Garrett Brookes:
Good afternoon and thank you for joining our Gator Capital Management third quarter 2024 webinar. My name's Garrett Brooks and I'm joined by Derek Pki, portfolio manager and founder of Gator Capital Management. How you doing, Derek?
Derek Pilecki:
Hey Garrett. Good to see you again.
Garrett Brookes:
Good to see you too. So a lot to review here. Strong performance for the firm overall through the end of the second quarter versus the benchmark, the s and p 1500 financials and on a year to date basis as well. So things are firing on all cylinders for us here, and we would love to share with you all a little bit about what we're seeing from a higher level perspective and then talk about some of the intricacies and the opportunity set that we have before us here within the portfolios. So if you have any questions, feel free and put them into the chat and we will address those in the order that they came in when we get to the q and a session at the end of the program here. But to start things here, I'm going to pass it over to Derek. And Derek, can you share with us please, your observations from the second quarter?
Derek Pilecki:
Yeah, the second quarter was a choppy market. We had a strong first quarter, second quarter was up and down. I think little bit of questioning about where the fed's going to go with interest rates, how strong the economy is, had to digest some of the gains from the first quarter. So I think, and we also of course had the ongoing tech outperforming in second quarter, so our sector held up okay. The sector lagged the market a little bit. We outperformed the sector, so just digesting some of the gains from first quarter as we kind of figure out what the economy's going to do going forward.
Garrett Brookes:
Sure, absolutely. And since you mentioned it, for those of you who are new to getting to know us here at Gator, we are financial sector specialists. The portfolio is a long short mandate really focusing in on some of the smaller to mid-cap names in this sector, some interesting stories there. And they tend to be names that are either overlooked or ignored or just not very well covered by other investors. And so when we look at our attribution, a good example was the second quarter. Typically you will see kind of a broad swath of different names from different industries and sub-sector groupings. And like I said, that was also the case for the second quarter. And so Derek, would you mind telling us some of the stories for the top contributors as well as maybe a detractor?
Derek Pilecki:
Yeah, so a couple of contributors I want to mention. One is Jackson National. So Jackson's variable life insurance company, it came public a few years ago. It was spun off from Prudential, uk. They write variable annuities. Variable annuities historically has been a very volatile business because the variable annuity writers are writing market guarantees to the policy holders. And so the accounting for it's very complicated and the tracking the cash flows from the business is very complicated and opaque. And so Jackson, when it was spun out, came out very cheap. So the book value was $110 a share and the first trades of Jackson worked only $26 a share. So 25% of book value was its initial trade. It is because the market doesn't believe the book value because of the guarantees that they're making. Over a period of years, Jackson's done a nice job, the management's done a nice job of continuing to grow the business.
They've proven they've been able to dividend earnings out of the insurance subsidiary up to the holding company. They've been doing a good job of returning that capital to shareholders through a pretty strong dividend and substantial stock repurchases. There was a change they made this year where they created a reinsurance company that guaranteed the operating insurance companies some of the risk transfer and the accounting with the reinsurance company makes it a little bit more clear to investors what the earnings are. And so the market responded to that, having that clarity of earnings and cash flows out of the underlying insurance company. So the stock responded and was strong in Q2 and so it's now up here and this is mid August now, the stock's in the mid eighties. So book value's risen while we've owned it, so it's still trading for only about 60% of book value, but the market's starting to close that discount.
And so we like Jackson National and it's been a good performer for us. Another name I'll highly we've talked about in the past is Robinhood. Robinhood will continue to be good in the second quarter, continue to have good organic earnings growth or both earnings growth and customer deposits in Q2. And so just continue it's on track. And if these customer deposits can continue at this pace, the earnings in the next couple of years are going to grow pretty rapidly. We're excited about that. We're really happy with the product introductions management team has been doing and the customer base is responding. On the detractor side, I'd say one of the most disappointing names has been Bank of California. So Bank of California took over Pacwest last year, bought it at a huge discount. We really liked the deal because the CEO of Bank of California used to work at pacwest, so we felt like the risk of merger integration was very low.
They came out in Q1 and he talked a really good game talking to the street about what the expectations were. And then the Q1 earnings were really milk toast. They just did not match the way he was so bullish during Q1 talking to the street. And so we knew that 2024 was going to be a transition year for Bank of California. I think it's a little bit more of a transition year than the street was prepared for. So that stock underperformed, we still think it's a very cheap stock. We think there's great earnings power, the franchise, he combined these two companies. There's a lot of things that Pacwest had to do to ensure their survival during 2023 that he's unwinding, like taking on very expensive one year CDs at five and a half or 6%. As those mature and it gets repriced to more and market rates, the earnings power is going to come through.
We also think, you think about that franchise, it's a southern California franchise and the LA banking market is very attractive. There's a lot of disarray in the LA banking market right now because of mergers. This merger union bank got sold, so Bank the West got sold. So there's a lot going on in the LA banking market, but I think it's a franchise that Bank of California will be sought after in a few years, whether it's a company like Citibank or PNC wanting to expand their base in California, bank of California is a bite size franchise for them to take. And so with Bank California traded below tangible book value here, we think the market, the company and the market just has to get through 2024 to see the earnings power come out.
Garrett Brookes:
Yeah, that makes a lot of sense. Were there any new positions in the portfolio or you working on any particular area that you're excited about?
Derek Pilecki:
Yes. Yeah, so I bought a new position in PayPal. So this is, I would say I can see PayPal becoming the first of a theme of FinTech or financial processing companies coming into the portfolio. I have a pipeline of other financial processors that I'm working on that I think are training a super attractive valuations PayPal kind of the story is the classic payment processor, the PayPal that we know is a small portion of the business. They do online checkout, they own Venmo. They were doing a lot of things in payments kind of spread too thin. New CEO came in last October from Intuit. I think he's focusing the company on three things to really deliver on those three important products. And in the meantime, the business is still growing. So this is not a shrinking franchise, it's growing. Earnings are growing, they're using the cash to buy back a lot of shares and it trades at a pretty cheap valuation.
So I really like it. I like the CEO change as a catalyst, strong financial profile of the business trades for 14 times earnings. Banks only trade for 11 times earnings. So here you have a non-capital intensive business trading for almost a bank multiple along those lines, there's other processors that are trading at that or even cheaper that we just think growth investors have just become disillusioned with these businesses. They're growing fine. Maybe they're not hitting the exact targets that growth investors had, but at the valuations, I don't really care. There's a couple that are trading for nine or 10 times earnings. There's a couple others that are trading like PayPal, 14 times earnings. Those valuations for growing businesses with this financial profile of capital light, high free cashflow conversion, I think are inexpensive. And eventually the growth investors or momentum investors will rediscover these franchises. So I think, and historically we've not been a big owners of the processing companies because they've always traded at very expensive valuations. We've been in more the single digit PE companies that are very balance sheet happy or heavy. And so I really like this change in the portfolio that I see coming of getting higher quality businesses into the portfolio. Maybe slightly higher valuations, but certainly not exorbitant.
Garrett Brookes:
Yeah, that's exciting. And I know that that comes up in meetings with our investors and potential investors questions on FinTech. And so now that they're coming back into some reasonable valuation, it's great to find some opportunity and see a new area coming into the portfolio
Derek Pilecki:
For sure. Definitely.
Garrett Brookes:
So it's crazy now it almost seems like a distant memory, but we had had a little bit of volatility in the market across sectors really. Seems like there was a hiccup, and I don't know if we're back on track, but I mean it seems like this part of the year, this late summer here is flying by at warp speed. And so I'm curious, what are your thoughts? What are you thinking about, I guess broadly the economy and then more into the financial sector and how's that affecting you?
Derek Pilecki:
Yeah, well, we continue to get mixed signals about the economy. This is a Q2 review, but a lot happens so far in Q3. July was very strong for the banks and they rallied because inflation reports in mid-July were pretty tame. So the expectation that fed rate cuts are coming had those stocks rally. I also think some of the political dynamics that were going on, banks are assumed to do better under a Republican administration. So with the assassination attempt and then Biden dropping out, there was some bidding up of bank stocks. And then we get to August and all of a sudden people get concerned about the economy and they sell off the bank stocks very quickly. The first three days of August, I think we have some mixed signals on the economy. It seems like the economy's pretty strong. Walmart had very strong numbers, but then you have some interest rate sensitive parts of the economy like housing and building and construction that seem very weak because with the inverted yield curve, it just doesn't make sense to get started on new real estate projects.
And so I think the feds at an interesting position here. I don't think it's sustainable to have the two year 4% and fed funds at five and three eighths. And so I think rates have to come down and you can lower rates, and that's not really an easy, you're still restrictive. If your Fed funds are above the two year and you have an inverted yield curve, you're still relatively tight or restrictive policy. And I think people who say, oh, the Fed is not at its target yet it at its target, it's close to its target and it's trending in the right direction. And just because you're not getting a neutral by cutting one, two or three times, you're just approaching neutral. I would say neutral is three and a half, 3 75. So the Fed has to cut six or seven times to get to neutral.
So I think rate cuts are coming. I'm a little worried that they're not going to come fast enough because I look at the housing market in Texas and Florida and Tennessee and some of the beneficiaries of Covid housing and there's a lot of inventory stacking up in those markets. And so I think price cuts are coming in those markets. I'm a little worried about those areas. And I also am worried about the construction trades I mentioned it doesn't make sense to get started on new real estate projects. Things that were put in place in 2022 when rates were really low. Those projects are coming to an end this year, next year, early 2026. As those projects end, are the opportunities for the construction trades going to dry up and are those businesses going to hurt? So we'll see. I really think the high rates right now are just hurting certain segments of the economy. The general economy is pretty strong. I think you can cut rates, get housings restarted, get some construction restarted, and we could have a Goldilocks economy here, but I'm worried about the Fed not cutting soon enough.
Garrett Brookes:
Yeah, I tend to agree with you too. I think that we have the potential for that Goldilocks economy. The Fed tends to be behind the curve, but time will tell I guess here. So what does that look like and how is that shaping up the opportunity set for you in the portfolio? We've talked a little bit about some of the processors are there, I know there are some other areas and any one particular area you'd like to mention?
Derek Pilecki:
Yeah, I still really like the growth banks. So as we're sitting here on the precipice of rate cuts, I think that will be a huge beneficiary for the banks. The banks are funding themselves at fed funds, but when they make loans, the loans aren't fed funds plus three and a half. They're like the three year or the five year plus 3%. And so the inverted yield curve is really hurting them. I think if we got some fed rate cuts, it would provide a tailwind to the margin margins might expand a little bit faster and it also would improve sentiment on the banks. And so I think the banks are cheap relative to their history. They're trading it like nine times, whereas a normal valuation for the banks is anywhere between 10 and 14 times. And so they're slightly cheap. They're not as cheap as they were last year, but they're still cheap relative to their history.
And then when I look within banks, there's a lot of high performing banks that are growth banks. They grow double digits loans and deposits, and you're not really having to pay a premium for those growth banks. And so historically, if the banks are trading for 11 or 12 times, those growth banks will trade for 14 or 15 times because they grow faster, have higher returns in capital. Right now they all trade for nine times the regular banks and the growth banks. So I think as the banks move back from nine times to 11 times earnings, the growth banks should see premium multiple expansion from nine times to 14 times. And so I think that's a super interesting opportunity because they're also growing while we're waiting. So if they're growing 10 or 12% a year and it takes three years to get there, if you compound 10 or 12%, I mean it's 34 to 40% growth and then the multiple expands from nine to 14, that's more than a 50% growth. So you get a double in three years from these growth banks. So I think that's super interesting.
Garrett Brookes:
Yeah, definitely. So why do you think the market's not giving them the premium that they have historically seen?
Derek Pilecki:
I mean, I think there's a real reason. I mean, are we headed into a credit crisis? And so there's the old financial investor or bank investor adage of you don't want to buy the fastest growing financials heading into a recession. And on top of that, last year there were three growth banks who failed Silicon Valley signature and First Republic. And so some of the historical investors in growth banks just got their heads handed to them last year by having those three banks fail over weekends. And so I understand that I think there were specific strategies that those banks had that the remaining growth banks don't have. I think the remaining growth banks are more diversified. I think they're not taking as much interest rate risk. And so I think those are big differences. I also think the credit quality of the growth banks is pretty sound historically, they've demonstrated pretty good underwriting.
I think the regulatory environment as far around credit underwriting is very strong. I think Dodd-Frank has pushed a lot of marginal lending out of the banking system. We've all seen this huge growth of private credit. Well, those are loans the banks used to make and now they're made by private credit funds, and that reduces the risk in the banking system. Now, the banks are providing leverage to those private credit funds, but they do it on a loan by loan basis. There's a lot of equity in the projects, let alone the private credit funds are providing equity. So the banks aren't funding those at a hundred percent LTV. So I think that's pretty low loss, low risk business for the banks to fund to the private credit industry. So I think banks growing fast here are, I think under the underwriting across the industry is pretty sound.
Now of course, we're worried about office, especially Office and the Gateway Cities is under attack. It is really, people don't want to commute. You don't want to live in Connecticut and commute in an hour and 15 minutes into Midtown anymore. And so I think there's certain buildings, class B, class C buildings in the gateway cities just are zero bid right now. And so to the extent that some of them are or have mortgages to banks, that's an issue. I think a lot of the towers have mortgages to CMBS, so I don't think it's a huge issue. The banks have done a good job of disclosure since last year when this really became an issue, and we haven't seen credit metrics fall off the table yet. So I'm comfortable with credit where it is now. I of course retain the right to revise my opinion as we get more data, but I don't think the doomsday scenario is playing out so far in the data we've seen.
Garrett Brookes:
Yeah, I can tell you anecdotally, I just had the chance to spend some time with a group of old friends of mine from school, and there were six of us, six different cities and all across different industries, and no one is a hundred percent in the office anymore. So I thought that was pretty interesting. I was thinking of that through those conversations. I'm curious, since you mentioned credit, and I know your view on credit has been a little bit stronger than maybe some of the more negative voices out there, what are you hearing when you're talking to bank management? What are they saying specifically about credit and what's helping to keep you comfortable with the banks that you own?
Derek Pilecki:
Yeah, so I mean, we're coming off a period where credit has never been better. So post covid credit was, there were zero losses in the banking system for credit. Not literally zero, but relatively zero. And you talked to the bankers about are you seeing any formations or early signs of credit weakening? And it's no bank after bank. It's like, no, it's not as perfect as it was, but it's nothing that we're super concerned about. It's just normalization. We're not seeing wholesale, wholesale issues as far as small businesses weakening or people are battening down the hatches or something. So that being said, I pay attention to what consumer companies are saying and the airlines are weak, so are people traveling less? Is that going to affect hotels? It seems like there's some signs that the consumer might be a little more judgmental about how they're spending their money. So we're still monitoring the situation, but the bankers are saying they're not seeing anything.
Garrett Brookes:
Sure, yeah. I also tend to look at that as we're coming from a period where consumers were spending as if the end of the world was coming and there was no cost of money. So what's the baseline? But I guess again, another thing we'll have to see how that plays out.
Derek Pilecki:
Yeah, I mean I think inflation prices have gone up and people are just more conscious about, oh, I was spending money pretty aggressively there and I understand why they spent money aggressively. I think about it 20 years ago before the financial crisis, people were spending money and then the financial crisis hit and we all were like, oh my goodness, there could be a downturn. And people really cut back and they'd never really got back to trendline on spending. Everybody just had such a scare during the financial crisis that spending was restrained for years and years for 10 years. And then we got to the pandemic and people are like, oh no, my life could end. Why do I have all this money? I'm going to go spend it. And they're like, I only have one life to live. It was like this fear of your own mortality. And so when people went out and spent the money and now they're like, Ugh, I was really spending a lot of money over those years and the prices are expensive. I'm not getting as much and it's not as easy to find jobs and headhunters aren't calling me, and maybe I need to take a little breather here.
Garrett Brookes:
People put check marks across their bucket lists in three years. So time to bat down the hatches a little bit, I guess now. Well, that was great. That was very helpful. As I said, any questions from the audience here? Go ahead and put them into the chat. I know we have a couple queued up here already and we'll go ahead and answer those in the order that they came in. First one here, Derek, what are your thoughts on asset managers? I know we have a couple in the portfolio, but what are your thoughts broadly on the industry?
Derek Pilecki:
I mentioned that financial processors have a good financial profile, capital light, high free cashflow conversion. Asset managers are similar. IT recurring revenue business, not capital intensive. The customers are less sticky than financial processors because you can get fired for active management. And there's also been the headwind of a shift from active management to passive management. And so that's been a huge pressure. The mutual fund structure has come under attack by ETFs, but there are certain asset classes where active management still rules the roof, like fixed income, small mid cap equities. And so we own a few small asset managers that are multi boutique firms. They acquire small managers, keep the investment teams together, but then consolidate the middle and back offices and put it on their platform and get common sales going, common dis sales distribution going. And so we think those businesses are pretty interesting.
They're trading for six or seven times ebitda, which is a super low valuation for the financial characteristics of the business. And so they're able to, and the good thing about these acquirers is they're paying pretty low multiples because that's what the market's dictating. So their new acquisitions, they're not paying up for, and then they use their cashflow to pay down debt and to buy back shares. So I like certain asset managers that are interesting. The bigger asset managers that mainly sell through the wirehouses or 401k plans or institutions, that's a harder business. And so some of the bigger asset managers are kind of just defending their existing a UM and not able to grow. And so those companies are harder to own just because they have so many products are kind of in a customer base, it's not really growing. And so I prefer the smaller boutiquey asset managers that use their cashflow to return capital or make acquisitions.
Garrett Brookes:
And like you said, they're not commoditized. It's a much different game going on at the bulge bracket size. Another question here on the heels of this is interesting on the heels of talking about looking at the processors and some of the market action that we've seen recently. How do you think about position sizing?
Derek Pilecki:
Yeah, I think for the fun, a normal position is five to 6%. So usually we'll buy a new position at four or 5%. If it outperforms, it gets up to five or six, or maybe we will see an opportunity to add to it at a good price and add one or 2% more to the position, tend not to add to it above 6%. We'll let positions run if they really outperform to get up to 10%. We try not to let positions get too far above 10% because there's mean reversion and if they've gotten up that high because of outperformance, they tend to mean revert back down. So we don't love positions that get above 10%. We have added more small positions recent in the last few years as we've owned more small banks than we normally do. And small banks, although they trade tens of thousand shares a day, even at our small size, we're owning a hundred thousand shares or 150,000 shares to these banks.
If they're only trading 50,000 shares, we don't want to take a month to get into them. So we'll own more small banks at smaller position sizes, like one or 2% on the short side positions, anywhere from one and a half to 3% is a normal position size on the short side. And we just are a little bit more conservative on the short side just because of the unlimited liability of we respect momentum and sometimes one of our shorts the market likes and they walk out higher and you can't stop it. So we just are a little bit more defensive on the short side.
Garrett Brookes:
Yeah, makes sense. Position that could take a month to get into, could to get out of, could end up taking you months and months and months or longer. So you like to maintain a nice liquidity profile of your portfolios.
Derek Pilecki:
Yeah, definitely.
Garrett Brookes:
That was actually the last of the questions to come through, so I'll go ahead and thank you all for joining us. Derek, do you have any last parting words that you'd like to leave us with here?
Derek Pilecki:
No, I mean I feel good about the portfolio. I think there's a lot of opportunities in the market and if somebody wants to talk to us about investing in our funds or what we think about specific parts of the financial sector, reach out to Garrett or me, we'd be happy to get on the phone with you.
Garrett Brookes:
Yeah, absolutely love having those conversations. We've had a lot of really interesting dialogues over the past, well even, I mean the past year, but really in the last quarter there's been a lot of really interesting conversations again, and I think one of the things that I've observed is the professional investors both domestically and abroad that are interested in the US financial sector is something that I think is really worth paying attention to. Great. Well, thank you all for joining us and look forward to seeing you on future presentations. Take care.