Gator Capital Management Q2 2024 Investor Webinar

Garrett Brooks:

Good afternoon, and thank you for joining our Gator Capital Management Second Quarter 2024 Investors Webinar. My name's Garrett Brooks. I'm joined with Derek Pilecki, portfolio manager of Gator Long/Short and the founder of the firm. Hey Derek, how are you doing?

Derek Pilecki:

Hey, Garrett. I'm doing well. How about you?

Garrett Brooks:

Very well, thanks. Very well. Well, strong quarter here for coming off of the first here. For those of you who are joining us for the first time and just getting familiar with the firm, Derek is a financial sector specialist, has been an analyst in financials for over two decades now. His portfolio is a long/short equity strategy focused on the financial sector, really drilling down into some of the more interesting names that you'll find in the smaller to mid-cap section of the sector. But we had, coming off a really strong calendar year for 2023, continued that momentum here through the first quarter of 2024, finishing the quarter a little bit better than 10 and 1/2% in line, maybe a little bit better than the broad S&P 500. Trailed the financial sector very slightly measured by the S&P 1500 financials. But really, a lot of interesting things and a lot of attribution going on there, some interesting stories that are different from the sector as a whole.

Derek, would you mind giving us your thoughts at a higher level and then drilling down maybe on some of the events and the stories leading the way in the first quarter?

Derek Pilecki:

Yeah. Thanks, Gary. I'd say Q1 was a continuation of the strong rally that started at the end of October/early November of last year. That rally was sparked by the prospect of interest rate cuts and inflation cooling off. Even though some of those expectations have reversed so far this year, the market continued to have good momentum into early part of this year. Within the financial sector, there was a little bit more volatility right at the end of Q4 earning season for banks. New York Community Bank reported a terrible quarter and caused the stock to go into distress. They got a capital infusion from an outside group and turned over their management team in early March. That really caused some disarray amongst regional bank stocks. Even though it was a strong quarter for the broader market and financials overall within the financial sector, regional banks wildly underperformed.

For our portfolio, we had a few stocks that really contributed to our performance. Robinhood, which we talked about on our last call, had a very good first quarter. First Citizens, our largest position, continued to perform well. We also had good results out of Barclays, Jackson Financial, and Sallie Mae or, as it's known, SLM Corp. All those stocks were strong.

Some of the detractors on the long side were Genworth, which had a really strong end of last year. Then, in January, it was weak. Dime Community, which sold off in sympathy of the New York Community. Then, Old Second Bancorp is a bank outside of Chicago. They have some minor credit issues in their loan book from a bank that they acquired, but it just didn't perform as well during the quarter. A couple of our shorts hurt us. We're short Bank of America. We have a small position in Root Insurance that we were short. We covered it. It had been a good short during 2021. We had left it on. Then, they started to recover during Q1. Those were some of the detractors in the quarter.

Going back to the New York Community issue, New York Community, historically, has been a very good New York multifamily lender. They lend against New York apartments. Their loss history over the past three decades has been pretty close to zero. New York apartment landlords don't default. There's such a shortage of housing in New York that they're able to just handle their debt. Most of the debt is very conservatively managed. They don't use high LTVs. New York Community has been one of the bigger lenders in that market. They just have done a great job for a long time. I guess their issue is on the interest rate risk side. I mean, a lot of these loans are fixed-rate loans, 5, 7, or 10-year fixed rate. Then, they convert the floating. They did a lot of business in 2021/2022 when rates were low. Those loans are going to remain fixed for a while.

They actually had a nice thing happen to them last year, where they were selected as the winning bidder for Signature Bank when Signature Bank failed. That brought in a huge influx of deposits and cash. They fixed New York Community's balance sheet. But what it also did was it took the bank's asset size above $100 billion. Within banking, there's different regulatory issues or supervision levels depending on the bank size, like 10 billion, 50 billion, 100 billion, 250 billion. That acquisition of Signature Bank tripped them over the $100 billion mark. Since, historically, they had very few credit losses from their loan book, they had a relatively low loan loss reserve because that's what their history would suggest.

But once they got over 100 billion, the regulators tapped them on the shoulder and said, "Hey, we think you need to look more like your peers. Your new peers is at $100 billion. You need to raise your loan loss reserves. You also need to raise the amount of liquidity you have. You can't be as fully loaned out. You need to hold more securities or cash." Both of those things were going to degrade New York Community's earnings power. That was a surprise to the market when they reported.

We had gone through the whole January earnings period. Banks had done pretty well. New York Community was the last one to report. It sent the whole regional bank sector or industry into disarray. I have a graph to share with you guys. I'm going to share my screen. You can see at the end of January... This graph is a graph of the large bank ETF versus the mid-size bank ETF. I mean, you can see right here, at the end of January, where the mid-size bank ETF really started to underperform. The large-cap bank ETF continued through the rest of the quarter just fine, up 6% for the quarter, whereas the mid-size bank ETF was down 10%. Just a huge disparity.

If you go back and look over the last 5 or 10 years, these two ETFs have traded almost on top of each other on a daily basis. This is really the first divergence we've seen. It is just a separating out of large bank stock performance versus mid-size. It was driven by New York Community. New York Community is part of the mid-size bank ETFs. That was one thing. Then, the other part of it is any bank that was in the 50 to $100 billion range, which will eventually... As they naturally grow or do M&A, they'll get over $100 billion. There is concern within the bank stock investor place of... Is the profitability level of these banks going to decline as they cross the 100 billion mark?

I guess there was also concern back in February that New York Community's issues were going to cause another round of deposit runs on banks and that mid-size banks would lose customers. In hindsight, that has not happened. New York Community lost a few billion dollars in deposits. No other banks saw any deposit outflows. There's less of a concern about regional banks, specifically like we had during March of 2023. That was a big story within the financial sector during Q1.

Garrett Brooks:

Yeah. That's really interesting. Very quickly, we can look at some of the attribution in terms of the performance that I laid out before versus the S&P 1500 financials. You saw the large institutions there pushing those, whereas our portfolio tends to hold some of the smaller names that we saw there struggled as a result of the New York Community. I did notice when you named some of the individual contributors... We have a really broad set of names there from different industry groups, and I was curious, from that perspective, on the contributing side, if there were any larger stories that were really helpful throughout the quarter.

Derek Pilecki:

Yeah. Jackson Financial, which is a variable annuity insurance company... They had a very strong quarter. Variable annuities is a very tough business here. The insurance company has to hedge against the guarantees that they're giving the policyholders. When Jackson National was spun off from Prudential UK a few years ago, it came out very cheap. I think book value was over 100 dollars. The first trade of Jackson National was 26.

Management's done a very good job of returning capital to shareholders, both paying dividends and buying back stock. They've grown earnings a little bit. But the accounting has been very problematic for investors because there's hedge accounting, there's gap accounting, and then there's the economic accounting. There was a mismatch between the way they were hedging and the way they had to account for hedges versus the true economics. During the quarter, they announced that they created a captive reinsurance company that was going to reinsure the core book of business that would improve the accounting treatment, and make some of their hedging more true to the economics rather than for accounting purposes. The stock really responded to that. I think that the financial results are going to be more consistent, and they're also going to be easier to understand going forward. I think that really reverberated with investors.

Garrett Brooks:

Absolutely. Then, obviously, we saw that the detractors. We understand the story there coming from a result of some of the fallout from the fears and jitters surrounding New York Community and would that spread throughout the broader group. As you look ahead over the next few quarters, what are your thoughts? What are you looking at, I guess, broadly from the economy, the market, and then even drilling down into your sector, the financials?

Derek Pilecki:

Yeah. At a high level, starting with the economy, how that's going to play out through the summer and the back half of the year? How's the Fed going to respond to inflation prints? Are they actually going to cut rates this year at all, or are they going to hold at this current high level? Then, we also have the election in November, of course. I would say, so far this year, the stock market's been much stronger than in a normal election year. It seems like the stock market investors are looking through the election, or they are pretty complacent with what's going to happen.

I would say that I would not be surprised if the market treaded water here until the election. We've had a good run. Summertime is never very good seasonally. We have the uncertainty of the election. I would think that we probably mark time until we get clarity on the election.

The Fed... I don't know what the inflation numbers are going to be like. The economy seems much stronger than everybody expected. There are interest-rate-sensitive sectors that are struggling. You have some mortgage bankers, real estate companies... New construction's not really getting off the ground. I do feel like there's parts of the economy that are slowing. The low-end workers got plenty of job opportunities. They're staying employed, renting apartments, and spending money. It's always a confusing thing where the economy is going to go. But so far, it seems like it's pretty strong.

For my sector, the big issue is how's the stock market going to go because of the capital markets firms and then how are interest rates going to go for the banks. A lot of generalist investors point to real estate risk with the banks. I think bank investors are more focused on interest rate risk because I think there's a lot of banks that are in a stuck position here with their interest rate positioning. They have a lot of fixed-rate loans. They're having to pay up for deposits. They're not really comfortable growing their portfolio with new deposits and putting on new loans because that spread's so narrow between new loans and new deposits. They're waiting for existing loans or existing securities to make sure so that they can put that money back out at current rates. It feels like there's a lot of banks that are just stuck marking time here. I'll pause there.

Garrett Brooks:

Yeah. That's a lot to think about. With that being said, where's the best opportunities? What sections and what kind of things are you excited about?

Derek Pilecki:

Yeah. I mean, I guess there's a few different parts of the banking sector that I really am attracted to. One is the Puerto Rico banks. We've talked about this in the past. Puerto Rico banking is now an oligopoly. We're down from 11 banks in 2007 to three. They're acting like an oligopoly. There's no threat of a US mainland bank trying to start to branch in Puerto Rico. We're down to these three banks. We're starting to see it in the results. Margins are higher than the median bank, and their valuations are starting to creep up to be at the higher end of regional banks. We own the second and third-largest banks in Puerto Rico, FirstBank Corp and OFG Group. I think they're pretty interesting. I think their valuations can continue to expand.

Then, the second group of banks that we think are very interesting are growth banks. There are some banks that just grow faster. They hire bankers from big banks. They earn high returns on equity that they're able to reinvest in the business. They have a long track record of growing their tangible book value faster than the industry. Historically, these banks have traded at a premium to the rest of the group. Where the regional banks generally trade 11 or 12 times earnings, this group of banks would trade 14 or 15 times earnings.

Right now, the group's trading at about eight times earnings. These banks are trading for 9 or 10 times earnings. They don't have that much of a growth premium. I think that they'll regain that growth premium. Not only will they grow faster than the industry, but then the premium will expand. I think that's a pretty interesting spot to be.

Then, there's a scattering of banks that we own that have their own unique stories. There's a couple of banks that we own that had collateral damage from NYCB's issues. New York City Metro Banks, ConnectOne, Dime Community, we think, are well-run, and they're going to continue to work through the interest rate pressures. Then, there's some banks that have M&A-related related growth and consolidations. Bank of California, we think, is very interesting. We like Old Second, which I mentioned is one of the detractors. They're earning very high returns on equity and have a great deposit franchise. We think the credit issues are ring-fenced and not going to be a big deal as we look out over 12 to 18 months.

Then, we also own a little bank in Maine called Northeast Bank that purchases discounted loans from other banks. They earn very high rates of return on these loans. They have attractive ROE. It trades just above book value. I think there's a lot of interesting stories within banks, even though banking overall might be a little challenge from the shape of the yield curve and a lot of banks being stuck. I think there are some stories that are better positioned than others.

Garrett Brooks:

Sure. How about on the credit side? Any concerns there from your perspective?

Derek Pilecki:

Yeah. I think there are concerns. I mean, I think, obviously, office is an issue. We all visit office buildings and see they're half empty. These leases are burning off. But I think the areas that we're most concerned about are the downtown areas, especially in the gateway cities and in the big towers in the gateway cities. Those loans don't tend to be in bank portfolios. They tend to be structured in securitizations like commercial mortgage-backed securities.

Banks have plenty of office exposure, but the disclosure's improved. The average bank has about 4% of their loan book in office loans. A lot of those are medical office buildings in suburban areas that are used. I think office CRE is going to be an earnings issue for the banks. It's not going to be a capital issue. I think there'll be one or two off loans every quarter for banks that are problems. But the loan losses generally are so far below normal that these office loan issues aren't going to be terrible for the banks.

Garrett Brooks:

Great. Speaking of office, I have a few questions here queued up as well as a few that I'd just like to repeat from recent investor meetings for those of us joining us to have a chance. But happen to notice that you have a different background there.

Derek Pilecki:

Hey. Yeah. After 14 years, we changed office space. We moved to a new office close to the airport. I can give you a little tour. This is my office. These are my new couches. The coffee table's on its way. When everybody comes to visit me, we'll sit on the couches and chat and talk about stocks. Then, I have a nice view of the water, so we can enjoy the waters of Tampa Bay while we talk. I'm pretty excited about the new office.

Garrett Brooks:

Yeah. Very nice. It's very nice. I can't wait to get down there and see it myself. I still haven't had a chance to stop in. But as I said, I had a couple of questions here from recent meetings, and then a couple of here queued up from the crowd. But the first that I wanted to ask you... because it has come up recently. We touched on it a little bit but didn't quite nail down your thoughts on interest rate cuts here, and what the path looks like, and what that impact might be for you and the portfolio.

Derek Pilecki:

I think the Fed wants to cut rates. I don't think they like the shape of the yield curve. The inverted yield curve is not healthy for banks. I also think the last one or two rate increases weren't necessary. I think the Fed feels the same way and wants to reverse those. Excuse me. But they need the numbers to be in their favor. They can't cut rates with inflation not calming down a little bit more. The print earlier this month in May was good. I think if we get another good print in June, we could get potentially a rate cut in September or something. The banks would really benefit. I think that's the next rally in the bank stocks. It'll be the catalyst of a rate cut. We've seen fits and starts, but that'll be the... More normalizing the yield curve is what the banks need.

Garrett Brooks:

Absolutely. We're looking forward to that. Now, just a corollary to that, although it's not quite applicable here. But do you ever do any type of interest rate hedging and maybe using rates, products, ETFs, or anything like that?

Derek Pilecki:

Yeah, I do not. I've not done that historically. I don't plan to. I try to have a variety of companies with different interest rate exposures in the portfolio so it's not a one-sided bet. There's plenty of companies in the portfolio that don't have interest rate risk exposure directly, like asset managers. There's plenty of banks that just pretty much run matched books or floating rate books/loan portfolios. But then, there are some banks that would benefit from hire-for-longer. Then, there's some banks that we own that would benefit from some rate cuts. I would say that, on the short side of the book, there's some banks that I think are just overextended with mortgage-backed securities or fixed-rate loans in their portfolio. They're really stuck. We are short some banks. If we get very aggressive rate cuts, some of those shorts we might have to revisit because those banks would very much benefit from near-term rate cuts.

Garrett Brooks:

Interesting. Since we mentioned real estate a little bit in terms of the banks and bank balance sheets, curious if you include REITs in your universe.

Derek Pilecki:

Yeah. When I started the fund, REITs were part of the financial index, and they were split off in... I think it was 2016. I've continued to include REITs in my universe. I'm short some office REITs right now. I own a few small real estate companies, one land bank in Florida, a real estate brokerage firm, and then a small hotel REIT. We do definitely keep REITs in our investment universe.

Garrett Brooks:

Great. Well, I think that concludes it for questions. Derek, again, I really appreciate you joining us here. Again, these calls are so instructive, and I know that a lot of the investors that I talk to really enjoy them. It's a great way to really understand your thought process as well as the current events in the portfolio. That being said, any parting words or thoughts that you might have for us?

Derek Pilecki:

Yeah. I would just say we're excited about what's going on in the fund. We have some pretty strong views and feel like we've been doing well for investors. If you want to talk about the fund in more detail, please reach out to Garrett or me. We'd be happy to set up some time that we can go through and answer your questions about the fund.

Garrett Brooks:

Yeah. Would love to do that. Always interesting stories. We have great conversations with investors. It's a great way to have your questions answered and then also maybe pick up different types of things and different viewpoints that you might not be thinking about. We really enjoy those. My contact information will be included below. Always feel free to reach out to me. We can set up a conversation in time to talk. But again, appreciate you all joining us here this afternoon and look forward to future programs. Have a great afternoon. Thank you again for joining, Derek.

Derek Pilecki:

Hey, thanks for setting this up, Garrett.

Garrett Brooks:

All right. Have a great afternoon, all.