Gator Financial Partners letter to investors for the first quarter ended March 31, 2017.
Dear Gator Financial Partner:
We are pleased to provide you with Gator Financial Partners, LLC’s (the “Fund”) Q1 2017 investor letter. This letter briefly reviews the Fund’s investment performance for the 1st quarter of 2017, updates you on the Fund’s positioning, discusses our investment thesis on Kingstone Companies, and discusses the Fund’s current net exposure and positioning by sub-sector.
Review of Q1 2017 Performance
Our 1st quarter 2017 performance was slightly better than the overall Financials sector. The Financials sector lagged the overall market as banks generally had negative returns. For Q1, the Fund returned a positive 3.05%. Syncora, BBX Capital, KKR, and Kingstone are the top contributors to performance year-to-date. On the negative side of the portfolio, several of our best performing stocks from 2016 gave back some gains, such as Ambac, Zions warrants, and Fannie Mae preferred stock.
The Fund’s inception date was July 1, 2008. Past performance is not indicative of future results.
Performance is presented net of fees and expenses. Please see Appendix A for additional disclaimers.
Gator Financial Partners - Update on Portfolio Positioning
Overall, we made minor adjustments to our portfolio in Q1 2017. We added to our positions in Kingstone Companies and Ares Management. We exited our position in Oppenhiemer Holdings.
In Q4 2016, we initiated short positions on highly valued small-to-mid cap banks. These shorts helped us to hedge our large positions in TARP warrants from SunTrust, Zions and Capital One. Heading into the election, we believed the hedge fund community was underweight the Financials sector. As the Financials sector began to rally the day after the election, we believe many market participants who were previously underweight Financials rushed into the sector. We believe these investors bought the largest bank stocks and the Financials sector exchange traded funds (ETFs) such as the XLF and the KRE. As we mentioned in our January letter, the buying of the KRE drove all banks in that index up 20% to 40% in the last seven weeks of the year. This was in spite of the individual bank’s valuation or interest rate positioning.
In 2017, the Financials sector has lagged the broader market and parts of the Financials sector are starting to “roll-over.” We think many post-election buyers of the Financials ETFs are probably exiting or reducing their positions. The bank shorts and hedges we laid out in Q4 2016 have helped to protect us in Q1 2017. We’ve seen additional weakness in bank stocks in early April. We think the weakness may continue as the momentum buyers exit the sector. If the weakness continues, we plan to use the lower prices to reduce our short positions and our hedges. We believe many of the positives from the November rally such as higher rates, lower corporate taxes, and deregulation will still occur even if it is later than originally thought.
On the long side of the portfolio, we continue to have four strong themes in the portfolio: 1) Financial Guaranty Recovery (Ambac, Syncora, & Fannie Mae preferred stock), 2) Alternative Asset Mangers (Blackstone, KKR, Carlyle, Ares Management & Colony Northstar), 3) TARP Bank Warrants (Zion, SunTrust & Capital One) and 4) Consumer Finance (Ally, Sallie Mae, Capital One & OneMain Financial). On the short side of the portfolio, in addition to the bank hedges mentioned above, we have shorted stocks of companies exposed to the shift from active to passive investment management, digitalization, and a few flawed business models.
Kingstone Companies (NASDAQ: KINS)
We purchased additional common shares of Kingstone Companies, Inc. (NASDAQ: KINS) in late January when the company raised capital in a follow-on offering at $12 per share. We’ve owned shares in Kingstone since their previous equity offering in December 2013 at $5.95. The shares have increased in value 25% since the recent equity offering. Please do not take this write-up as a recommendation to buy the shares today. We merely want to continue sharing our investment process with you.
Kingstone Companies is a homeowners’ insurance company based in New York State. The company has grown quickly since Superstorm Sandy as Allstate and State Farm have reduced their coastal exposures on Long Island. Kingstone also writes insurance on several smaller lines such as physical damage on livery, which is purchased by Uber drivers, and business insurance for small business.
We like Kingstone for the following reasons:
1. Strong organic growth – Kingstone has been posting strong gross written premium growth. The company has benefitted from large insurers, such as Allstate and State Farm, reducing their exposures to coastal areas, especially Long Island. We believe these large insurers reduced risk systematically along the coast without consideration for pricing, so Kingstone has been able to grow while being able price the risk appropriately.
We believe Kingstone will continue this strong growth by expanding into adjacent states like New Jersey and Connecticut. Homeowners insurance is a product that every homeowner is required to buy. Kingstone has carved out a niche among independent insurance agents by providing superior service without channel conflict.
2. High returns – Kingstone has stated goals of 20% earnings growth, 20% operating margins, and a 20% return on equity. We think these goals may be too ambitious in light of management wanting to keep premium-to-equity leverage at 1.5x but like that management is trying to generate attractive returns.
3. CEO is a proven money maker – With any small company, we believe the management is even more important because their decisions have higher impacts on the business. We think very highly of Barry Goldstein, Kingstone’s CEO. In our interactions with him, he has been thoughtful and very astute about insurance. He has shown the ability to recognize business opportunities but is able to balance this to protect his downside risk. For example, he has exited lines of business where the economics are poor, such as commercial auto. Goldstein is Kingstone’s largest shareholder. Even though he sold a portion of his holdings in the most recent equity offering, we still believe his interests are closely aligned with other shareholders. We believe he is an owner-operator and not an employee-manager, so he will sell Kingstone if an appropriate offer is made. We believe he has no interest in hanging around to collect a paycheck.
4. New capital will drive earnings higher – Kingstone recently raised $30 million in a follow-on equity offering. The company will use this capital to reduce the amount of quota-share reinsurance it buys. The company has grown so quickly that it had to use quote-share reinsurance in support of its growth. The company has steadily reduced the amount of quotashare insurance from 75% to 55% to 40% as it has grown its capital. We believe they will lower the amount of quota share reinsurance to 20% on July 1st. The company still uses a conservative amount of excess-of-loss reinsurance to protect itself from storms.
5. Active buyer of reinsurance – Kingstone buys catastrophe reinsurance to protect itself from a 1-in-250 year storm. We believe this is more conservative than its Florida peers. Kingstone has been using the declining reinsurance price environment to further protect its balance sheet. With its current reinsurance treaty, if Kingstone were to have a large loss, it would simply wipe out one quarter’s earnings. It would not impact its equity capital.
6. Received a ratings upgrade which will drive business volumes – With the recent capital raise and continued increases in catastrophe reinsurance purchased, A.M. Best raised the company’s rating from B+ to A-. This improved rating will help the company write additional business. Many insurance agents will not place policies with companies with ratings lower than A- from A.M. Best. The potential ratings increase will help accelerate new business as the company enters new states.
7. Thoughtful, consistent expansion – Kingstone has methodically planned its expansion beyond New York state. It has licenses to write homeowners in Pennsylvania, New Jersey, Connecticut, Rhode Island, and Texas. It has decided not to enter Texas because management could not get comfortable with the severity of windstorms in recent years. Instead, Kingstone has recently started to write homeowners in New Jersey and will begin to write policies in Connecticut and Rhode Island later in 2017. These states have similar weather patterns and clientele to New
8. Valuation is attractive – At the price of the recent capital raise, Kingstone was trading at 1.5x book value or 6.5x our $1.95 estimate of 2018 earnings per share. With Kingstone’s 20% growth rate, unique positioning in the northeastern US, and lower likelihood of hurricanes compared to its Florida-based peers, we believe the stock should trade at a significant premium to the 8.5x 2018 earnings at which the Florida-based homeowners’ insurance companies currently trade.
9. Candidate for consolidation – At less than $200 million in market capitalization, Kingstone would be a bite-sized acquisition for another insurance company. For the Florida-based homeowners companies, there would be risk diversification benefits from owning Kingstone’s NY state book of business. For example, a homeowners company with exposure to Florida and New York would be charged lower reinsurance rates than a company writing solely in Florida.
10. Investment by RenaissanceRe Ventures – In early 2016, RenaissanceRe, the well-regarded catastrophe reinsurance company, approached Kingstone to make an investment. They invested $5 million through a private placement of Kingstone common stock by their venture capital arm. We infer from this investment that a smart player in catastrophe reinsurance liked the opportunity Kingstone has in homeowners insurance. We believe RenaissanceRe has given Kingstone informal advice on its reinsurance program since making the investment, which raises our comfort level.
1. Higher operational risk due to small organization – Small companies have greater risk of an operational misstep. Fewer people are involved in making decisions. Key executives may have to fill multiple roles, so the level of expertise may be lower. We do not have any specific concerns regarding Kingstone. Rather, we note they are small.
2. Potential for higher competition – Kingstone has benefitted from the vacuum left behind by State Farm and Allstate when they decided to reduce their exposure to Long Island. If these giant competitors reversed course and wanted to increase their exposure to Long Island, they could take business away from Kingstone. We would note that these companies have steadily retreated from Florida since Hurricane Andrew hit in 1992, so we don’t think these companies will reverse course without serious consideration.
3. No direct writing capability – Kingstone has focused on distributing its policies exclusively through independent insurance agents. As we all know from the never-ending TV ads, auto insurance companies have convinced customers to come to them directly to cut out the agent. This shift to direct distribution has lagged in the homeowners’ insurance market. If direct writing in the homeowners insurance market catches up to the auto insurance market, Kingstone is not well positioned. That being said, there will always be some portion of the homeowners insurance market that will be sold through brokers. Within the independent brokerage channel, Kingstone has such a small market share that the channel can shrink and Kingstone would still have plenty of room to grow.
4. Catastrophe reinsurance market may tighten – Kingstone has benefitted from the loose market for catastrophe reinsurance. There have not been significant losses in catastrophe reinsurance since the 2005 hurricane season, so catastrophe reinsurance prices have declined for several years. As these prices have declined, Kingstone has used the lower prices to buy the same dollar amount of reinsurance but has been able to secure higher levels of coverage. If the catastrophe reinsurance market were to tighten, Kingstone would have to pay higher rates for reinsurance. This could squeeze Kingstone profit margins if the company is not able to raise rates to its customers.
Overall, we believe Kingstone is an undiscovered gem of an insurance company. The company has an attractive growth opportunity in front of it. As shareholders, we are aligned with a money making CEO. We like the fact that management has high return targets. We believe the company will compound our capital at attractive rates for several more years. Eventually, we believe Kingstone will become part of a large organization.
Below are the Fund’s largest common equity long and short positions. All data is as of March 31, 2017.
From this list, we exclude ETFs and fixed income instruments such as preferred stock.
Below is a table showing the Fund’s positioning within the Financials sector as of December 31st:
The Fund’s gross exposure is 181% and its net exposure is 20.6%. From this table, we exclude fixed income instruments such as preferred stock. Preferred stock positions account for an additional 5.4% of the portfolio. We want to point out that due to the TARP warrants held by the Fund, the net exposure of 20% understates the effective net exposure. Also, the reason there is such a large short position in the Banks (large) is due to hedging a portion of the Fund’s TARP warrants.
We continue to see opportunities on both the long and short side of the portfolio to capture value. Thank you for entrusting us with a portion of your wealth. On a personal level, I continue to have more than 80% of my liquid net worth invested in the Fund.
As always, we are available by phone whenever you want to discuss the Fund or investing in general.
Derek S. Pilecki
Managing Member of Gator Capital Management, LLC
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