks like businesses underpriced. And so I think Markel is harder. I mean, Tom Gainer's super smart, a great investor. Markel's just been harder on the insurance side. Great stock portfolio, understands businesses and oats. And if I had to own one of those two, I'd own Fairfax.
Tobias Carlisle:
What happened in the casualty markets between 15 and 20 that caused that underpricing?
Derek Pilecki:
I think some lost costs, inflation. So the litigation costs went up and healthcare costs went up in casualty, there's usually some loss, health-related loss. So I think it's just lost cost inflation mostly was higher than what the pricing anticipated.
Tobias Carlisle:
So we've discussed regional banks and insurers. What other parts of your investment universe have we not really discussed?
Derek Pilecki:
I mean, I wanted to talk about financial advisors. So Ameriprise, Raymond James, Stifel, LPL. So just use Ameriprise as an example. I think it's a super interesting stock. It spun off from American Express in 2005, and then in the last 20 years, it's the best performing financial stock since they spun off.
Jake Taylor:
Wow.
Derek Pilecki:
It's a financial advisor business. Over the last 10 years, they've compounded earnings growth at 17%. It trades for less than 11 times earnings. They buy back a ton of stock. If you look at their share account over time, they're accountable. They've bought back, I think it's 60% of their shares since they came public. So you compare that to a generic regional bank like Truist or PNC that trade at 12 times earnings. They don't really grow loans. Ameriprise is not priced correctly given the characters of the business. I could say the same thing about Raymond James. Raymond James came public in 1986. It's compounded for 40 years at 17%. So people don't really think about that. The compounding of the Raymond James stock has been unbelievable. It's life-changing for people if you bought the IPO. So they're just good businesses and the valuations right now are very inexpensive.
Has
Jake Taylor:
It been mostly inorganic acquiring other bigger RIAs and wrapping them together?
Derek Pilecki:
No, I think it's been ... I mean, that has added some to Raymond. They bought Morgan Keegan and that was a great deal. I think it's the compounding of the financial advisors. They add financial advisors, financial advisors grow over their books of business over time. I think it's just that compounding and what to do with the capital. They don't really need the capital to grow, so they've put it to work in other places either through acquisitions or buying back stock. And so I think those are just ... If you describe those businesses, you would think, okay, maybe it's a mid to high teens multiple business, but they're sitting here 11 times earnings. And just think Morgan Stanley is the same business with an investment bank, which is volatile and lower multiple, and Morgan Stanley trades at 14 and a half times. So just-
Jake Taylor:
Maybe Mr. Market's haircutting today's current market valuation, because if you're paid based on AUM then and you reduce the market by 30%, all of a sudden the top line shrunk.
Derek Pilecki:
Totally fair. Yeah. I mean, but you think about it. Also, you think about the moat, the traditional asset managers valuations have come way down because they're not growing, they don't control their ... They have to go through these intermediaries to get to the end customer where these intermediaries are customer facing and they can't get ... That customer relationship is what's sticky and what creates the franchise. And so to the extent that asset managers used to have high teens, multiples, these financial advisors should have those high teen multiples.
Jake Taylor:
Is there the generational change happening there where ... Do kids take their parents' financial advisor?
Derek Pilecki:
No, they do not.
Jake Taylor:
Okay.
Derek Pilecki:
So you've
Jake Taylor:
Got a bit of a melting ice cube potentially there with ...
Derek Pilecki:
Yeah, maybe, but they're all constantly adding ... I think people have Schwab accounts and then they come into a liquidity event and they're like, okay, I need to talk to somebody. I need a reel.
Jake Taylor:
Yeah.
Derek Pilecki:
I need a real. I need somebody I can trust, that somebody I can call when the market's doing what it did this morning. I just need-
Jake Taylor:
Someone
Derek Pilecki:
To open. I need a guy. I need somebody who can give me advice and talk me off the ledge. And so I think that those businesses were on the door, whether it's Merrill's embedded in Bank of America, Morgan Stanley, all those businesses will endure.
Jake Taylor:
It has been surprising how, I don't want to say little penetration, but remember when robo advisors were like everyone was talking about them all the time? I feel like you don't hear about that anymore at all, but maybe I'm missing something.
Derek Pilecki:
I think Betterment's going to try to go public. So I think you're going to hear more about it, but the revenue they ... I think it's a decent business. I think it's an okay business. The scale is pretty good. Pretty well, yeah. They've gotten big. What
Tobias Carlisle:
About Vertis Investment Partners?
Derek Pilecki:
So
It's tough. Their biggest franchise is Kane Anderson, which is small mid-cap quality growth, and that sector has just been out of favor. And so they've had a lot of outflows out of Kane Anderson, so that's been tough. Super cheap stock, super cheap stock. So it's six times, or it's four times EBITDA because they have cash in the balance sheet, they have no debt, and then they have a big investment in their own funds for seed investments. So you theoretically could buy back a third of the shares and still have a zero debt. So it's super cheap, but the flow picture is really ugly.
Tobias Carlisle:
Yeah, full disclosure, that's one that I own through funds that I control. Derek, we're coming up on time. Thanks so much for spending time with us today. If folks want to follow along with what you are doing or get in contact with you, what's the best way to do that?
Derek Pilecki:
Yeah, so you can follow me on Twitter or Gator Capital is my handle, or come to gatorcapital.com and sign up for ... We send out our quarterly letter, so four times a year, no spam. I Just investment ideas.
Tobias Carlisle:
Yeah, great letter. I'm a new subscriber to that. JT, any final words?
Jake Taylor:
No, just keep your wits about you while others are losing theirs. Very
Tobias Carlisle:
Good. And folks, we'll be back next week. Same about time, same bat channel. Thanks very much. Derek Paulicki, Gator Capital. See you folks.
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