Financials Unplugged

We want to thank Derek for jumping on this months Happy Hour to chat all things Financials! Was a great episode and we learned a lot! We urge everyone to shoot him a follow at @GatorCapital and sign up for his quarterlies.  We have read him for a decade and highly recommend!

As always, we will get the recording up asap on the video page of the website.  In the meantime, let’s let AI do some heavy lifting for those that missed it live:

1. Derek’s Background and Investment Philosophy:

Derek has 25 years of experience on the buy side, with 17 years running Gator Capital, a boutique investment advisor focused on the financial services sector. His firm manages a long/short portfolio of financials. His past experience includes working at Goldman’s growth team and Fannie Mae, where he gained extensive knowledge of fixed-income markets and interest rate risk analysis.

• Journey to Equities: Derek’s interest in stocks was sparked by reading Buffett’s biography while at Fannie Mae, leading him to transition to equity research after business school. Covering financials was a natural fit.
• Investment Goal: His “rule of thumb to buy a stock is if I can come up with the thesis that it’s going to double in 3 years, that it’ll find its way into the portfolio.”
• Agnostic on Growth vs. Value: Derek aims to be flexible, investing in both growth and value stocks within the financial sector. He highlights “growth banks” (high ROEs, organic growth) as a strong recent trade since the Silicon Valley and First Republic failures.
• Evolution of Portfolio: Historically, his portfolio included “special sits slash liquidation plays” and “binary bets.” He now focuses on “cheap regular businesses,” leading to an improved “quality of the portfolio” and reduced volatility during sell-offs. He also notes a shift towards “less capital intensive or balance sheet heavy banks” like retail brokers and asset managers.
• Portfolio Concentration: Derek has moved from a “much more concentrated portfolio” (22-24 names) to 40-45 names in recent years. This change is partly attributed to the availability of cheap small banks post-COVID and SVB, which require smaller position sizes due to lower liquidity. He believes owning more names in a specialized sector like financials doesn’t necessarily mean less diversification.
• Confidence and Repetition: He believes “investing is about repetition and and getting reps and like the longer you invest the better you get.” His recent strong performance has boosted his confidence, though he acknowledges it will likely be “humbled” eventually.
• Blind Spots: Derek identifies his past “shorting” strategy as a blind spot, particularly shorting “expensive, high-quality small cap banks” that didn’t provide adequate protection during market sell-offs. He’s also “too patient with stocks” that haven’t worked, and is actively trying to improve his exit strategy for underperforming names.
• Idea Generation: Ideas often come from “cheap stocks” (low multiples) or “corporate change that hasn’t shown up in the valuation yet (editor note: That why we all read KEDM!!).” His process involves regularly reviewing his current portfolio (grading each holding), maintaining an “idea list” of names he’s done work on and is comfortable buying, and a “watch list” for new or developing ideas.

2. Key Market Observations and Thematic Views:

• Yield Curve: The current inverted yield curve (overnight to two-year) suggests the Fed can cut rates “one or two times.” Derek believes this is advisable due to “slowness in consumer spending” (e.g., Las Vegas visitor data) and a struggling housing market.
• Impact on Financials: A steepening yield curve (specifically, 50-100 basis points between overnight and five-year rates) would be “hugely beneficial to regional banks.”
• Regional Banks: Derek sees “small midcap regional banks” as “undervalued,” trading at “eight nine times next year’s earnings where normally they’re 11 or 12 times.” This undervaluation is partly due to the flat yield curve.
• Shorting Challenges: Shorting is “hard.” Most of Derek’s alpha has come from the long side. He highlights the difficulty of getting “multi-baggers on the short side” and the risk of being right on a short but then seeing the stock “bounce in your face” (e.g., $OPEN becoming a “meme” stock, which he was short).
• Market Volatility: While not a primary investment area for him, Derek agrees that “volatility is probably on the rise here.” He acknowledges that “volatility based businesses” (like CME, SNEX, MRX and CBOEs) should “over earn going forward.”
• Financial Nihilism (Project Zimbabwe): The concept of increased financial volatility and potential for a “steep yield curve” due to government money printing is discussed. Preferred Assets in this Scenario: Derek suggests “Visa and Mastercard” as “the best tollkeepers” due to their fee structure based on transaction volume, which benefits from inflation. He also points to “exchanges” and “brokers” like Raymond James and Ameriprise as high-quality businesses that could perform well. The key is to avoid “long, you know, lenders or fixed rate lenders.”
• Historical Context of Recessions: Derek believes that strong banks lead to “shallow recessions or rolling recessions,” rather than deep ones. He argues that the banking system is “safer than it’s ever been” due to Dodd-Frank regulations.
• Commercial Real Estate (CRE) Concerns: There’s a discussion about banks “holding on to basically crappy loans” in CRE, delaying recognition of losses. Derek views this as a historical pattern of banks getting into trouble by not resolving problem loans. He also notes that regulators have been “slow” and “distracted” in addressing these issues.
• Private Credit: Derek has a “polyanna vision of private credit” from a bank’s perspective. He believes it’s “very good for the banks” because it handles “more marginal loans” that banks can no longer make post-Dodd-Frank. Private credit also uses less leverage and is more flexible in working out problems. He concludes that “private credit’s here to stay. It’s going to grow.”
• Private Equity & Alternative Managers in Insurance: The trend of PE firms acquiring life and annuity insurers is seen as them “trying to put a lot of money to work” and utilizing permanent, long-duration capital. While Derek initially had concerns about Apollo acquiring Athene, he notes that these insurance companies don’t require high returns (e.g., 8% compounded) to pay off annuities, making it potentially “okay.”

3. Specific Investment Ideas and Observations:

• Robinhood (HOOD): Derek originally shorted HOOD, but covered when he realized its cash per share provided a floor. He became interested when the company cut costs, became profitable, and introduced new products, anticipating accelerated customer growth. He drew parallels to the “online brokers” growth curve of 1999-2000. He bought at $8.07, expecting a double in three years, but the Bitcoin ETF approval accelerated its performance. Concerns: He worries about new customers being less profitable “buy and hold investors” and the long-term risk of a “crypto implosion.” However, he sees “room for Robin Hood to increase their spreads on retail crypto trading.”
• WEX: Derek recently bought shares of WEX, a payments company trading at “like eight times earnings.” He highlights its share buybacks, asset-light nature, strong free cash flow conversion, and “leverage” as attractive features (viewing it “almost like buying a publicly traded LBO”). He acknowledges some investor fatigue due to the stock’s long period of flat performance.
• Jackson Financial (JXN): Derek still owns JXN, an annuity provider. His initial thesis was based on it being a “classic spin-off” from Credential UK, leading to a “super low” valuation (25% of tangible book value). The stock has since risen significantly. He commends management for “pulling cash out of the insurance regulated subsidiary and using that cash to buy back stock at a discount to tangible book,” paying a dividend, and diversifying products. He hopes for a sale to private equity.
• Barclays (BCS): Derek has owned Barclays for six years. The thesis is based on “returning a bunch of capital to shareholders,” increasing ROE, and shrinking the investment bank relative to the rest of the bank. He acknowledges its history of scandals but notes a recent improvement in this area.
• French Banks (BNP & SocGen): Derek recently added BNP and SocGen to his portfolio, seeing them as undervalued (trading at a significant discount to tangible book value). He highlights the “sea change” in management, with new CEOs focused on increasing ROE by “selling off low return businesses and reinvesting in high return businesses,” a departure from the historical “empire builders” approach.
• Growth Banks (Non-Failing Post-SVB): He sees opportunities in growth banks that didn’t fail during the 2023 crisis, such as Pinnacle, Western Alliance, Customers, United Missouri, and Axos, which trade in line with the rest of the industry despite faster growth and higher ROEs.
• SoFi: Derek acknowledges SoFi’s ability to offer “innovative things” and compete on pricing (e.g., cash deposit holds, interest rates on deposits) where large banks won’t. He believes “there’s a real place for growth for for the web banks like SoFi.”
• JP Morgan (JPM): Derek views JPM as a “monster,” rapidly taking market share both online and through branch expansion. He sees this as a “real issue for the midsize guys” in banking.
• Mortgage Originators/Services (e.g., PennyMac Financial Services): Derek previously owned PennyMac but sold it due to concerns about origination business in a high-rate environment. He recognizes the value of servicing businesses.
• Anywhere Real Estate: Derek is long Anywhere Real Estate, a “super speculative play” as a “residential real estate broker” with high leverage, anticipating a rebound in existing home sales.
• Mortgage Insurers: Derek is short mortgage insurers due to their “pretty well” pricing relative to historical levels and concerns about “home price volatility in some of the COVID boom towns,” potentially leading to higher credit reserves from their 2022-2023 books.
• Canadian Banks (e.g., RBC): While acknowledging RBC as a “well-run business” that “trades cheap,” Derek no longer owns it due to concerns about the “Toronto and Vancouver condo markets.”
• Texas Banks (e.g., TCBI, Business First Bank): Derek sees Texas as a compelling growth area. He finds TCBI “interesting” due to its aggressive shift towards a merchant/investment bank model. He personally owns Business First Bank (BFST), a small Louisiana bank expanding into Dallas and Houston.

4. Broader Industry Trends and Challenges:

• Bank M&A: Derek sees bank M&A as “super interesting” for analyzing good vs. bad deals for both long and short positions. He also believes more deal activity will attract “more investors” to the space, potentially leading to “higher valuations.”
• Regulatory Consistency: Derek criticizes regulators for a lack of consistency, highlighting their failure to identify interest rate risk in 2022 (leading to SVB’s collapse) and their distraction from “nuts and bolts of banking 101.” He attributes this to “different agendas” and a lack of experienced “career regulators.”
• Underpriced Loans by Banks: Derek implies that banks may have been “underpricing” certain riskier loans that private credit is now taking on at higher yields.
• Institutional Exposure to Private Equity: A “potential problem area” is that “too many institutions are illiquid because they’ve committed so much money to private credit and private equity,” a concern that briefly manifested with college endowments selling off PE holdings earlier in the year.

Turning back to KEDM, we are planning another Happy Hour in the next couple weeks, so be sure to keep your eyes peeled for our next great guest!!