Motley Fool Hidden Gems Investing - Big Banks Sure Are Quiet These Days

Episode Date: March 13, 2023

Regulators seized another bank over the weekend, as the federal government came up with a plan to use money from a fund paid into by U.S. banks to make SVB's depositors whole again. (0:21) Jason Moser discusses: - Signature Bank failing and shares of First Republic Bank falling 60%. - Why "bailout" is probably not the right word to describe what's happening - How big banks like JPMorgan Chase and Bank of America are gaining strength simply by going about their business (11:20) We're celebrating our own version of "March Madness" by having analysts face off, bracket-style, as they go head-to-head over which stock is a better buy. Jim Gillies and Jim Mueller kick off the week with a biotech software company and a well-known real estate broker. Companies discussed: SIVB, SBNY, FRC, SCHW, BAC, JPM, SDGR, RMAX Host: Chris Hill Guests: Jason Moser, Jim Gillies, Jim Mueller Producer: Ricky Mulvey Engineers: Dan Boyd, Kyle Carruthers Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. We're kicking off our own version of March Madness. Motley Fool Money starts now. I'm Chris Hill. Joining me today, Motley Fool Senior Analyst Jason Moser. Thanks for being here. Hey, thanks for having me. So, I said this on Friday's show, the situation is fluid. It continues to be that way. And for anyone who missed it on Friday, you, me, and Matt Argersinger talked about Silicon Valley Bank, the possibility that by Sunday night, Silicon Valley Bank could by then be the property of another bank. That is not the case. What is the case is that Signature Bank, which is a commercial

Bank, based in New York, has also been seized by regulators. Shares of First Republic Bank, which is based in California, are down 60%, as you and I are chatting on Monday afternoon. And at one point today, shares of Charles Schwab, just plugging along, I don't want to use the word boring, but I can't think of another, just boring old short. I like Charles Schwab. But at one point, Charles Schwab was down 20% this morning. I think our retirement plans were through Charles Schwab, right? Right. Which sort of got me wondering, wait, what's happening at Charles Schwab that has this? So, there's a lot going on here. Where do you want to start?

Well, I mean, I think this is all just a really good reminder of the psychology that is in play when something like this happens, right? I mean, when you talk about Silicon Valley Bank, I mean, in simplest terms, this was a failure of bank leadership that ultimately resulted in a bank run. The bank put itself in a precarious position with its investments. Clients started withdrawing funds at a more precipitous rate. Word got out there might be some capital issues and it just feeds on itself. Regulators had no choice but really to get in there and shut it down. There were a lot of questions over the weekend. One of the big questions was, is this something indicative of something more systemic throughout the entire banking system?

I think most of us felt like it probably was not. I think the main reason was just because of the nature of Silicon Valley Bank and the clients that it serves. Its clients are generally companies that keep very large balances, balances well beyond the $250,000 FDIC insurance limit. Further, these are companies where they're not only keeping part of their balance sheets, but they're also running their day-to-day operations to keep the business running, which includes, of course, payroll. You don't see companies meeting the payroll, then employees don't get paid. And now you start to see the second and third order impacts from a problem like this. And so, I think it made a lot of sense for regulators to view this as an

urgent situation. I mean, it sounded like they were trying to go a few different ways with the solution there. It was very interesting to see that they didn't really have any bidders. So, they had to kind of get creative with the solution. And I think ultimately, the solution is a good one. I mean, of course, it's going to be politicized and you're going to have fundamentalists from both sides of the aisle arguing their cases. Granted, I think that's more philosophical and theoretical in nature. This is the real world. We have to come up with real-world solutions. Longer-term consequences be damned. We can deal with those another time. But like they say, the patient's bleeding out, you've only got so much time. Solving the problem doesn't

help if you let the patient bleed out first. They really stanched the bleeding, and I think it makes a lot of sense. I think it's important, too, to remember, you're going to hear the phrase bailout bandied about, I think, a good bit with this. I would be careful using that term. I think that this is not something that bails out shareholders. This is not something that bails out executives. Their fate is sealed. This is something that is protecting depositors who really, at the end of the day, were just looking for a place to put their money to run their businesses. I think it's going to be interesting to see how this shapes that deposit landscape going forward and how we view banks and our financial system here in the United States.

It does feel like banking has really become a utility. I don't know that we should blame folks for just wanting to deposit their money. It does feel like we'll see a shift in how that risk is perceived going forward in these new facilities that regulators are developing to protect not only the institutions, but the depositors as well. So, a lot going on for sure. Still plenty, I'm sure, to unfold. But it does look like they got ahead of this to prevent what could have been a wider spread contagion. And to be clear, the money that's being used to reimburse the depositors would come from a fund that has already been established that is paid into by U.S. banks.

So, I mean, I won't speak for anyone else. When I hear the term bailout in the past, one of the places my brain automatically goes is like, oh, this is going to be taxpayer money. They're going to write a check from the federal government, and it's going to be taxpayer money. It'll be added to that sort of thing. This is not that situation. So, to your point about, let's be careful with using that word. I think that's well taken. As I said on Friday, somewhere on the spectrum of outcomes for Silicon Valley Bank was a larger bank steps in and buys them. I suppose technically that's still a possibility, although the big banks have been very quiet for the most part. And I'm wondering, since this is an industry that you and Matt

used to talk about every week on the Industry Focus podcast, what you see when you look at the big banks right now, because one of the things I'm wondering is, are the big banks, simply by virtue of sitting quiet, are they strengthening their position? Are they just very quietly making it obvious, hey, you know what you're not going to have a problem with if you bank with JPMorgan Chase or Bank of America, you're not going to have this problem. Yeah. Well, it's a very fair question. That would be a criticism, I think, a lot of folks would have in regard to what's going on and in regard to the solution is that ultimately it makes the rich richer, it makes the strong stronger.

There certainly is something to that. We saw over the weekend the news in regard to First Republic Bank out there in California, $15 billion bank, well-capitalized regional bank. They even felt the need to get out in front of this and notify their account holders and shareholders that they were well-capitalized. This was something that was not impacting them. The technology-related deposits represent only 4% of their total deposits. Yet even that didn't do it. We saw lines over the weekend of folks wanting to get their money out of First Republic, and that in turn led them to then shore up capital from not only the Fed, but from one of the big banks. JP Morgan helped infuse some capital into First Republic, more or less to just make sure.

That communicates a message where on the one hand, First Republic is putting out an 8K saying, hey, don't worry about us, we're fine. Then at the same time, they're raising money just to make sure. It does create a conflicting message, which makes you wonder. I think that's going to be something going forward. That's one of the reasons why figuring out a longer-term reasonable solution to this makes so much sense. Because at the end of the day, we're to a point where deposits, I mean, you can't really be blamed for wanting to deposit your money. Deposits, that's now more or less just a utility. You're not going to just keep your money in a coffee can under your bed or buried in your backyard. You got to deposit your money somewhere. For many of

these businesses, you want to split up your $250,000 among however many banks, it becomes not very practical. I think at the end of the day, this will give the banks, small, medium, and large, an opportunity to participate on at least somewhat of a level playing field because those deposits will essentially be protected. Now, we have to see ultimately how this facility works out. We saw the regulators produce this facility. Going forward, banks who run into this situation where they see a run and they need to shore up some capital to make sure, even if it's through no fault of their own, they had the opportunity to participate in this lending facility to keep their finances short. It remains to be seen whether that ultimately works or not,

but in theory, that should help keep these banks a little bit more level playing field as far as depositors are concerned, and that will be good. But right now, it certainly does make it look like the rich get richer and the strong do get stronger. That's not a surprise. Banking is certainly not the only industry that deals with that type of dynamic. But again, I have a feeling we're going to be discussing, we're going to be talking about this, I think, for the rest of the year. I was just about to say that, and I was also going to add, I have a feeling by the end of the week, we're going to hear from from Jamie Dimon. Oh, yeah. Yeah. Yeah, absolutely. I mean, even with Jamie Talks, people listen.

Jason Moser, thanks so much for being here. Thank you. March Madness starts this week. And even if you're not a fan of college basketball, don't worry. We've got our own tournament with eight analysts facing off against each other, pitching a stock that they believe is a better buy than the other analyst's stock. Today, in the first of our quarterfinal matchups, Ricky Mulvey referees a debate between Jim Gillies and Jim Mueller. Which stock is a better buy, a biotech software company or a well-known real estate broker? This segment was recorded during the morning show on The Motley Fool's live video stream, which is available to members of any Motley Fool service.

Kicking off the first round of March Madness, the Motley Fool Money World Champion Stock Competition. Jim Mueller, five to six minutes is yours. I'm going to go on mute and listen in. The company I'm going to pick is one I own myself, and one that is an active options recommendation. It is Schrodinger. It's on the NASDAQ under ticker SDGR. And it is, and you might think of it as appropriate given my biochem background, but I've never ever recommended or have not invested in biotech for years and years and years. It is a biotech company, but not your general run-of-the-mill biotech company. No, This is actually, if they didn't do biotech, they'd actually be profitable and cash flow positive.

It started off as a software company, so it has four ways to make money, software sales being the first one. It's a software company that has developed a way to predict how molecules interact with each other down at the molecule-to-molecule scale using physics and a whole bunch of x-ray crystallography, and NMR imaging that have been developed over the years. What they're doing is being able to use a computer, an algorithm, or an AI to predict how the molecules interact, and therefore, finding the best molecule that could act as a drug against a particular target. What you want with a good drug is you want high specificity.

That is, the drug molecule will bind only to its target and not to anything else, so fewer side effects. And you want strong binding, and so they use this algorithm, their software, to find candidates that will do that. And what this does for drug discovery companies is cut down several years out of the decade-long process of finding a drug. But it's all at the front end, the discovery phrase. So instead of screening in a laboratory hundreds and hundreds of molecules, they can screen on computers thousands and thousands of molecules to find the best one. And then they go through the process of making sure it works the way they think it does, starting up the clinical trials, the phase one, phase two, phase three trials, and so forth.

So that long part of actually trying out the drug, first in the lab and then with actually humans, hasn't changed, but it's the front end. And that's a fairly expensive portion of the drug discovery process that companies are willing to pay to shorten. And that's how Schrodinger got its start. And they had a couple of successes early on, got a couple of drugs all the way through FDA approval with one of their partners, Adios. And they have since collaborated with many of their customers. They sell the software, they've collaborated with many of their customers, and currently they have nine different drugs in their collaboration program in clinical trials, three of which are in phase two, the other six are in phase one. We're in the slow

part of that portion. That's the second way they make money. As those drugs meet certain milestones such as being approved by the FDA or passing phase one or passing phase two, get paid. Last year, they got paid about $45 million from those kinds of milestones. This year, they expect to double that. Their third way of getting paid money is by buying, actually investing in some of their partners. As that company becomes more valuable with a successful drug, they get their portion of that value. That's their third way. The fourth way is the prize itself, finding their own drugs and being able to get them through this process and start selling them to the market or licensing out to a big pharmaceutical.

They have several of their own drugs now just entering clinical trials. They've got one in phase one, and they have identified another that they've just identified last quarter. They're putting it together, getting data ready to apply to the FDA to be allowed to used to do the phase one trials. So, drug discovery is very, very expensive, and most of the time companies like this get invested in by other companies, and they get money from that, and they sell that, and all this other stuff. Schrodinger is funding itself from its own software sales and from the drug milestone payments that it receives. So, they burned about $112 million off their cash balance last year. At that rate, they have about four,

and a half years' worth of cash on the balance sheet. But this year, they're expecting to get about $90 million instead of $45 million, about $90 million in drug discovery milestone revenue. That increases the length of term. If all else remains the same, they're only going to burn about $80 million instead of $112 million off their cash. They're extending their lifetime as a cash-burning company at this point. It's a bet on the future, a bet on software being able to lead to better molecules that lead to better drugs and getting them through the FDA process. It's a long-term bet on that. The share price, I think, is attractive at this point. It was as high as $110 shortly after they became public in February 2020. It's since fallen down

into the mid-20s. It was down as low as the teens at the end of last year, but it's recovered quite a bit since then. Five, six minutes on a high-level software company without talking about artificial intelligence. Look at that. I mentioned it. I said AI. But AI is just computer software algorithms working together. That's all it is when you come right down to it. Yeah, that's not as fun. All right. Jim Gilley is coming with his stock. Five, six minutes is yours. Sure. I am coming at it from almost pretty much the opposite end of the market, as my esteemed colleague is. He's coming for high-tech and brainiac performance. I'm going, you know what, I'm going to look at companies that are, well, some of the things I like to say are

run towards fires, which is a variation of, say, contrarian thinking. I want to run towards fires, I want to buy businesses that are on fire. My take on it is, because we want to do, this is a long-term contest. We're not just fighting over March Madness, we're looking for stocks outperforming for the long-term. For that perspective, I hold the view that long-term performance, your best long-term performers come from low prices paid during pessimistic times, either for the market itself or for the stock itself. This is a company that has a pessimistic market. That company is not as cool and sexy as Schrodinger, it just makes money, which is different than Schrodinger as well. It is REMAX, the real estate people. REMAX is a franchisor

of real estate and mortgage brokerages. They have about 143, 144,000 agents under them, roughly 60% in North America, the rest international. What's interesting about REMAX is it is not a traditional business. They like to sell franchises, and I like franchise businesses because I sell someone else a concept, I get a royalty from them, they get the operational risk, what is not to like? I call them check-cashing machines. I sell you my concept and branding operational know-how systems, franchisee sends a percentage of their gross revenue back to me as royalties in addition to paying regular franchise and regular marketing fees. That means RE-MAX gets to hold onto a high-margin growing revenue stream for them to deploy.

One of the interesting things about RE-MAX, and I'm going to share my screen in the middle of this if that's okay, this is a history of RE-MAX's transactions per agent at their largest brokerages. You can see they're typically in the 16 to 17 plus transactions per year per agent at these large brokerages compared to a number that goes between seven and eight for their competitors. This has been a long-standing trend. Why is that? There's something different happening. When your average competitor, the average agents do about seven and a half times transactions a year, and you're doing 10 more than that, what's going on? on. This is the secret sauce for RE-MAX, it's how the commissions are split. Traditional

brokerage, the broker takes 20-30% of the commission. So, when you pay a fee to sell your house, one-third of that, say, goes to the brokerage, two-thirds stays with the agent. Then, of course, they have to split it with the other agents and whatever. RE-MAX has a more agent-favorable mix. The agent keeps 95% of the commission, and RE-MAX, the brokerage, takes 5%. That leads to a phenomenon where the best agents, people really good at selling, they migrate to RE-MAX banners, because I'm betting on myself, I get to keep more of my money. That's a very powerful incentive. I get to keep more of the money, I go out shoot and kill and bring it home, I get to keep more, that's fantastic. The way that RE-MAX,

the company, offsets that more favorable mix to the commissions, setting up their people who are causing their money to do better, the way they do that is, there's annual dues paid per agent by the brokerage, there's a fixed fees per agent, there's our broker fees, which is that 5% of take, franchise sales and monthly fees for their mortgage office. Look, there's no tag days for Remax, but there's a not-easy-to-replicate secret sauce that brings the best agents under their banner. Why did I say an industry on fire? Well, a year ago, real estate was great. Everyone, we don't build enough houses, homebuilders are going to the moon. Then central banks said, hey, interest rates are too low, started jamming them straight up. That has quashed house prices,

it's quashed sales. The entire real estate market has kind of washed out. Anyone who's a Redfin owner could attest to that, or a Zillow owner. And so, I'm looking for a company into the space that's blown out. I'm getting catcalls from Mueller here. I'm looking for companies in the space that are going to do better on a cash flow basis because they can weather the problem. So, here's RE-MAX today. Hopefully, you've bought into what I've said here. RE-MAX today is pretty much at its lowest share price of all time since its 2013 IPO, aside from the downdraft and the pandemic, which was kind of weird for everyone. But what do we have in RE-MAX today? We have a company, oh, and by the way, the insiders, the founders still own 40%. It's a dual share class

structure. They own 40%. The two members, it's a husband and wife team. The husband was CEO for years, took zero in compensation because he just gets dividends. Same deal with the wife. They're both on the board today, take zero compensation. Something about foolish founders we like. I don't know. You can insert it here. But the company today, if you adjust for the 40% ownership by the insiders, you have an enterprise value of about $890 million. million. They have about $448 million debt, $109 million cash, and their enterprise value, like I said, $890 million. I estimate this company can do about $70 million to $75 million a year in free cash flow. That means the stock is trading at about 12, 12.5 times free cash

flow. That cash flow number is going to be going up over time as they sell more franchises and more motto mortgage franchises, I should say the motto mortgage brokerage, which is a nascent thing within them, about 230 outlets, going to go to 1,000 over the next decade. That is currently a cash suck, it's going to be a cash contributor in the future. But I say, for 12X cash flow in a depressed industry, I am willing to do this all day long with a recognizable brand, because here's the thing, we know Schrodinger, and I don't mean to pick on Schrodinger, but Schrodinger has got, you know, there's a great deal of uncertainty of what drugs are going to work, right? I mean, that's the whole shtick of biotech. What is going

to work? I'm not smart enough to figure that out. Okay. But here's what I do know. I do know people are going to be selling more and more and more houses. People need to move. There'll be household formations. I am going to bet on a much, much, much more sure thing. And, you know, that's pretty reasonable price. So, oh, and by the way, you get 5% dividend yield to wait. So with that long unwindedly, I yield my time. Jim Gillies, thank you. Jim Mueller, thank you. We'll reveal the winner next week during the semifinals again. That was recorded during the morning show on Motley Fool Live, which if you're a member of any Motley Fool service, you can watch on tomorrow's show. Tim Byers goes up against San Mateo. As always, people on the program may

have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.