We Study Billionaires - The Investor’s Podcast Network - TIP669: Quietly Compounding at 20%+ Per Year w/ Derek Pilecki

Starting point is 00:00:00 You're listening to TIP. On today's episode, I'm joined by Derek Pellecki. Derek is a portfolio manager at Gator Capital Management, which specializes in the financial sector. Since its inception in July of 2008, Gator Capital has compounded at 21% per year versus 11.8% for the S&P 500 over that same time period. During this conversation, we discussed Derek's experience of launching a financials-focused fund just 10 weeks before the collapse of Lehman Brothers, how Derek achieved a return of 186% in 2009, what led Derek to purchase general growth properties whose stock increased by 20x in less than a

Starting point is 00:00:41 year, why Warren Buffett likes to invest in financial companies, especially to big banks, how banks can create a sustainable competitive advantage in their market, why First Citizens, bank shares, and Robin Hood are top positions in Derek's fund, an update on the current market conditions for banks and much more. This was a really fun discussion with a thoughtful investor who's quietly compounding capital for his investors, so I think you'll really enjoy this one. With that, I bring you today's discussion with Derek Pilecki. Celebrating 10 years and more than 150 million downloads.

Starting point is 00:01:17 You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Clay Fink. Welcome to the Investors Podcast. I'm your host, Clay Fink. And today I'm happy to welcome Derek Pellecky.

Starting point is 00:01:47 Derek, welcome to the show. Hey, Clay. Thanks for having me on. Well, Derek, I've been quite excited to bring you onto the show as you have an impressive track record to date. So your fund, Gator Capital, it's compounded at 21% net of fees since the inception. back in July of 2008, and it's certainly one of the best track records I've ever come across. And your fund, it was ranked number one in the financial sector in 2016, 2019, and 2023. So let's jump back to when you first launched Gator Capital.

Starting point is 00:02:20 You decided early on in life that you eventually wanted to manage money full-time, and then sometime later, you launched your own fund that was on July 1st of 2008, in the midst of a once in a century global catastrophe. And then 10 weeks later, you witnessed the collapse of Lehman Brothers. And I should also mention that your fund focuses solely on the financial sector. I was curious if you could just walk us through what that experience was like launching a fund at that time and how you ended up surviving as a new fund manager. I would say I'm barely survived.

Starting point is 00:02:55 So I launched July 1, 08, and after three months, my fund was down 29%. And I thought, oh, my goodness, like my journey of 15 years to get to launching my own fund has gone after three months. That was quick. And, you know, I had hired an analyst. I'd rented office base. And at that point, I was like, well, I just need to batten down the hatches. And, you know, I've had to give severance to my analysts and send them in New York to go find a job

Starting point is 00:03:20 and just said, I don't think I could go find a job myself. I need to just start making money in the market. And so I remember October 1st, I just sat down and said, okay, I'm going to make money today. and every day in October that month I tried to make money that day. And I actually had a very good October of 08. You know, the market was down 16% and I was up 16%. And it was the type of thing where like I was reporting to my wife intraday. Like at lunch, I would be like, I made $3,000 this morning and just trading.

Starting point is 00:03:47 And so it was like one of those experiences where your back gets up against the wall and you have no way out but to go forward. It's just like a huge character building event to be in that. precarious position and then dig your way out. I finished 08 down 15%. And so I wasn't down the 30%. I called my way back a little bit. And even at that point, like, it wasn't clear at all that the hedge fund was going to become a business. I was just trying to make money for myself because I was the only investor in the fund. You know, I kind of caught a break in early 2009. So like, at the end of 08, I've been trading the Fannie Mae Preferreds. Fannie got put into the conservatorship

Starting point is 00:04:27 in September 08. and one of the first events of the crash, the really precipitated the crash. And I was trading the Preferreds, and there was like 17 different classes of preferred stock, and they're all para-pissue, but they didn't trade at the same valuations. And there'd be one day where the class R preferreds would trade down. I'd buy them, and I'd sell the Class T's and then swap back into the class houses, just relative value trading amongst different classes. And during 08, I was able to build that position without adding cash to it through that relative value trading. So coming into to 2009, I think I had a 5% position in Fannie Preferreds, Fannie and Freddie Preferreds, but just

Starting point is 00:05:04 referring to him as Fannie Preferreds. And they finished 08 at one and a half cents on the dollar. And I think by January 10th or 12th, they were trading at nine cents in the dollar. So I was a 5% position that went up six times in two weeks. And so here I am mid-January 09 and I'm up 20% for the month, 25% for the month. And so that kind of dug me out of my hole. I was like, okay, I'm going to survive this. And it also put me in a really good frame of mind emotionally to take risk, right? I'm up big, the market's down. If you look at Bank of America in January 2009, it was down 50%. And I was up 25% during that month. And so I was pretty negative on the market still in early 2009. I was worried about Citigroup and Bank of America being

Starting point is 00:05:50 nationalized. That was the market. I thought that was going to be a mistake. They did that, and the market would take a leg down. And so I was relatively neutral on my positioning and was just trying to trade around positions, make money. And then towards the end of February, they bailed out Citigroup for the third time. And they did a preferred for Common Swap. And at that point, I thought, okay, that's the signal that Bank of America is not going to get nationalized.

Starting point is 00:06:15 Like, at that point, it was kind of like a tiering. Like, Citigroup was the problem child at that point. Bank of America was a notch higher. And when they gave Citigroup that deal, I looked at it. and said, well, if they gave Bank of America the same deal, their prefers should be money good, and they were trading for 30 cents on the dollar. So that was the start of taking advantage of O'9. But like the, going back to starting the fund, I moved to Florida to work for G-SAM. So Goldman had their growth team based in Tampa. The team had previously been part of Raymond

Starting point is 00:06:43 James. And they spun out of Raymond James and Goldman acquired him in 97. So I joined the team in and you know, I always geared my life towards starting a hedge fund. Like I told my wife on our second day, hey, I'm going to start a hedge fund one day. And so we moved to Florida, I worked for Goldman, and they paid New York salaries while I lived in Florida. And so that was a huge savings. And my wife and I live a modest life. And so I was able to save that Goldman salary and accumulate a little nest egg that was able to sustain me through the first five years of running the hedge fund fund. I mean, when people talk about starting hedge funds today, I tell them you need to have five years of savings to live off of because you're not going to make any money for the first five

Starting point is 00:07:27 years. If you're going to start a fund on a shoe string with no seed investor or no significant capital, you're just going to do it with friends and family money with under $10 million in AOM. You need to have five years of savings to make your way through. And your wife has to be prepared for that. Like, it's no joke. It's so hard to start a small hedge fund. I think it's even harder today than it was in 08 because the number of people who are investing in small hedge funds has shrunk. The requirements for the infrastructure of a small hedge fund are so much higher than when I started. And look at my experience, I had a great 09 and have put together a great track record. And I've barely scratched by to build this fund over 16 years. So it is no joke trying to start a small hedge

Starting point is 00:08:09 fund. So I've seen people try to start hedge funds on their own and they don't have enough savings and their spending's too high. You'd have to live a very modest lifestyle and have significant savings to give yourself a chance, to give yourself enough runway to build a track record and attract outside capital.

Starting point is 00:08:27 So, I mean, I think that's one piece of advice I have for people who want to start a fund is you have to have significant savings and not a high burn rate to do it. Well, at the start of your answer there, you mentioned that you were just trying to make money that day. And it's surprising because you listen to a ton of different investors and they say, hey, they're value investors. They think

Starting point is 00:08:49 long term. And it surprises me to hear that. You say that you were just trying to make it through that one day. So I guess my follow-up question to that is, could you talk more about sort of this short-term versus long-term dynamic getting by for that day, but also considering the long-term tenure of the fund? And also, since you mentioned you just barely scraped by, is there anything you would have done differently, considering you already were living a modest lifestyle and whatnot? Yeah. So I think there's different market environments, right, for long term versus short term. And I'm a long term investor. And I don't mean to sound like I was a day trader. But like in October 08, the volatility was so high, there were real opportunities to make significant money in a very short

Starting point is 00:09:34 amount of time. And so you kind of have to flip your thinking based on the environment. Like, you know the famous Soros quote of like he questions another money manager like you go to the office because you think you have to do something every day I don't go to the office every day I just go to the office the days where there's something to do like I think it's similar to that like there's times in the market where it's very stressful and there's a lot of volatility and there's things to do and you have to focus on a very short period of time of what's going to happen and then there's periods of the time where the markets are relatively calm and there's not much to do and you can be a longer term and have a longer term focus. And I think October 08 was the peak of you need to

Starting point is 00:10:14 focus today on making money today. And because you can have long term views like things are going to turn out fine, but you could have a drawdown of 50% before that long term thesis played out, right? So you had to think what's going to happen today. Like I can get blown out of the water if I don't focus on protecting capital today or taking advantage of this opportunity today. So I think it depends a lot on the market environment. And right now, markets are pretty bullish, right? Everybody's having a pretty good year. It's not like I'm coming in today saying, I've got to make money today.

Starting point is 00:10:44 Like, things are kind of trending and you can have a longer term view. This is not one of those market environments where you're thinking about today. You think about December of 18 or March of 2020 or March and April of 23. Those are markets where there's stuff going on and you have to focus day to day. I also think for those sort of with markets where the long. term trackers are built. You can make huge mistakes in those markets and you can also find great opportunities in those markets. And so I think one way I approach those markets is I know I'm under a lot of stress. Markets are moving. It's stressful. You're losing money. It's stressful.

Starting point is 00:11:19 You have client money at risk. You're stressed. And so you only have a limited amount of decision-making ability. Or I think of it is you can't make decisions all day long without getting worn out. And so during those stressful environments, your amount of decision-making ability is reduced because there's so much stress. And so you just limit the number of decisions you make and only do very high-confidence trades or things where things line up perfectly for you. And you can't make too many decisions because then you'll make mistakes and that adds your stress. So reduce decision-making. Like, I don't choose what I'm going to wear to go to work. I wear blue jeans and a blue shirt every day. I don't make any decisions on meals. I just, like my wife knows.

Starting point is 00:11:59 like, I'm stressed. I don't care what I'm eating. You just reduce decision making so you can focus on investing. And I think that's where long-term track records are built. And if you really focus on day-to-day in those environments, that's where the long-term records get made. And looking back, is there anything you would have done differently? I think it's one of those experience I had. Like, I knew it was risky. I didn't realize how risky it was. I wouldn't want to go through it again. If you told me the path that went on, I'll be like, whoa, that was a little too risky, right? But I made it through and I'm here on the other side, so I'm going to keep going, right? But I think a lot of people go through those in their life. Like,

Starting point is 00:12:37 you just have this brush of like, wow, I didn't realize how risky it was, but I made it through. And I think it was one of those events. I guess the things that I really thought that it worked out for me was I posted research on my website from day one and I tried to accumulate email addresses of people from day one. And so I thought that when I send out my quarter of the letter, a lot of those people get that quarterly letter and a lot of those people become investors. And, you know, I've had people invest in the fund who signed up for my newsletter when they were in college and now they're 30 years old and they've got some liquidity and they invest in the fund. So the sales cycle is super long. I think I did a decent job of like guerrilla marketing

Starting point is 00:13:17 on marketing my hedge fund. And I have a very granular investor base that's very long tenured. and the people who invest with me are not worrying of Derek put up a bad month. We need to redeem. Derek's going to invest for another 20 years. We're going to invest with him and see where it ends up 20 years from now. And so, like, those small investors are gold for a hedge fund because they're so stable and it gives you so much advantage to invest during tough times that you're not worried about redemptions, where the big institutions, they're putting their career at risk by investing a small hedge fund. and then if you have a down month or a drawdown, then they need to protect and pull the money and add stress at the wrong time. So I think if you're going to start a small hedge fund and kind of do it on a shoestring, you need to really focus on getting high net worth investors, but people who put in relatively small amounts of money. And then as you put a performance,

Starting point is 00:14:12 that money compounds. And so, you know, I have a retired lady in St. Pete who invested with me in In 2010, she put her quarter million dollars in, and now it's $2.5 million, and she's one of my top 10 investors. And so over a long period of time, that money just compounds. So that's just some advice for people thinking about starting small hedge funds. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom

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Starting point is 00:18:48 when we were talking about your track record. And I was like, well, how good? And you humbly mentioned 186 percent. And I went and checked what the S&P financials did that year. And it was up 15 percent. And it's not like you just had that one exceptional year and then a bunch of subpar average years after that. You've had a consistent, really good long-term track record since 2008. Could you talk more about just some of those opportunities that you capitalized on in 2009 that just led to such a phenomenal year for you? Yeah. So, I mentioned the Bank of America refers.

Starting point is 00:19:22 That was a big win. And then I was wanting to turn bullish. I put on the Bank of America trade. I was thinking about, okay, things are really cheap. And there's no way that scores of financial companies are going to go out of business at this point. If you look back at September early, Fannie and Freddie were put in conservatorship, Lehman declared bankruptcy. Merrill got sold to B of A, Washington Mutual got sold to Chase, Warkovia got sold to Wells Fargo, AIG got a huge infusion. I thought there were,

Starting point is 00:19:52 regulators made a lot of mistakes and destroyed confidence in the financial system. And I had a thesis that they had learned that lesson, or they had realized very quickly that they had made mistakes. I thought they were not going to make the same mistakes with B of A and Citi Group, and they didn't. And so I thought that was super positive. I had a huge benefit of being neutral during January and February of 2009 because the financials index, I think it was down like 40%. So I missed that 40% drawdown in the financial index. And then in early March, I started buying some large cap financials. They weren't large cap in the time, but they used to be large cap. And I think I went through and tried to buy every financial company that used to be at least $5 billion that was currently trading under $5 a share. And it was regions. 5th 3rd, Genworth, there were just tons of Excel Capital. There were just tons of solid financial companies that were trading for under five bucks a share. And then, I don't know if you remember, but the first Sunday in March of 2009, Ben Bernanke was on 60 Minutes for the entire hour. I was watching it with my wife. And during that interview, he said, we're not going to

Starting point is 00:20:58 nationalize any more big banks. And I turned to her and said, he just rang the bell. That's the bottom of the market. And two days later, the market bottomed, you know, on the famous Mark Haynes call that he thought the market was bottoming. That happened. I went long as many of the financials as I could. So I missed that drawdown in the first half, first two months of the year and then had a really good time. Use that 60 Minutes interview to time I buy on the market. That's not a normal thing, right? We don't watch 60 minutes every great to get the stock market picks, but that was just a unique experience. The other thing that happened, that was happening at that same time was Bill Ackman was pretty public with his plans for general growth properties. And so, you know,

Starting point is 00:21:39 I think general growth had financed all their malls through the CMBS market. And the CNBS market was closed. They were going to have to refy some of these mortgages. And the stock, if you look at a chart of general growth properties in the fall of OA, it just went straight down. And Bill Ackman came out and was very public about he owned 40% of the company on, you know, you can only buy 10% of every, but he accumulated a 40% position through swaps through, I think Deutsche Bank and another investor bank. So he had this huge equity position in general growth. And he said, I'm going to walk it through bankruptcy. And the equity holders are going to come out on the other side. And I think it was Alexander and Alexander as his example, something that had the playbook of that he

Starting point is 00:22:22 was going to follow. And when he was public about this, the stock was at 60 cents. And then the day they declared bankruptcy, the stock went to 40 cents. And so, Ackman's a very smart investor. I bought a 1% position in general growth properties at 40 cents. And the stock ended the year above $8 a share. So that was a 20-bagger. So 1% position went up 20 times. Did I look at every mall that General Growth owned? No. Ackman gave you the playbook and I thought there was a good chance he could do it. And I was up so much from the Fannie Preferreds that, you know, 1%? Maybe it's a 0. It's 1%. Who? Who cares? And so maybe that's not great risk management. It's like Druck and Miller's parlay theory. Like when you're up, that's the time to bet big because you're kind of feeling it and you're thinking

Starting point is 00:23:07 clearly and you can kind of parlay it. A lot of people ask when you're up big, why don't you just lock it down and hedge for the rest of the year and earn it. And I have the exact opposite view of when you're up big, then you should bet big because you can get those monster years of parlaying your bets. And your frame of thinking is in the best position it is, it could be because you're up and you're thinking clearly. You know, you can't have hubris, right? But you have to still do the work. But it's kind of like parlaying your bets to get the big years. Yeah, that's amazing. I wanted to transition here to talk more about financials specifically, since that's the area that you specialize in. And you're really a value investor at heart and also a big fan of Warren Buffett

Starting point is 00:23:53 like us here at TIP. And Buffett is known for parking quite a bit of capital and things like bank stocks and financials as well. And Bank of America is the top holding for Berkshire at around $40 billion. And then I look at his list of holdings. He also has American Express at around $35 billion. Why do you think Buffett likes these financials companies? I think it's within his circle of competence. He's known about the banking business for a long time. I mean, I think he used to to own a small bank in the late 60s, and he's always had significant investments in the banks. He just understands the business. I think even he was surprised by the high returns the banking business had. He thought it could have been a commodity business and the returns should be computed

Starting point is 00:24:39 away. But I think interstate branching laws protected the banking business for a long time. And so the competitive intensity of banking was not as high as it could have been, given the number of banks that exist in the country. Things are very different now. Like Chase is entering every now have a branch in every state in the country. They're in every major metropolitan area. They're taking share. And so competitive intensity of banking right now is different from during a lot of Buffett's career. And I think that kind of explains a couple of things. Like he sold during the pandemic, he sold down a lot of his banking positions. I don't think he owns M&T anymore. He sold down Wells Fargo. He sold down U.S. Bank Corp. I think he might own a little bit still. And recently he's

Starting point is 00:25:19 been selling down Bank of America. I think that selling is his response to the competitive intensity of banking is increasing. And for a long time during his investing career, banks earned very high returns and had very stable businesses. And I think he understood them. American Express, he's had a long time position there. It's a very high ROE financial company with the discount revenue they get from the credit card on top of the lending business. It's a very good compounder of capital. And so he had that early experience in his career where he put 40% of the fund in American Express during the scandal they had in the early 60s and made a ton of money. So I think he's always had a big affinity for them. I think he's also teamed with bankers who've had very good management style. So like Bob Wilmers from M&T Bank or Wells Fargo in the early 90s, those were very good bankers that ran those banks and created a lot of value. And so he understood the business. He teamed with bankers that were very good bankers. and the business used to be a better business. I think it's gotten to be a worse business.

Starting point is 00:26:23 Yeah, you mentioned him selling some Bank of America shares. So recently he's actually sold over $7 billion worth, which is, I think is somewhat of a surprise to people, given Berkshire's cash pile, because it's all about opportunity costs. I'd be curious if you have any thoughts on him selling these shares. I think him trimming Apple so much around 50% of his position he's sold. That seems more understandable,

Starting point is 00:26:47 given the multiple it's at and how that's sort of developed over the years. I'm curious if you have any more thoughts on him selling Bank of America. Yeah, so Bank of America has about $600 billion in a low coupon MBS. My guess is he's looked at that position in the Bank of America investment portfolio and was disappointed with that risk management or that decision making of they've encumbered their balance sheet with a lot of low coupon MBS that are going to hang around for years and years. Now, Bank of America has a great, great deposit franchise so they can endure that mistake. And they weren't the only bank that made that mistake. Of course, we all know Silicon Valley made the same mistake. And there's other banks, Bank Hawaii, Schwab has done the same thing. And so I think I can't

Starting point is 00:27:31 mind-read Buffett. But when I look at Bank of America, I'm disappointed by that decision that they put so much of their balance sheet into one and a half or two percent coupon MBS that they know have the ability to extend durations for a very long time. And I think my guess is he downgraded his view of management after I've seen them do that. So turning back to Gator Capital here, I'm sure many in the audience are wondering why one would put 100% of their focus on the financial sector, given that it's a somewhat relatively unattractive area of the market. But of course, with so many stocks, investors like you can sift through and find some of these great opportunities that are overlooked. So the financials index, for example, is compounded at around 8% while your fund

Starting point is 00:28:17 is compounded at that 21% rate. So maybe you could share more about why you end up focusing purely on financials and starting Gator Capital. Yeah, I mean, I guess there's two things that when I started the fund, I wanted to focus on financials because that's where my expertise was, right? I mean, I didn't think people would pay me to pick healthcare stocks or tech stocks. And I thought there was a better chance of me creating value within the financial sector. I mean, I think there's a pretty big diversity of business types within financials. You know, you have insurance and banks are totally different. You have capital markets firms like brokerage firms and asset managers. And then there's a lot of specialty lending businesses, not to mention REITs. And so I just like

Starting point is 00:28:56 that diversity within financials and I understand the businesses. I feel like I've created expertise within that universe. I also think after the financial crisis started the fund right at the beginning of the financial crisis, I think that there's a lot of general investment. investors who just shy away from financials because it massively underperforms the rest of the market. And I think there's some people who just view of like, why don't I even need to bother with the financial sector? And like every generation it goes down with SNL crisis in 1990, the financial crisis in 08. I mean, that was only 18 years apart. Like, could you have a good career as an investor just ignoring the financial sector? I can't argue against that. I mean, there's going to be another

Starting point is 00:29:34 crisis in 20 or 30 years where financials all go down, you know, some credit crisis or something. I actually think that might have been put off a little bit by some of the change in regulation. Maybe it won't come in 20 or 30 years. Maybe it'll be further away. But I think there's rational people, rational investors who just don't play in that sandbox. And so that creates more opportunity for people like me. I just, when I look at small midcap financials and see some of the valuations and they sit there for months at a time at very inexpensive valuations, even though good things are happening, it's just less people are looking at the financials. the value does come out and the market recognizes it, but it's not instantaneous. I feel like

Starting point is 00:30:15 it is in other sectors. So I just feel like it's a little bit moving a little more slowly. And I've been able to extract out that out of the sector. So I'm just going to continue moving all with that. And I think there's a lot of opportunity right now in financials. There's a lot of cheap stocks. There's a lot of changes. I think the rate cuts are going to be very good for the sector. I think the inverted yield curve has been a huge headwin for the sector for a while. the regional bank index is the same price it was six years ago, even though some of the banks have compounded and grown. And so I think there's a lot of inexpensive companies there. And I think there's a lot of opportunities still. So I'm going to continue focusing on it. Yeah. And I loved one of the

Starting point is 00:30:51 slides in, I believe it was your investor presentation that essentially showed that your fund has minimal overlap with a lot of the institutions. And it essentially shows that you're looking where a lot of other funds aren't looking, so certainly you can create some opportunities there. And in one of your recent letters, you outlined how you tend to have a 130% gross long exposure. And I thought that was quite unique, considering all the guests I've chatted with on the show, you know, a lot of value investors are just long only, no shorts, no leverage or whatnot. So in practice, I'm curious how you get to that 130% gross long figure. and what led you to taking that approach?

Starting point is 00:31:35 I guess there are a couple things. Buffett uses leverage, right? He gets leverage through the insurance business. And he's made comments in the past where he wishes he took more risk during his career because things tend to work out. And so, you know, I wanted to take advantage of that insight. When I look at my return attribution between my longs and my shorts,

Starting point is 00:31:55 you know, if the index is returned about 8% a year, my shorts have been like 7% a year. Like, I've lost money in my shorts, but they've underperformed the index a little bit. But then I look at the performance of my longs and the numbers are in like the high 20s, low 30s of my longs. And so I was trying to figure out a way, how do I get more of my longs? And so I've been used a little bit of leverage. And if I can increase the size of my long portfolio by 30% and hedge it with shorts that I

Starting point is 00:32:23 lose money on, but that's the spread between those is 20%. That's additive to the fund's returns. So that's kind of how I think about it. it. Would I love to find shorts or leverage that was free like Buffett had or negative costs like Buffett? Like, yeah, that would be ideal that I think it's unlikely that I'll be got in an insurance company anytime soon. So I'm just enduring the way it's set up now with losing some money on my shorts. Over time. Right. And it's quite interesting too to think about just like adding another sort of pocket to your portfolio in your case is the shorts. This takes a lot of time and research to get to

Starting point is 00:33:01 know these companies. Yeah, it's interesting how you, you know, you're taking that approach and it's adding a few percentage points of alpha at the end of the day still. Yeah, I mean, I think there's a lot of companies that are kind of just fairly valued and maybe management teams make some strategic mistake and make an acquisition that is high priced and that can be a good source of shorting. Sometimes there's capital markets offerings that you think, wow, that's super overpriced. You know, when the spec raise was happening in 2021, you know, there were some newly mentioned financial companies that came out, especially in the mortgage banking industry, or the tech-enabled, especially lending businesses, that came out at ultra-high valuations, that if you look at the

Starting point is 00:33:41 incumbents, they trade a tangible book value, and they are trading multiples of tangible value. So there's good opportunities from time to time on the shorting side, but the big money's made on the long side. When a number of people think about financials, they probably think a lot about banks. and banking is certainly a tough business to be in, and it can be challenging to differentiate yourself against your competitors. You mentioned Buffett earlier, and many people sort of assuming that it's a commodity-like business. But some banks have actually proven to be great long-term holdings, including the top name in your fund for citizens. What are some ways in which banks

Starting point is 00:34:17 can create some sort of competitive advantage relative to other companies they're competing with? Yeah, I mean, I think there are several ways. is to be a specialist on asset generating, like particular type of lending or on deposit gathering. And so like there's certain banks that are very good at gathering deposits. And so just having that specialized focus and that knowledge of, you know, we're going to grow the franchise value or our franchise by focusing on deposit gathering as a way to get competitive advantage. And then I also think all the banks that earn high returns on equity all have expense discipline. You can't that bureaucracy creep. You have to be really hard-edged on managing expenses. I think it just is hard.

Starting point is 00:35:04 There are so many constituencies when you're running a bank, it's really hard to be tough on expenses all the time. And I think there are some bankers that have just proven over the years that they excel on managing expenses. And so I think those are the things. From time to time, you can have banks that add value by managing their balance sheets very conservatively, so that when we go into recessions, that they're the buyer of choice. So you mentioned first, citizens, that's how they operate. M&T Bank is the classic case of that. I mean, they always buy the down-and-out franchises in adjacent footprints to buy franchises on the cheap and integrate them into their way and doing business, make them run a little bit more conservatively,

Starting point is 00:35:45 charge premium prices for their loans, and keep expenses low, so their entire returns on capital. I think when you look at the banks that are the best returning banks of the banks that grow tangible book value the fastest and you grow tangible book value by not doing down acquisitions and having a high return on equity, you also have to have some organic growth to reinvest those returns of equity back into the business. And so that's the formula that I look for. And you know, if you look at banks that I own and then you look at the banks that have the highest growth of tangible book value per share over the past 10 or 20 years, there's heavy overlap between those two lists.

Starting point is 00:36:24 One of the items you mentioned there was a conservatively run balance sheet and being the buyer of choice when the tough times hit. So first citizens, they purchased Silicon Valley Bank during the banking crisis. Is that right? And talk about some value accretion that led for first citizens. Yeah, so they were the buyer of Silicon Valley Bank. It was rumored the week before they bought it. And then the deal came out.

Starting point is 00:36:47 And the deal that they struck with the FDIC was so valuable to them. I think it doubled tangible book value that day. So they bought Silicon Valley at such a discount to the net assets they're accumulating, it doubled their own tangible book value. But that's not the first time they've done a deal like that. They bought CIT during the pandemic. And prior to that, during the great financial crisis, they were the biggest acquire FDIC assisted deal.

Starting point is 00:37:13 So they bought banks across the country as the FDIC closed them. And so they have this very dispersed branch network. They're just buying these little franchises that have deposits and they bought them at a discount to their net worth and they just were able to create value that way. So they run at a very high capital ratio compared to their peers and they have become the buyer of resort or buyer first choice for the FDIC or other troubled franchises. I think it's helped out its family runs. So like the holding family runs the bank and have run the bank for close to 100 years. There's dual classes of common stock, so the family controls the B class shares, and so they're in control.

Starting point is 00:37:56 Yeah, there's some controversy there, right? I mean, the institutional shareholders don't like having dual classes of stock, but the family has done a great job of creating value, so you can't really say that having the family in control has hurt the returns of the stock. I would say that having the two classes of common shares is preventing them from getting into certain indices, and they don't have as much passive ownership as their competitors do. And so they also trade, they don't trade necessarily in line with the banking indices. Like there'll be days where, like, today I think the stock's down, but the regional bank index is up almost a percent.

Starting point is 00:38:32 And it's just because they're not included in the industry. So when people are doing those program trades for regional banks, they don't necessarily trade that stock. But I think that'll get worked out in coming years. I think the company has a very long-term focus on how to manage the business. They don't try to maximize ROE this year. They try to make sure that the bank endures through any recession that comes through. And I think the real opportunity right now with First Citizens is it's cheaper than other

Starting point is 00:38:59 regional banks. It's trades 1.2 times tangible book. Other regional banks are like one and a half times regional tangible book. I think that valuation discount's going to close. And now it's a huge stock buyback because they're still like. were capitalized, even after they do this buyback, they'll still have more capital than their peers. So I don't know that they're actually be able to execute the stock buyback because I don't know that there's enough sellers in the stock to actually get them to buy all the shares at the

Starting point is 00:39:26 data outlined. So I think that'll be a nice lift to the stock as they execute on that stock buyback program. I think the other thing that people are missing with them is they're treating Silicon Valley. The old Silicon Valley franchise is a runoff business that's going to decay. And I don't know that that's the case. I think First Citizens done a good job of retaining bankers, retaining clients. I think the venture capital community is going to come back to the bank. Certainly, they won't retain the same amount of market share they had before. When Silicon Valley was running their business, I think they had a 60% market share of all venture-funded companies banked at Silicon Valley.

Starting point is 00:40:02 I think venture capital firms and venture founders have realized they need to diversify their bankers. So they're banking at Chase or Schwab or Stiefel or HSBC. So I don't think Silicon Valley will retain its same level of market share, but I think they're going to level out on market share and grow with the venture community. I think they add a real value to the venture capital community through their networking and people they know. And so I think there's upside just for citizens as we see the former Silicon Valley franchise start to grow. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect

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Starting point is 00:43:42 material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. There's certainly a lot to alike about first citizens. They've compounded at 15% for 30 years. It's run by the third generation family with significant insider ownership. And what you were saying there about just the dual class structure, it can't be put into the indexes and institutions tend to shy away from it. It's sort of just like this situation that's just like a dream for investors that are looking for opportunities in the market where you see this family that runs it so well. But for whatever

Starting point is 00:44:27 reason just is ignored or it literally cannot be included in an index because the family owns so many the shares and there's not enough liquidity and whatnot. Why is it that institutions would shy away from a company like this? Is it just the liquidity issue or is there something more to that? You know, a lot of institutions, a lot of lonely managers benchmark themselves against the S&P. And for citizens, isn't in the S&P. So then you're taking it out of index bet by buying the shares. I think there's some institutional investors who just have it in their bylaws. They're not going to buy companies with dual class voting shares. Even though I say institutions underown it, it is a hedge fund favorite.

Starting point is 00:45:07 So, like, we're in this unique situation where generally long-only institutions don't own it in size, but there's a lot of hedge funds who own it and see that value. So it's very similar to me to the time period from like 12 to 17 when hedge funds owned KKR and Blackstone and long-only managers didn't own them because they were publicly traded partnerships. And so they couldn't own because they couldn't get K-1s to their tax-exempt institutions because they'd get taxed on those earnings. So they just didn't own the private equity firms because they weren't C corporations. Hedge funds owned them.

Starting point is 00:45:42 Long-only institutional managers didn't own them. I think it's very similar for citizens to that setup of that worked itself out. And then those KKRA and Blackstone have been great stocks since they converted to C corporations and got included in the indices. I'm not predicting that the dual class voting is going to go away because I think the family's pretty firm that they like that control. But on the other hand, there hasn't been a hostile takeover a bank since the late 1980s. And even that wasn't successful. So the family can retain control this bank, even if they give up the super voting shares that they have. It's impossible to do a

Starting point is 00:46:16 hostile takeover or banks. The family is not going to lose control of the bank if they collapse the share structure. So we mentioned First Citizens purchasing Silicon Valley Bank, and it's been around 18 months since the banking crisis in early 2023. And rather than rehashing what happened during that crisis, how about you give a sense of how you would describe the current environment with respect to banking and what the recent interest rate cuts by the Federal Reserve mean for the sector overall? You also mean some of us were aware the issues with Silicon Valley. I guess what I underestimated was how that would quickly convert into a funding crisis for regional banks. And so the regional banks had been lagging their deposit rates as the Fed had increased rates.

Starting point is 00:47:02 And then when Silicon Valley happened and there was the run on Silicon Valley and bank by its customers, the cost of capital, the cost of funding for all regional banks went up, especially the ones with the weaker deposit franchises. And so we've been in this weird situation where we've had Fed funds up at 538, and the yield curve's been inverted, and there's been a lot of pressure on regional banks for funding. Like, if they want to make new loans, they have to raise capital over 5%. And so then they're charging 8% on the loan, just to make 300 paces points. I think that's a very different environment from where we were before, where their cost of funds were 1 or 2%, and they could make loans at 6% or 7% and earn a big spread. So, like, they haven't been wanting to grow because deposit costs have been

Starting point is 00:47:45 high. As we get rates cut here, it should make regional banks more willing to make loans, it should ease the deposit funding costs. I think it'll just make the operating environment much better for the banks. I think we need more rate cuts to make it even better for them. I think we need to get the Fed funds rate down to three and a half for three percent for it to really be a good environment for the banks, but pressures off and it should be easy as we get through these next few Fed meetings and we get see continued cuts. I guess the other thing that has been in the news about regional banks is the commercial real estate issue and office buildings going to auction and trading for under $10 million. And we haven't really seen that huge problems come through the banking system

Starting point is 00:48:28 because of that. I think a lot of those loans are in the CNBS market. A lot of them are in life insurance portfolios. They're not necessarily in regional bank portfolios. We've seen one-offs here and there of problem assets, but it hasn't been taking down the whole sector like people have feared. and now we see the office reits really have rallied this year. And so it doesn't seem like commercial office real estate is going to be a real problem for the banking sector like people have warned. Yeah, that is a great point that I think many people assume that banks might not be a good place to be just because of commercial real estate or office real estate not performing well over the past few years. But it seems like overall the exposure to that pocket of the real estate industry is

Starting point is 00:49:12 minimal, if anything. I think the banks have also done a good job of increasing their disclosure around how big are office portfolios, what are the segments within office portfolios, what are the buildings used for, how many are owner-occupied, that companies own the buildings, they have a mortgage on versus non-owner-occupy, which are just investor buildings where they're leasing outspaced to other companies. I think that disclosure has really helped investors segment which banks have issues or are at more risk than others. And I think that's helped the industry. I think more transparency helps investors get their arms around issues. So with the U.S. federal government running deficits near $2 trillion a year in the U.S.'s net interest expense now exceeding their

Starting point is 00:49:57 spending on the defense and military, for me personally, it's hard to foresee inflation not being an issue for the years that lie ahead. I don't know what inflation is going to do over the next year, thinking out further, this seems to just create just a lot of new money flowing into the system. And I think eventually that might lead to higher prices of goods and services overall. If we see a higher inflation environment in the future, how are banks going to potentially manage that risk if it ends up playing out that way? Yeah, a high inflation environment would not be good for the banks. Like, you know, moving rates up substantially and staying at high levels for a long time would really heard that they have a lot of fixed rate loans in their books at low rates, and it takes

Starting point is 00:50:42 a long time for that to turn over. I guess that is not a concern that I have. Like, I am not worried about a high inflation environment. It's not clear to me that deficit spending creates inflation. Like, if you look at the 80s, inflation came down a ton, and we were running deficits. I think of money supply is more of the issue. So, like, we get into a period like the pandemic, and we have the PPP loans, we have stimulus checks being sent out to people, and there was just, everybody got money. And so then prices went up. I think there are some natural forces of deflation globally.

Starting point is 00:51:15 We have 7 billion people on the planet, and a lot of them have standards of living way below ours. I think that's a deflationary force on labor prices. Globalization, that's a huge deflationary force. And then the internet has been destroying a lot of industries. There's a lot of middleman industries that have gone away. I think there's increased transparency and increased competition. because of the internet that is deflationary. So that scenario of persistently high inflation

Starting point is 00:51:43 is not something that I worry about. I think it's just, it's hard for an investor like myself. I feel like I can get too distracted by macroeconomic views or political views and need to stay focused on individual companies and the macro kind of takes care of itself. We've been lucky over the last 30 years that macro has been pretty good. But I'm also pretty optimistic. I think one of the ways to make money is that just be persistently optimistic. As a nation, capitalism is trying to advance the standard of living of everybody. And I think it generally works. And so I think one of the pieces of advice I give to average investors is be optimistic. Like, you'll make more money by being optimistic. The chances of you calling the downturn are so low. You'll make more money by

Starting point is 00:52:29 being optimistic. I certainly agree with you. It's so easy to get distracted by things like macro. And I also agree that being optimistic is definitely the best way to go, and history is a good indicator of that. So today I wanted to discuss two of your holdings. We discussed First Citizens, which is your top holding weighted at around 10% as the time of the recording. And occasionally, when I look at a portfolio, there's a stock in there that really sticks out as something that I wouldn't think sort of fits in with the rest. And for your portfolio, I thought that was Robin Hood. And this is a stock that you added in Q4, 2023. And since the lows in November, the stock is up over 180%.

Starting point is 00:53:13 And as of September 2024 here, it's around a 6% weighting and your third largest position. And I think most value investors would likely view Robin Hood as a broker with limited profitability. It's been heavily influenced by these shifting interests within the retail crowd that's chasing the next hot trend. And ironically, you even shorted this stock in December of 2021 through April of 22, and the stock fell by 50% during that period. And you mentioned earlier, you putting on some shorts during the SPAC boom and some of these companies coming out with IPOs and whatnot. What did you see in Robin Hood in Q4 of 23 that you thought presented a good opportunity for you? When I covered the short in March of 22, the stock had gotten down to 10 bucks, and I knew the tangible book value, which was mostly cash.

Starting point is 00:54:00 was about eight bucks. And so I didn't think there was much more downside. It was just time to move on. But I had been following the stock, and I was impressed by the number of young people who've gotten into investing, and they have the Robin Hood app. That's their introduction to it. You just paid attention to their business. And one reason is, I think the discount brokerage business is a pretty interesting business. Like, I remember when I first got into the business Ameritrade was up, I think it was up 11 times in 1999. it's on the boom of the internet trading. And they weren't profitable at the time,

Starting point is 00:54:34 but they thought about their business and the value of a lifetime account. Like if they spent money on advertising, they opened a new account, that customer lasted so long, the value they brought over their life more than paid for the advertising cost up front. And so I knew that as you accumulate these customers,

Starting point is 00:54:52 they have persistent benefit. And Schwab's really consolidated the discount brokerage industry. I mean, they bought Ameritrade, which had merged with TD Water. house and had bought Scott trade and Morgan Stanley bought a e-trade. And so, you know, we're left with Schwab, Fidelity, Interactive Brokers. I guess e-trade still is a business, but I don't know how committed Morgan Stanley is to the business. And so, like, Robin Hood was out there of like, oh, this could be a business and it's pretty small. It could grow and create some value at some point,

Starting point is 00:55:21 but it was marginally profitable. It was a tangible book value. It was kind of bouncing around there. But one thing I became interested in, as I was studying it over the 22 and 23 time frame, was starting to introduce new products. And there was a regular cadence to new products. And you could almost see a like a roadmap of like introduce a new product growth comes. And you can think about how limited their product set was and they were still profitable and marginally profitable. And if they continue to introduce these products, would they become very profitable?

Starting point is 00:55:52 And so early November of 23, they reported earnings and they missed. sternings and it was kind of a couple of stupid environmental factors. I think like the yield curve shifted so they changed forward guidance and then the crypto trading in September of 23 was late. And so stock was down 15%. It was at tangible book value. And I was like, okay, like, what's my downside from here? It's already tangible value. It's profitable. So it's not like book values going down. And if these new products eventually accelerate customer growth, then, you know, maybe we'll make some money. I got a little lucky there, right? I mean, I bought it while I was, I guess it was the week.

Starting point is 00:56:26 of Thanksgiving, a 23, bought a tangible value, and then, you know, the Bitcoin ETF got introduced, and then they introduced matching for opening IRA accounts and customer deposits just accelerated from there. I couldn't have predicted how quickly it played out. He was just one of those things where it got lucky, but at the current rate of customer growth, they're growing like, I think net deposits are running about 35 to 40 percent annualized. And if, you know, that's not going to sustain at that level, but if they keep growing, they could earn $1.60 in 2026. And I think the stock's at 23 today. So 15 times earnings for something growing 30% a year, I think that's still pretty attractive from here. So when I originally bought the stock at 8, I wasn't thinking, oh, well, they're going to earn a $1.16, 2026.

Starting point is 00:57:10 That has evolved as I've held the stock and done the math and the growth's changed and the story's improved. I think it's still a very good holding here. There's some downside risk, right? I mean, there's the meme stock issue. there's still some regulatory litigation risks. They've resolved some of those issues, so it's not riskless. They do have some revenues from Bitcoin trading. They have some revenues from payment for order flow. So it's not a riskless trade at all. But I really like how management's reined in stock-based compensation costs. They've gotten their operating expenses in line to become profitable. Now they're still introducing new products, even though they're cutting expenses. I just think they're doing a very good job.

Starting point is 00:57:53 Yeah, and it's a reminder to me of value investing has many different flavors, whether it's your high-quality, consistent growing bank, or just a discount broker that's just like heavily punished situation where the baby just sort of gets thrown out with the bathwater and was shorted two years ago or three years ago is now a long idea. And I was quite surprised to see just the quality of the business. So in your letter, you noted they were adding 30,000 new accounts per month, $1 billion of customer inflows per month, and it's just like amazing. The risks that you mentioned in the letter, I think there's one or two here that you didn't mention there that I thought was quite interesting. So they're definitely targeting a lower end customer base because the average

Starting point is 00:58:36 account value is around $4,000. You mentioned the risk of these customers graduating to another broker. And I just think of myself, I've used Robin Hood a couple times just as like these small bets that I wanted to place. And now I don't touch for Alvinhood at all because of what you mentioned were, quote unquote, graduating to some other broker. And then what I also thought was worth mentioning is the consistent insider selling. So I think these high level managers just consistently dump a bunch of their shares, it's probably a no-go for a lot of value investors, but it can still work out if they end up continuing to grow and grow their EPS over the years. Yeah, I still don't have a good answer for the insider selling. So, like, I kind of bought it despite that

Starting point is 00:59:17 issue. Not every investment can line up perfectly on every item on the checklist, right? And so hopeful on the graduating to different brokers, I'm hopeful, like, they've introduced a desktop site now, like, kind of amazing to me when I bought the stock with, they didn't have a desktop site. So hopefully as they add these things, like, I think they're just adding joint accounts. So, like, you couldn't have a joint account with your wife before. And so, like, those things are all limiting to having people stay there. And so I think hopefully as they introduced these new products or these enhancements to the business that they'll be able to retain people longer. I guess one other risks that I think is in the business is like they're growing,

Starting point is 00:59:57 the customer deposits are very high, 35, 40 percent. Are people going to trade as much when they move their bulk of their assets there? If they move the bulk of their assets there, will the velocity of their trading remain as high as it is, or will their percentage of revenues go down versus their assets? And so I think that remains an unanswered question about what's the business going to look like if they are able to become a place for longer term investors. We'll see. And I think you first purchase a stock just over $8 a share, 807's what I have down here.

Starting point is 01:00:33 And the tangible book value at the time was $7.92. I'm curious if you could share, what are some of the primary components of that tangible book value figure that give you the confidence that the value is there? It means, mostly, you can see it on the balance sheet, their cash. So they have some margin loans to customers. The way a brokerage balance sheet looks like on the liability side, they have equity capital and they have customers cash on deposit. Like the residual cash in your brokerage account that's not invested in stocks is a liability

Starting point is 01:01:03 on the broker's balance sheet. And then they generally, they'll invest that cash into treasury securities and or margin loans. So like there would be other customers. So say you run your $100 brokerage. account with $90 in stocks and $10 in cash. And then I run my brokerage account with $110 in stocks, but I borrow $10. So Robin Hood has a $10 margin loan to me, and they have a $10 payable to you. Of course, the margin loans in aggregate are smaller than the excess cash,

Starting point is 01:01:34 and they take the difference in invested in Treasury securities. So I don't think there is much risk on that tangible book value. One topic I don't cover too much on the show here is Bitcoin, and that's become more of a talking point in recent months and captured interest from Wall Street and some of these larger financial institutions. We had the ETF approvals in early 24, and from an outsider's view, it seems that more players are becoming more interested in it, whether that be through custodying Bitcoin or offering it to their clients in some form. And I imagine that most players in the space still remain skeptic, but I'm curious if you've seen anything interesting emerge with regards to Bitcoin as a lot.

Starting point is 01:02:15 in the financial space. Yeah, I mean, I would say I had been a skeptic on Bitcoin. Like, I understood the, you know, a set number of coins that it can go up over time, and it's a protection against money printing by governments around the world. I had been a skeptic because I was worried about the money laundering aspect of the U.S. government, you know, after 9-11, the Patriac, and really cracking down on knowing where money was and who controlled the money. and I was worried that Bitcoin was being used by terrorist organizations to move money or by

Starting point is 01:02:48 criminal organizations that hide money. I was worried that if I invested or clients invested in Bitcoin, there would be a catastrophic risk of one day the U.S. government would wake up and be just like, we're going to end Bitcoin. I don't know how they would do it exactly, but they would just be like no-go. It's a national defense issue, any money laundering. It's used in too many legal activities. And I think that catastrophic risk is off the table now that they've approved Bitcoin ETFs. And so I just think that the government can't go back and somehow try to prevent Bitcoin from existing. Maybe it sounds like a naive thing, the thinking the government was going to outlaw Bitcoin,

Starting point is 01:03:23 Bitcoin can get around it and operate it outside the government. But I just wasn't comfortable with that catastrophic risk. And I think that I've changed my view. I don't think that catastrophic risk is this anymore because of the ETFs getting approved. That's hugely positive, like if you own Bitcoin. All right. Well, Derek, I really can't thank you enough for joining me on the show here. I hope we can do it again someday. Please give the audience a handoff as to how they could learn more about your work, follow along with Gator Capital and potentially get in touch. If you go to GatorCapel.com, you can sign up to receive our newsletter or investor letters.

Starting point is 01:03:59 If you want to hear more about our investment products, we're happy to have a phone call. So you can just reach out. My email address is Derek at gatorcapital.com. Just send me an email and we can start a connection. Great. Thanks again, Derek. I really appreciate it. And I know the audience is really going to enjoy this one. Clay, thanks for having me on the show.

Starting point is 01:04:19 I really enjoyed talking to you. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to the Investorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP669: Quietly Compounding at 20%+ Per Year w/ Derek Pilecki

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