Florida based Gator Capital Management is one of the most overlooked investment firms in the US. Managed by Derek Pilecki, the firm has returned a net annualized 24.9% since inception, (mid-2008) vs. 9.9% for the S&P 500 by focusing on financials during a time when most other investors have been too terrified to touch the sector. And ValueWalk only heard good things about the dirm (although of course this is not an endorsement)
In the August 31 issue of Value Investor Insight, Derek Pilecki speaks about his strategy, why he believes there’s still value to be found in the financial sector, and he highlights some of his favorite ideas. Below are some highlights of the Gator Capital Management interview.
Gator Capital Management: Finding Value In Financials
Over the past decade, investors' dislike of the financial sector has made the sector one of the market's most volatile. Since 2008, investors have struggled to regain trust in the industry as profits have slowly recovered. Poor investor sentiment has certainly led to opportunities for Gator Capital Management which says, "Since I started my fund in 2008 there have been three times – the global financial crisis in 2009, the U.S. debt downgrade and European crisis in 2011, and when interest rates were bottoming in late 2015, early 2016 – when the sector has been pretty universally hated, which can, of course, create opportunity." On top of the wider sector issues, more traditional situations such as turnarounds, spinoffs, and divestitures are fertile hunting grounds for Pilecki who tends to have "more ideas than I have room in the portfolio."
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One example of a situation where Gator is using its expertise to invest against the herd is with OFG Bancorp, Puerto Rico's third-largest bank.
Puerto Rico's bankruptcy proceedings have damaged the whole state's reputation, and many investors now want nothing to do with the region. However, Pilecki notes that OFG is in an unusual position as unlike other lenders, the group has no direct government loan exposure. What's more, a strong balance sheet has allowed management to be opportunities in buying failed competitor banks to expand its franchise. The bank's strong position in the market, coupled with its consolidation efforts and zero exposure to bankrupt government debt has led Gator to conclude that the firm will be able to weather the declining economy and come out the other side stronger than before.
Today, bank stocks comprise around 30% of Gator's portfolio. In the past, the weighting has been as high as 50%. Much of the current bank exposure is "in the TARP warrants of large regional banks such as SunTrust, Zions and Capital One." Why is Gator Capital Management no longer involved in larger banks? Gator Capital Management says that "valuations are somewhat higher than they’ve been historically and I’m just finding more of interest elsewhere." He doesn't believe that small banks are good value either. In fact, he thinks "small- and mid-cap banks are expensive," and the firm has "hedged a good portion of our TARP warrants with shorts on small-cap banks trading with high teens multiples on out-year estimates."
Gator's short book is an essential part of the fund's investment strategy, especially considering how volatile and strongly correlated to the economic cycle the financial sector is. Today the Gator Capital Management short book is much smaller than it was back in 2008 because the financial sector is much stronger than it was nine years ago. Short bets are focused on "names we think have real headwinds" for example, companies that are " more vulnerable to the shift from active to passive investing than is reflected in their share prices." Gator Capital Management gives the example of Morningstar, which is "well run, but its products cater primarily to active mutual-fund and stock investors". The shares currently trade for "30x earnings, with no sell-side analysts following it and a bit of a cult following among buy-side holders." He goes on to say that the firm deserves a valuation closer to that of rating agency Moody's, which trades at 22x earnings.
Gator is also taking aim at fintech companies that "promise to disrupt various financial sub-sectors, but which we believe have flawed business models." Lending Club is given as an example. The company currently trades at around 3x book value but Gator Capital Management believes the stock "will end up trading closer to book as the company starts securitizing loans on its balance sheet as other lenders do."
On the long side, one of Gator's key picks is OneMain Holdings. OneMain operates a network of over 1,800 low-cost branches in 43 states and is focused primarily on underwriting small-ticket consumer loans. The typical loan is for two years at a rate of 25% for $4,000. After buying Citigroup’s consumer-lending arm, OneMain Financial, in late 2015, the company found itself nursing a debt to tangiable equtiy ratio of 18x and management has since been working to reduce this. Gator is looking for 7x by the end of next year.
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The biggest threat to OneMain is credit risk. A good credit profile of both the company and its borrowers is required for the company to function effectively:
"OneMain is dependent on the capital markets to fund its liabilities, which it does through a combination of unsecured debt and asset-backed securitizations. It also has a large bank credit line. As the company retains earnings and continues to de-lever, we think it can manage through any tightening in the unsecured-debt market."
Meanwhile, the creditworthiness of the firm's customers is "heading in the right direction."
Over the next few years, Gator Capital Management believes OneMain can earn up to $6 per share as big banks pull back from the consumer loans market, it pays down debt and expands via acquisitions. A multiple of 10x earnings would give a prospective price target of $60.
Another of Gator's top stock picks is London-based OM Asset Management, a holding company that owns majority stakes in eight boutique U.S. asset-management firms, including such names as Barrow, Hanley, Mewhinney & Strauss, Acadian and Copper Rock Capital. The group manages $260 billion in assets across various active strategies. While this recommendation might seem to run against Pilecki's view that the active management industry is going to run into problems, he believes that all of the firms under the OM umbrella have "done a good job in diversifying assets by adding alternative and non-U.S. investing strategies that are seeing inflows and earn higher fees." One example is the purchase of "a 60% stake in Landmark Partners, a Connecticut-based firm that has more than 25 years of experience investing in secondary private equity, real estate and real assets." Assuming low-single-digit organic growth, Gator believes OM can earn $1.70 per share in