Idea Brunch #2 with Derek Pilecki of Gator Capital
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Derek Pilecki!
Derek is currently the portfolio manager of Gator Capital, a Financials sector long/short fund he launched in July 2008. Since inception, Gator Capital has returned ~1,900% compared to ~485% for the S&P 500 and ~260% for the S&P 1500 Financials index. Before launching Gator Capital, Derek was an analyst at Goldman Sachs and Clover Capital. Derek was previously featured on Idea Brunch in November 2021.
Derek, thanks for doing Sunday’s Idea Brunch again! Can you please tell readers about your background and why you decided to launch Gator Capital?
Thanks, Edwin! I launched Gator in the middle of the Great Financial Crisis. It was a crazy time to start a Financials sector fund. But the crash in 2008 presented a lot of opportunities. It was an exciting time. The volatility was extreme, and there was a tremendous amount of news affecting stocks. I was able to find many opportunities post-crash in stocks that were priced for failure. I had a view in early 2009 that regulators had realized they made mistakes in September 2008 and forced too many large banks and financial companies to shut down. Regulators realized they had hurt the economy because they had shattered confidence in the financial system. I thought this meant they wouldn’t shut down Citigroup or Bank of America. As the financial system recovered in 2009, I was well positioned to take advantage of the recovery.
I decided to focus my fund on the Financials sector because I had industry experience at a major financial institution and had covered Financials while I was on the buyside. Prior to business school, I worked in asset/liability strategy for Fannie Mae. My main responsibility was running the model that stress-tested the company’s investment portfolio for extreme interest rate scenarios. I had to load Fannie’s entire investment portfolio into the computer and set all the inputs for the interest rate scenarios. This was circa 1996, and we could only run one interest rate scenario at a time. It took 10 hours to run a single scenario on a Sun Sparc workstation, so if I made a mistake on setting up the inputs or inputting the portfolio, I would waste a chunk of time. This was a great motivator to get the portfolio and the inputs set correctly before starting a new rate scenario. I spent so many nights and weekends running rate scenarios in the depths of Fannie Mae, that I got to know their investment portfolio very well at a CUSIP level.
While I was working at Fannie Mae, I fell in love with stocks and decided I wanted to move to equity research, so I left Fannie to go to business school at Chicago. I was able to use business school as a transition to equity research. As an analyst on the buyside, I covered the Financials sector because of my experience at Fannie Mae. Prior to starting Gator Capital, I worked at Goldman Sachs Asset Management (“GSAM”) on their Growth Equity Team covering the Financials sector. When I was deciding on my investment strategy for Gator, I thought my best chance for success was to specialize in the area I knew well.
I believe the Financials sector is one of those sectors like energy or biotech where you need specialization to really dig down deep within the sector. I’m not trying to go long JPM into the earnings print or trying to play the spread between long FITB vs. short KEY. I’m trying to find a gem like HOOD late last year that is left for dead when there are a lot of positives that the market is ignoring. Within the Financials sector, there are many different business models. Each business model has its own income statement and balance sheet. Whether you look at a bank vs. a life insurance company vs. a property-casualty insurance company vs. a stock brokerage firm vs. a real estate investment trust vs. an asset manager, you must analyze a different income statement and balance sheet. My specialization in the Financials sector has allowed me to familiarize myself with smaller companies in the sector. I have followed many of them closely over a long period of time.
I love investing in Financials because there are regular opportunities. I find that companies go in and out-of-favor for crazy reasons, which provides opportunities. A lot of generalist investors avoid the sector altogether. Investors lost so much money in so many banks and other large financial companies during the GFC that almost everybody still has scars from that time. But, I think the Dodd-Frank bill was a game changer for the Financials sector in that it has greatly reduced the catastrophic risk of large banks failing. I don’t think we’ll have another bank crisis like we did from 2007-09 during my lifetime, but the market prices the Financials sector like it is going to happen every other year.
Can you please tell us more about Gator Capital’s portfolio and investment strategy?
At Gator, our fund uses a long/short strategy focused on the Financials sector. It is a bottom-up, deeply researched portfolio of companies that we believe are undervalued, because they are overlooked or misunderstood by the Street. We look at areas like banks, non-bank lenders, capital markets, asset managers, insurance (both property & casualty and life), and REITs to find pockets of value and opportunity. Our sweet spot lies in small to mid-cap companies, where we can extract value from our research, experience, and patience.
I run the portfolio net long, historically between 40% - 80%, with 20 to 30 names each in the long and short book. We hold a slightly higher number of positions right now because we hold some small cap banks that have less liquidity, so I prefer to hold smaller weights in those positions. But, for most of our small-to-mid cap positions, our initial position sizes are 4% to 5%. I find that I am able to build those positions in a short period of time. For example, I was able to build a large position in Robinhood one morning last November within a couple of hours without moving the stock.
We use a relatively mild amount of leverage at approximately 130% gross long. On the short side, we short individual companies that we believe will underperform the sector. Historically, the vast amount of our outperformance has been attributable to stock picking on the long side. Although our shorts have contributed a small portion of our outperformance by lagging the broad sector over time. As a result, I think about our shorts as providing us the opportunity to own more of our longs, and they provide some ballast in volatile periods.
The average holding period for long positions is about three years. I am looking for opportunities where I believe a stock can double over that timeframe. Turnover has been a bit higher during periods of volatility in the sector because during drawdowns we tend to sell names that have held up in order to recycle capital in those stocks that I believe have been over-sold. This has helped us to recover relatively quickly.
The portfolio is not constrained by any top-down allocation mandates, so sub-sector industry weightings and themes in the portfolio are the result of stock picking, and we want to give the heaviest weightings to our highest conviction ideas. Currently, our heaviest weighting is to banks, and I see the greatest opportunity in smaller and mid-sized banks. I was underweight regional banks from 2014 to 2020, but with the current valuations, I think the industry is mispriced. Asset managers, insurers, and capital markets firms are some other industries with significant weighting in the portfolio right now.
The housing market, with its ups and downs, is another area I am watching closely. Given the Fed's current high rates, I foresee potential gains once mortgage rates ease and supply-demand dynamics improve. Then there are the growth banks. These banks operate in specialized niches among the 600+ banks across the US. They often fly under the radar of mainstream research but have shown impressive returns on capital.
Where do you get your ideas from? What is the primary metric or metrics that you use to evaluate potential investments?
I am a value investor at heart. Value speaks to me. When I see companies trading at 6x or 7x earnings, I need to understand why. Are earnings about to go down or are investors disappointed with the current growth prospects? At the same time, I worked for a great growth investor, Herb Ehlers, so I was well-schooled about how growth is an important part of the value equation.
My ideas come from a variety of sources. US Financials encompass roughly 1,000 companies, 600 of which are microcap banks, which narrows my universe to approximately 400 names. Having covered the sector for more than 25 years, I am familiar with many of these companies. I screen this universe periodically. I look at companies with low valuations. I look at companies with high return on assets or return on equity. This universe doesn’t change significantly from year-to-year. There are not a lot of IPOs in the Financials sector.
Through the years I have also found sources of outside research that I think are valuable. There are a few sell side analysts that know certain banks and their management teams very well because they have covered those banks for years. I also talk to some long-time friends on the buy side to share ideas and get their perspective.
People give me feedback when I write up my quarterly letters, telling me why they agree or disagree with my ideas, and I find it helpful to think through their arguments. For example, years ago I wrote a long article on my short thesis for publicly traded companies that own single family homes and rent them out. An investor who ran a distressed debt fund wrote me back and we had a phone call about why he disagreed with my thesis. He had been around the markets for a long time, and he agreed with some parts of my thesis, but he believed there was a shortage of new building in homes and home prices had nowhere to go but up. He said, “To the extent that I agree with you, they don't have the economies of scale that apartment owners have, but if home prices go up, these stocks work, so I don't think it's a good short.” Interactions like that are very productive for the process.
Between Signature Bank, Silvergate Bank, Silicon Valley Bank, and First Republic, we’ve seen a meaningful number of bank failures in recent years. How do you avoid investing in banks with a heightened risk of failure? And is there anything regulators should be doing differently?
The recent failures of banks like Silicon Valley Bank (SVB) and Signature Bank in March of 2023 were indeed significant events for the industry. SVB, for instance, faced a crisis when it announced the sale of its low-yielding MBS securities on March 8th, triggering a massive $40 billion withdrawal from depositors in a single day, mainly from its concentrated base of venture capital players.
We had invested in SVB in 2019 but decided to sell our stake in 2020 at the onset of the pandemic, as we saw better opportunities elsewhere. While SVB had successfully expanded its deposit base, its low loan-to-deposit ratio of around 50% forced management to find other investment assets. Unfortunately, management invested in long-term, low-yielding mortgage bonds. When the Fed began raising rates, the value of these bonds declined sharply, leading to significant losses in SVB's portfolio. This impacted their capital and liquidity to the point where their concentrated customer base caused an overnight run on the bank.
In assessing banks for investment, I focus on key metrics that gauge their ability to generate returns. The recent failures highlighted how banks heavily invested in low-yielding, high-duration bonds struggled under rising interest rates. They faced challenges in maintaining desired spreads, which strained liquidity as they paid out higher interest to depositors while capital was tied up in longer duration investments, impacting future growth.
As for regulatory improvements, I am frustrated that regulators have not addressed the core issues with the bank failures in March 2023: 1) the modern speed of money movement and 2) deposit insurance limits that are archaic.
With the ease of using their banking apps on smartphones, depositors can move money faster than ever before. You don’t have to go into a branch to withdraw funds or send a wire. It is simple to move money to your linked accounts with a few clicks. Regulators haven’t addressed this issue. Instead, they want banks to hold more capital. But, more capital doesn’t mean more liquidity. What we need is for banks to report to regulators about customer concentration and account types. We need regulators to require liquidity based on more drastic customer flows. Silicon Valley had 60% of its deposit base withdraw within 48 hours.
Depositors would be less likely to flee if there were modern deposit insurance limits that considered the faster moving modern world. We should have unlimited deposit insurance for non-interest-bearing checking accounts. We can’t stop the flow of business because consumers and companies are worried about losing their operating funds. Everyone needs comfort that the money for their next mortgage payment or next payroll is safe. Then, we should raise the deposit insurance limit for consumer interest-bearing deposits. We can’t expect consumers to evaluate the health of their bank. There has never been a bank management who has changed their risk tolerance because a consumer asked them to. Even as a significant, long-term shareholder, I have a hard time getting bankers to change their risk appetite. Plus, the task of predicting when a bank may fail is almost impossible for a consumer. Silicon Valley Bank had a market capitalization of $16 billion only 48 hours before it failed.
I think the bank failures in 2023 were the result of idiosyncratic issues within those banks, rather than a systemic problem. In general, the industry has become more conservative since the Great Financial Crisis as the passage of Dodd-Frank has forced some of the riskiest lending away from the banks and into the growing private credit segment. I believe the reduction in leverage and the amount of lending that was pushed out of the banking system will make another debacle like 2008 unlikely. Regulators continue to scrutinize banks’ loan portfolios during exams and credit quality has been exceptionally strong over the last several years.
What are some themes in your portfolio today?
The major theme in the portfolio right now is what we term growth banks. When you think about the distribution of banks that are out there, some are well-run, some are not well-run, some grow by acquisition. There is a group of banks that have strong organic growth and have high returns on capital. These banks are able to reinvest that capital generated into organic loan growth. To foster growth, they might hire small teams of bankers from bigger banks or enter new business lines. They might buy a small platform lending company and use their balance sheet to expand it. When I think about it, there are seven or eight of these growth banks including Western Alliance (NYSE: WAL — $8.45 billion), Pinnacle (NASDAQ: PNFP — $7.19 billion), Webster (NYSE: WBS — $8.20 billion), Wintrust (NASDAQ: WTFC — $6.49 billion), and Axos (NYSE: AX — $4.04 billion). These banks grow faster than the rest of the industry. They also usually trade at a premium to the rest of the industry. The industry usually trades at 11 or 12 times earnings, while these usually trade at 14 or 15 times.
Right now, there is no premium in the growth banks’ multiple, and they all trade along with the rest of the industry, at eight times earnings. This is historically low and would imply that you get that growth for free. I think this is partly because the banks that failed last year were considered growth banks, so people are shying away from growth thinking the growth banks names are riskier.
I think these banks are well run and conservatively run. These banks are not mono-line type banks as the banks that failed last year. There is a long-held view of investors that you don't want to own the fastest growers as you head into a recession, and we may or may not be heading into a recession or credit cycle now, so there are valid reasons why the growth banks are languishing underperforming. I'm comfortable owning them, because I think their credit quality is going to be fine through the cycle, and bank stock prices will generally mean-revert up, plus the growth banks are going to regain their premium valuation. And while we wait, they are going to grow faster than the other banks.
My view on credit is not as pessimistic as some other investors. I think office towers in the major markets like New York, Chicago, and San Francisco will struggle for a while as old leases run off and companies do not renew for the same amount of space. However, most of those credits are held in CMBS, CLOs, and not on regional banks’ balance sheets. Credit is certainly something that we watch very closely, but I do not see it as a problem for the next 4-6 quarters. Most of the management teams I talk with are very transparent about their exposures and the portions of their loan books that are concerning. They also have begun to break out their real estate exposure by sector. Right now, I am generally comfortable with credit quality.