Slingshot Financial Podcast

Garrett Brookes:

Good afternoon everyone, and thank you for joining us. My name's Garrett Brooks with Slingshot Financial. Slingshot is a Colorado registered investment advisor. We also serve as a fee-based representative to institutions for specialized investment managers. And I'm very excited to have with us today our partners at Gator Capital Management. Joining me is Derek Pilecki, the founder of Gator Capital Management, the firm which he founded in 2008. He's currently the portfolio manager for the firm's long short equity, which is a financials focused strategy. Obviously, we'll get more into that. But really excited to have Derek with us here today. He manages his portfolio in a variety of structures, both private and public. Slightly different fee structures for each and liquidity constraints. But the same kind of principles, philosophy drive the investment process for each.

He's received numerous accolades over the years for top of its class or category. And I think in an environment like we're in right now, where the easy money and the Fed tailwind is not quite in place anymore, I think you really have to think differently. You have to specialize and really understand how to pick your spots, and manage risk in order to outperform on a risk adjusted basis. And I think Gator's strategy offers some great opportunities. So we're going to get into that a little bit here in a second. I would say if you have any questions, go ahead and put them in the chat and we'll answer them as they came in at the end. But to get things kicked off here. Hey, Derek, thanks for joining us.

Derek Pilecki:

Hey, Garrett, thanks for hosting the webinar.

Garrett Brookes:

Glad to. And again, glad you could be here with us. To get things started, would you mind telling us a little bit about your background, how you came to form Gator. And I guess some of the experiences along the way which have shaped your investment philosophy and process?

Derek Pilecki:

Yeah, so getting to the point of starting Gator, Gator's going to celebrate its 15th anniversary this June. But it was a long process to get to start Gator. When I had my first finance job after college, it was working for Fannie Mae, the mortgage company. So I was in their asset liability strategy group and I was an analyst. I ran the company's risk-based capital stress test. And back in the mid '90s, Fannie was one of the most admired companies in the country. And it was a great learning ground to learn about the fixed income market. Fannie's basically long mortgage backed securities and short agency notes. And they were on the cutting edge of structured notes. We'd issued structured notes and swap out at the whatever interest rate payment it was back to LIBOR minus 12 or whatever the street was offering.

And so, it was a great way to learn about the whole fixed income market. And while I was there, I was doing a lot of reading on my own about stocks in the stock market. I came across Roger Lowenstein's biography of Buffet, The Making of an American Capitalist, and just fell in love with the idea of having a small hedge fund. But I knew in my mid '20s, I wasn't ready to do it. I needed to get a little bit more training. So I went on this process where I went back to business school. I went to the University of Chicago, got my MBA, and used business school as a transition period to move from fixed income into equity research. And so, I worked at a couple small value shops after business school and it really made sense for me to cover financial companies, because I had worked inside a big financial company, and knew about interest rate risk management, and the like.

So I started covering financials on the buy side and then a classmate of mine from Chicago, who had gone to Goldman Sachs Asset Management, recruited me. He called me off and was like, "Hey, our bank analyst is just retired. And we own a bunch of Fannie Mae, will you please come interview?" And so, I moved to that. The Goldman job was actually in Tampa. They had bought a manager that had been previously part of Raymond James. And so, I moved to Tampa in 2002, 20 years ago, and worked for GSAM for five years covering financials for their team. And that team managed about $25 billion in growth stocks. I was one of two financials analysts on that team. Great training ground. I would say their investment philosophy was like a Charlie Munger style, buy great by great franchises, own them forever.

And so, I had my value roots and then influenced by a manager who followed Charlie Munger. And so, in 2008, it wasn't so fun being an analyst at an equity shop, a growth shop following credit sensitive financials. So I'm not the favorite child, so I used that as an opportunity to start Gator. And so, I launched Gator. So we started our financials long short strategy in 2008.

Garrett Brookes:

That's great. That's a heck of a time.

Derek Pilecki:

Yeah, it was a crazy start. Yeah, I launched 10 weeks before they short Lehman Brothers, so that was a crazy time. But there was also a ton of opportunity [inaudible 00:05:37]. So I was able to maximize.

Garrett Brookes:

Yeah, it's certainly a good time to be able to short.

Derek Pilecki:

Yeah, but that rally in 2009 was really tough to shorten too.

Garrett Brookes:

Right. Yeah.

Derek Pilecki:

You had a view the credit markets would heal and they weren't going to nationalize any more big banks. I was able to call the turn in '09. And so, we just have continued to find opportunity in the financial sector since then. So one of the outcomes of the financial crisis is there's a lot of generalist portfolio managers who don't love financials. They lost a bunch of financials in '08, and they kind of just ignore the sector, or they don't really dig deep into it. And so, I was always surprised by the number of good franchises that trade at cheap valuations in my sector.

Garrett Brookes:

As just a result of less analyst coverage, less fund managers covering. And then it's also, if I'm hearing you correctly, a fairly good amount of dispersion among the constituents in your universe. So you kind of stack opportunities there to grab some premium.

Derek Pilecki:

Yeah, I mean I always think the opportunity sets right now is as good as it's ever been with these changing interest rates, and companies, and financials... People say, "Oh, financials are an interest rate play." Well, not every financial company responds to interest rates the same way. You have a lender that's making fixed rate multi-family loans, and they have hot CDs as their funding base. They're not going to benefit from higher rates like a bank that has commercial floating rate loans, and a really strong core checking account deposit base. So I think there's a bunch of dispersion amongst returns within my sector, which is good for a long-short manager.

Garrett Brookes:

Absolutely. Absolutely. So you formed Gator in 2008 and began with the private fund, as well as some separately managed accounts, individual portfolios. And from there then assumed management of a mutual fund, a legacy mutual fund. And this is in November of 2017.

Derek Pilecki:

Right.

Garrett Brookes:

And then over the course of a year, transitioned the portfolio to your strategy as it is now, which was complete I guess in Q1 of 2019, if I'm not mistaken.

Derek Pilecki:

Correct. So Michael Orkin retired and started our process in 2017 to identify as a successor manager. I won that process and started on an interim basis. Took it over in November, 2017. The proxy was official in February of 2018. And Michael had run the portfolio as a bear market fund that he had really protected well on the downside in the internet bubble and the financial crisis. But that's just not my style of investing. So I agreed with the board in early 2019 to transition the portfolio to be more similar to how I run my main strategies. And so, now it reflects my investment style. And there's heavy overlap between the mutual fund, Caldwell & Orkin Gator Capital long-short fund, and my private fund.

Garrett Brookes:

Great. And actually I just checked on Morningstar before we jumped on here, and you are top 5% for the three year, and well within the top decile for the five year amongst your peers. So there is a clear change when you institute your portfolio on the legacy fund and it really bears out.

Derek Pilecki:

Yeah, I mean I think there's been a good opportunity over the last few years and we definitely have been able to create some value over the last five years, and looking forward to the next five years because I think there's still a lot of opportunity out there.

Garrett Brookes:

Yeah, and I am too. So with that being said, do you mind talking a little bit about your investment process and idea generation? I know it's a bottom up portfolio and would really like to hear your thoughts as a specialist on how you go about constructing the portfolio.

Derek Pilecki:

Yeah, so we're looking for stocks that are misunderstood. So usually that means they have a low valuation because people are ignoring them. They have a view that they're just dead or the earnings are going to evaporate. We take a look at the low valuation stocks is okay, if these earnings can maintain and the street changes its view of what the value of that earning stream is, then we can get a higher multiple. So a five PE stock goes to an APE stock, that's a pretty big return. And we're also looking for some kind of catalyst that's going to make that change. So an example would be Genworth Financial. We bought this stock last year. We had owned Genworth from 2012-2014.

And back then, the real issue was the mortgage insurance subsidiary ,where they're going to have to raise additional capital to fill a cap potential capital hole in mortgage insurance. And that stock played out well as it became clear that mortgage insurance was just going to be fine, housing marketing was clearly recovering. Well, the stock kind of blew up on long-term care insurance in late 2014, early 2015. Long-term care insurance is a really tough business. You're selling policies to 60 year olds for when they potentially go in a nursing home at 85. And so, they've written these policies 25 years ago that people are just making claims on, and the claims were way higher than anybody expected. So they kind of went through a long period.

If you look at the stock chart from 2014 to 2022, the stock flatlined. And during that period there was an aborted attempt to buy a Chinese insurance company to acquire them. They weren't able to get that past regulators. And so, the stock flatlined around three or $4 a share, and investors just lost interest. I mean their socks were moving all over the place and Genworth's just sitting there.

But during this time we had been following, Genworth had been doing a good job of raising prices in their long-term care insurance business. And they also were able to get the mortgage insurance subsidiary separated from the life insurance business, and they actually did an IPO of the mortgage insurance subsidiaries now enact holdings, which 20% trades on the New York Stock Exchange and Genworth still owns an 80% stake. And so, Genworth was fixing its capital. And then on the Q4 call last year, they said, "Hey, we're getting this cash in. We're going to our debts get paid down to the level where we're comfortable. We're going to start using excess cash now to buy back stock. And we're going to probably make an announcement on Q1 earnings."

And stock didn't really respond. And so, we bought a position, they announced it on Q1 earnings, stock still didn't respond. It wasn't until they actually started implementing the stock buyback in late 2022 that the stock started going up. So it's an example of follow things for a long time. For a long time there was nothing to do in Genworth, but then when the catalyst came of we're going to start the stock buyback, we took a position and move forward. So cheap stock trades for... I mean I think it trades for three times earnings now. I think there's creating value.

There is potential that long-term care, they could salvage some value out of that business. To own the stock here, you don't really need that. They're probably going to spin off the mortgage insurance business. And so, just a hated stock, couple billion dollar market cap, people weren't paying attention, and we were able to make some money in a pretty tough stock market last year. So that's just an example of the type of things we do. I would say right now, only about 20% of the portfolio has a market cap above $10 billion. So we have a lot of small mid-cap companies in the portfolio.

Garrett Brookes:

Yeah, and that's actually been a great spot to be so far year to date.

Derek Pilecki:

It has. And if you look at the style boxes on Morningstar, they classify us as a small cap value style box. And when I think about positioning our mutual fund in a portfolio, I mean I think it's a replacement for small cap value. We're not just hugging the index with a lot of unique stories within small cap land. I think small cap is a place where active management still pays it. You can extract alpha if you're following companies. The streets pull back on research efforts as big firms have experienced outflows due to shift from active to passive that there's less buy sign analysts on the street. So I just think that the opportunity in small caps is still robust.

Garrett Brookes:

And in the same spirit, you know came from one of the large firms, one of the gorillas really just before forming Gator, and then larger firms before that as well. Do you think that you have any additional advantage in having your own firm? And is there anything else that you're able to do that you couldn't do at some of the larger firms, I guess?

Derek Pilecki:

Yeah, I think large firms have resources and they have a lot of people to throw at problems. I think one of the main advantage of a small firm is the lack of bureaucracy. I mean, I don't have my day filled with administrative meetings. I spend a large percentage of my time focused on investment research. I don't spend the month of the July writing 360 degree reviews of 15 team members. I give feedback instantly to my small team of four. And we're not spending hours in meetings rehashing things or trying to posture. I mean, I'm doing investment research. So I think I go through more names, I spend more time on names. And I think that's a real advantage.

Garrett Brookes:

Yeah, absolutely. Well you mentioned just before a little bit about the profile of the mutual fund. And in the spirit of having some fun here and also disclosure, I also am an investor in Gator long-short. And so, we work together. I'm also an investor in the strategy, and I thought my style is probably not very different than some of the investment advisors on the call here, and the other folks that I talk to on a daily basis. And so, I thought it'd be fun to give you an idea of my insight and the [inaudible 00:17:17] portfolio in.

And so, I've always been... I've shared this with you and just about anybody I've talked with, I'm a big fan of alternative strategies. My own portfolio could best be described as a risk-based asset allocation model. I use both active and passive. I dedicate a specific allocation to alternative strategies. They're all liquid in a public format. And in the fourth quarter of last year, preparing to rebalance for Q1 here, I had decided that I wanted to reduce my traditional exposure in favor of increasing the alternative strategies.

And so, along the way throughout last year with the increase in vol, I had basically pulled out of some of my opportunistic equity allocations, you could consider them satellites I guess. Just because the vol became unpalatable for me. And also to dovetailing on your point, I tend to favor for the foreseeable future here, small value in favor of small growth. And so, what I did was actually removed small growth beta, a small growth beta position, and with the proceeds from that combined with some of the sold out of opportunistic equity, invested in the Gator long-short strategy, and included that in my liquid alternatives allocation.

Derek Pilecki:

Yeah, I mean I think that makes a lot of sense. You remember back from the internet bubble when small growth blew up, it was years. It was like a good 10 years before small growth showed any relative performance. I mean value went on a multi-year run after the internet bubble and we could see the same thing here. You look at some of the values of small growth companies and it's still pretty high. And so, I think that makes a lot of sense.

Garrett Brookes:

And I just think also with... Certainly we could say, you could argue that liquidity will be pulled out of the system. It's certainly not being added as it has been for the past 10 years. And so, I think that some of the more speculative, higher flying names, large cap as well as small caps, it's going to be a little bit tougher. And so, I think that the value space is where you're able to really extract some excess return for the level of risk.

Derek Pilecki:

Yeah, I agree. I think that makes a lot of sense.

Garrett Brookes:

So now some of the fun parts. Where are you seeing opportunity? What do you like right now?

Derek Pilecki:

Yeah, so in the portfolio, I really like midcap banks. So there's many mid-cap banks that are growing earnings, they're growing loan growth. That they're well run, I think the underwriting's conservative, and they're trading for six or seven times earnings. And so, last year was really interesting. Banks came out of the gate the first January, February, hey rates are going up, banks are going to outperform. They outperformed the S&P by like 12% in January and February alone. And then Russia invaded Ukraine and they gave up all that outperformance through the end of June. And then from June on they kind of tracked the broader market. So super disappointing year last year for banks, especially given that rates are higher.

But with higher rates, earnings are higher on average for banks. Not every bank but on average for banks. And so, right now we have the cheapest valuations I've ever seen with for banks or not ever, but going back to the mid '90s cheap. And so, I just don't think these mid-cap banks should trade it for six or seven times earning. And so, examples are Pac West, Western Alliance, East West Bancorp, Webster Financial. So really excited about this group of banks. And I think that there could be easily a scenario where these banks trade for 10, 11, or 12 times earnings. So going from six, seven times earnings to low double digits would get a nice return. And in the meantime they're growing their business and low growth is attractive.

I guess the negatives that people point out is, "Oh, well there's deposit funding, costs are ramping up." And yes, that that's happening, but at some point that will level off and they'll earn their normal margin. And in the meantime they've compounded their growth through continuing to put up one growth in the high single low double-digit area. A tangentially to that, I really like Puerto Rico for the banking environment. So Puerto Rico is a US territory. Banks there regulated by the FDIC, they issue press releases, they attend the American banking conferences. They are US banks.

Puerto Rico only has three banks on the island. So it's an oligopoly. And if you go back to the pre-financial crisis, there were 11 banks in Puerto Rico and it was super competitive. And so, if you look at another island banking market, Hawaii, there's four banks in Hawaii. And each of those four banks earn wide margins, and they have high returns, and they have premium valuations. But the Puerto Rican banks trade in line to at a slight discount to US banks. So I think that we've already seen evidence that their margins are going up and their returns are increasing. I think it's a matter of time before the multiples go to a premium. So really think Puerto Rico's interesting.

I think there's selective opportunity in asset managers. So the two groups asset managers. Alternative asset managers, private equity firms. And then traditional asset managers, they publicly traded. They manage mutual funds or vehicles that we're familiar with. And so, I think I see opportunities in both groups. So in alternative asset managers, I really like Carlyle. Carlyle had a phenomenal 2020, 2021 as all the private equity managers did. In 2022, Carlyle took a step back. They botched their CEO transition. So the founders had appointed dual CEOs five years ago. One left to become governor of Virginia. The other one, they didn't renew his contract, so the founders stepped back in and took over management of the company last year. And the stock got crushed because of it.

It was like the street took this view of like, "Oh, it'll never be fixed. People will leave Carlyle without a CEO," which is just nonsense, I think. I can think there's investment professionals that are there at Carlyle, they've been there their whole lives. They're not going to leave just because there's a little bit in transition. Well, the new CEO finally got appointed yesterday. And he's a former Goldman guy. I think he'll bring some credibility to Carlyle. One of the knocks on Carlyle is they're less profitable than the other the private equity shops. Carlyle had always managed their business where we run and operate the business on management fees. So we spend all our management fees trying to grow the business. And then we pay ourselves on the incentive fee. Well, when that was fine, when they're privately traded partnership, but now that they're publicly traded, and Blackstone, and KKR showing huge profitability on the management fee line item alone, Carlyle changed.

And so, they've shown a ton of operating leverage the last three years, that transition's happening. I still think there's some probably excess expenses in Carlyle's expense base. I think the new CEO will come in and attack that and they'll show even more operating leverage. So I really like Carlyle valuation came down to nine or 10 times fee related earnings, and then you get all the incentive income for free. So I just think that's way too cheap. Normally people, they do some of the parts and they buy 15 or 18 times to management fees, and maybe a two or three multiple to incentive fee. So I think there's a lot upside with Carlyle. Within the traditional asset managers, I like Vertice and I like Victory Capital. Both are acquisitive firms. They buy smaller managers, they consolidate the back office and the sales teams, they hold onto the assets they acquire, and they're hugely creative deals.

And so, I think it's a little bit of financial engineering. They're able to get these small managers cheap because traditional asset managers are so out of favor because we have the shift from active to passive. But it just works in an acquisition strategy. So they both trade at six times the EBITDA. I think that's too cheap. I think they'll continue to make a creative acquisitions, and they've been smart with their capital management.

And then on the long side of the last thing that I like, is the selective life insurance companies. So I already mentioned Genworth, another one I like is Jackson National. It's a classic spinoff type story. It was a subsidiary of Prudential UK, the British Insurance company, they decided to spin it off. Prudential UK, of course, trades in London. When they spun off the shares, the shares traded in US. So you had a bunch of UK investors all of a sudden end up with this tiny position, this unloved newly spun off US insurance company. So the valuation came on the first day of the spinoff, came out super cheap. Still trades at a cheap multiple. Management team's been very aggressive with capital management, buying back shares, paying an attractive dividend. It's an ugly business. Variable annuity platform is... There's a lot of downside risk when the market goes south, but I think they've done a good job of managing the risk and managing their capital. So those are the ideas I like on the long side.

Garrett Brookes:

And I think you're hammering home just how differentiated the different drivers of excess return within the financial space. Myself and other kind of macro level asset allocators, I think we tend to look at financials as a pure yield curve shape play or kind of a price momentum. And this really is kind of eye-opening that there are deeper value situations here and different ways to add some premium.

Derek Pilecki:

Yes.

Garrett Brookes:

How about... Oh, I'm sorry.

Derek Pilecki:

Oh, I was just going to say the view that you want to only buy financials when the yield curve steep, you miss all these stories. There's a lot of stories that are not driven by interest rates.

Garrett Brookes:

Yeah. How about on the other side, the short side?

Derek Pilecki:

Well, I think the most glaring obvious thing is office. We have a problem with offices. I mean, people aren't going to go back to work. If they go back to work, they're not going every day. While there might be the investment bankers, and the advertising executives, and the attorneys need to be in the office, so they do their apprenticeship model. There's a lot of people who are not going back to the office. Law firms that you should have 10 floors in midtown Manhattan, their back office people don't need to be in-person, they're going to work from home. They're going to take seven floors when their lease renews.

And so, what we've seen is people are paying their leases when they expire, they're going to take less space. That's a problem for office owners. So the bull case on office rates is, oh well they trade a huge discount to NAV. Well an NAV implies private market values are real. I totally disagree with that. There's a problem. We have too much office space in the US. It's an acute problem in the central business districts, New York, Chicago, and San Francisco. The commutes are too long. People aren't going to do make those commutes anymore. Excuse me.

Garrett Brookes:

Sure.

Derek Pilecki:

So I'm sure at every office street, I think it's a huge opportunity on the short side.

Garrett Brookes:

Yeah, and that's a great point because you do... That is what you hear. If you listen to the financial press, they're already a discount to NAV. Well, that's a great point. What is the NAV? And I think we've talked about this before and there's just not a lot of transactions in office right now. So those are probably kind of due for markdowns, those NAVs.

Derek Pilecki:

Right.And we also see it from the bank lens. We talked to banks. Banks are starting to call out what their office exposure is, what the LTVs are, how big the portfolio is, how much is suburban versus central business district. They're all talking about we're not making new office loans. And when capital leaves a sector like we saw with oil and gas, when you cap service sector, stock valuations do not work. Stock prices do not work. And so, if they can't get loans rolled over, it's just not going to work.

Garrett Brookes:

That's great. Thank you.

Derek Pilecki:

And I guess on the other short opportunity is there's been a lot of new companies that have come public through SPAC or IPO over the last two or three years. And so, some of those business models are untested, some of them are flimsy. So I think a lot of them got crushed in 2022. But with this junk rally in early 2023, we're revisiting some of those stories that we're going to get a second bite at the apple wall. So I think that's pretty interesting

Garrett Brookes:

That's interesting. That's a great point. This kind of risk on rally that we're seeing has giving you a new entry point for the shorts.

Derek Pilecki:

Definitely.

Garrett Brookes:

Well, thank you. Thank you for the time. Like anybody has any questions here? I'm going to again open up this chat and field a couple as they came in. Looks like there's just a couple in here. Okay. So I think what this one is getting at is, can you talk about what drives long versus short percentage or allocation in your strategy?

Derek Pilecki:

Yep. So right now the mutual fund is 90% gross long and we're 30% gross short, so the net 60. I would say that's pretty typical when I look back through the history of my strategies, can't say that changing the net exposure has added a ton of alpha. Really the alpha has been from stock picking. And so, we focus on that. I would say it's driven from a bottom up perspective of if we find more shorts, our net exposure will be less. We do not use leverage to the extent that we don't make gross longs above a hundred percent.

So I think about this level is about what you would expect. Maybe it'll go to 50, maybe it'll go to 75 or 80, but in the 60 range is what I would expect the normal course would be. I think that there could be a scenario where if I got uncomfortable with underwriting in the banking system generally, where I thought that there was going to be real problem with credit losses, we could get our net exposure way down. I don't anticipate that happening. I think everybody still has PTSD from the financial crisis and underwritings staying strong, that regulators are solo over the banks. The Dodd-Frank Bill has gotten a lot of the more risky lending outside of the banking system. And so, I don't envision a scenario where banks will really loosen up underwriting in the near term.

Garrett Brookes:

That's great. And you already answered the next one, which was about do you employ leverage? And so, we have one more here. This is a fun one. Do you think we will see more mergers in the asset management space?

Derek Pilecki:

I do think it's going to be a consolidating industry. I think there's a couple things driving it. I think there's some headwinds with the shift from active to passive. I think we have some generational turnover, And so, people are going to be looking for exits. I think there will be continued consolidation in that space. Yes.

Garrett Brookes:

Great.

Derek Pilecki:

Yeah, we know how hard it is for small managers to get started, and consultants are really driving the market, and flows gravitate to the bigger managers. So I think there's a real case for scale and asset management.

Garrett Brookes:

Yeah. Great. And I guess we can wrap it up here. It doesn't look like there's any more. Obviously, if anybody has questions, specific things that they'd like to talk about offline, feel free to reach out to me. You could also just quickly pop a message here into the chat and I'll catch up with you at a convenient time. But any parting words here, Derek?

Derek Pilecki:

No I mean, I appreciate everybody's attention. We've been running the mutual fund for five years. We've been running our broader strategy for 15 years. I think there's a lot of opportunity and long short financials, especially in the small midcap area. So appreciate everybody's time today.

Garrett Brookes:

Fantastic. And I think there's a ton of opportunity as well. All right, everybody, thank you for joining us. And hope to talk to you again and join us for future programs here. Take care.

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