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No Fat Pitches

My process, if you can call it that, goes something like this:

I have a whole bunch of ideas.  These ideas have taken the form of stock trades.  Some are working and some are not.  Most of the time more are working than those that are not.  But sometimes, usually at least a couple of times a year, that flips.

I start losing money.  Losing money makes me antsy.   Then angry.  This anger leads to disgust.  The disgust eventually leads me to go on a selling rampage – throwing in the towel on many names and what keeping many others in smaller quantities.

At that point I go through a period of mild depression.  All those hopes and dreams from the stocks I have just sold are lost.  I am left to reconcile my new portfolio level, which is inevitably off the highs, instead of clinging to the hope that the same names that led it down will lead it back up again.

But then I come out of this period of despair.  I suddenly feel invigorated again.  Why?  Because I have opportunity.  I have cash.  I have decisions to make.  I am not stuck with past decisions that aren’t working.  Many times, I never look again at the stocks I just sold.  If I do it is with new eyes.   Why do I own this?  Why should it go up?  If it’s a short – why should it go down now.

I start looking at new names, thinking of new ideas, having lots of cash opens up opportunity rather than it seeming like a burden to managing finite capital.   I spend my time trying to figure out where the fat pitch is instead of hoping that it comes from something I already own but that isn’t panning out.

This is the same process I have gone through for 10+ years. The only thing that has changed is my risk tolerance. It used to happen on a 10% drawdown. Today, its more like 2%.

I just went through this process in the past week.   We got earnings season and I got whacked.   First Thursday on Impinj and then Friday on Snap/Sentinel/Crowdstrike.  At that point I said enough, I’m clearly NOT thinking clearly, and sold a whole bunch of everything.

As it often happens, as I work my way from despair to invigorated, I get sent something that puts it all in perspective.  This time a friend sent me a great little interview from Stanley Druckenmiller that really summed it all up.

Druckenmiller is pretty, pretty negative.   Or at least unsure.  Well negative – after all he is in the “hard landing camp”.  When Stanley Druckenmiller says he is more uncertain about the market than any time in his 40 years, that is saying something.

But the comment that summed it up to me is when he said – I don’t see any fat pitches right now.

I hadn’t really thought of it that way until he said it, but its really what I’m feeling right now.

2022 was actually kind of easy.  At least straightforward.  Try to stay out of the way of the freight train.  The first couple months of 2023 wasn’t too bad either – just look for a bounce.  But now?   Man, its hard to know.  Are we still bouncing, is this back to a 2022 playbook, or something altogether different?

That isn’t to say there aren’t promising stocks out there.  There are.  But where we are with the market, the economy, it just makes me reluctant to call them a fat pitch.   A fat pitch is when it all lines up.  There are plenty of stocks, especially in the micro-cap world that has been really hit hard, where the valuation looks quite attractive.  But with rates at 5%, with the market up here well above 4,000, I just don’t know if I want to pull the trigger on them.

I have survived the last 2 years. I have not lost money yet and have actually made a little money mostly on account of shorts and GICs even as the market has gone down a decent amount. I have done this by:

  1. Being cautious
  2. Selling when it isn’t working
  3. Taking only small positions in just about everything
  4. Always being hedged

Here is what I have not done.  I have NOT survived because of my incredible stock picking ability. 

I simply haven’t.  I wish the opposite was true.  I’d love to say I’m Michael Burry and I have found multi-baggers in the bear market. But unfortunately, no. I’ve had some nice winners over the last two years and some equally terrible losers.  Even this year, I’ve done better on the short side then the long side (which is really weird to me given the market we’ve had).  Overall what has kept me in the game is the process (essentially puking up whatever is not working quickly) and not the picks.

In fact I have been best served by scalping profits quickly when I do have gains.  Take Impinj for example, which was a mess this week.  I sold half before earnings on no other reason than the knowledge of my own fallibility. This helped offset the massive drop on Thursday.

Apart from a few large caps it just isn’t paying to buy and hold in hopes of a larger trend.  Unless you have more knowledge about the business than I can divine from conference calls and earnings releases.

As I lean into Druckenmiller and his ‘hell if I know’ thoughts about the market right now, I think that remains the path to be on.   There’s gotta be a really good bull market out there at some point, and when that happens I can try to rack up another one of those years, but until it feels like its coming, I gotta stick to the process that keeps me in the game.

Trying to be Better at Evaluating Banks – PNC

In my last post I made a decidedly poor attempt of figuring out where the banks are going.

I didn’t think through my assumptions. Because of that my guesstimates were off.  When I thought about it more, I realized that I was effectively using the average loan interest rate for the entire year 2022.  That meant that my average included about half a year of very low rates.  And this meant that I was using an inaccurate depiction of earnings sensitivity going forward.

Hopefully I do a better job this time.

We have seen the reports of a few banks for the first quarter.  I can use Q1 numbers to look at the same sort of sensitivity as I did before, but with more detail and more recent baselines.  If I make some assumptions about where deposit rates might go,  I can come up with where earnings might go – hopefully with more accuracy than before.

I am going to start with one of the bigger regional banks that has reported, PNC Financial.

PNC is not anywhere close to the center of the deposit runs we had in March.  It is safe to assume that PNC is more likely to have deposits run to them than run away.

You saw some of that in Q1.  PNC saw deposits grow QoQ.

Clearly there is no “bank run” concern here.  The concern, if there is one, has to do with what those deposits are going to cost in the next few quarters and how much that is going to hit their bottom line.

PNC provided very good color around both their deposits and their loan book this quarter. That is why I am using them as a test-case of sorts. The earnings reports of smaller banks are hard to figure out until the 10-Q is released.

Let’s start with PNC’s guidance. This is what they are guiding to in 2023.

It is not a ton of detail, but along with the deposit information below, it is enough.

What I have done below is extrapolate earnings from PNC’s guidance.  This estimate is based on deposit beta (remember, beta is how much interest bearing deposits increase as a fraction of Fed Funds rate) guidance of 0.42 by year end (I used 0.39 as the average for the year), a Fed Funds rate peaking at 5.5% and an average of 25% non-interest bearing deposits (NIBs).

The resulting earnings look pretty good.  Up 10% YoY.

So why is the stock only $124? Why does it trade at a 7.9x PE?

The two things that come to mind are:

  1. the market is pricing in much bigger earnings hit, presumably by rising deposit costs.
  2. the market is pricing in big defaults

Let’s look at deposits.  What happens to PNC earnings when deposit costs go up a lot?

Below is PNC with a deposit beta of 60% (instead of 39%) and with non-interest bearing deposits dropping to only 20% of total deposits (instead of 25%).

It has a large impact on earnings. But even with an extreme assumption, it is no death blow. It puts PNC at an 18x PE.

Moreover, this assumption seems quite extreme. Deposit betas of 60% would mean the average rate for PNC’s interest bearing deposits would go to 3.3%. In Q1 it was 1.66%. That’s a huge jump. Is that really realistic?

I doubt it.

What I see right now are two worlds. There are banks paying high deposit rates and banks paying low deposit rates. PNC is, of course, in the latter group. Here is where the banks in my watchlist sit so far:

The other possibility is that the market is worried about credit losses. Which is always the great unknown for a bank.

PNC gave a lot of information about potential credit losses in their Q1 report.

The biggest worry with loans comes from commercial real estate. Within the CRE bucket the biggest worry is office.  Office makes up $8.9 billion of PNC’s loans – or 2.7% of total loans.

Of course, while office is not a lot of the whole, $8.9 billion is still a lot.  But those office loans have a lot of buffer. 

PNC gave a very detailed summary of their loan origination practices on the call:

Reserves against these loans, which we have built over several quarters, now totaled 7.1%, a level that we believe adequately covers expected losses. In regard to our underwriting approach, we adhere to conservative standards, focus on attractive markets and work with experienced, well-capitalized sponsors. The office portfolio was originated with an approximate loan to value of 55% to 60%, and a significant majority of those properties are defined as Class A.

 We have a highly experienced team that is reviewing each asset in the portfolio to set appropriate action plans and test reserve adequacy. We don’t solely rely on third-party appraisals, which will naturally be slow to adjust to the rapidly shifting market conditions. Rather, we are stress testing property performance to set realistic expectations. To appropriately sensitize our portfolio, we’ve significantly discounted net operating income levels and property values across the entire office book. Additionally, tenant retention, build-out costs and concession levels are all updated to accurately reflect market conditions.

 Credit quality in our office portfolio remains strong today with only 0.2% of loans delinquent, 3.5% nonperforming and a net charge-off rate of 47 basis points over the last 12 months. Along those lines, we continue to see solid performance within the single tenant, medical and government loans, which represent 40% of our total office portfolio. These have occupancy levels above 90% and (inaudible) levels of 3% or less. Where we do see increasing stress and a rising level of criticized assets, is in our multi-tenant loans, which represents 58% of our office portfolio. Multi-tenant loans are currently running in the mid-70% occupancy range. (inaudible) levels are greater than 30% and 60% of the portfolio is scheduled to mature by the end of 2024.

 In the near term, this is our primary concern area as it relates to expected losses and by extension, comprises the largest portion of our office reserves. Multi-tenant reserves on a stand-alone basis are 9.4%. Obviously, we’ll continue to monitor and review our assumptions to ensure they reflect real-time market conditions.

The key points here are:

  1. They’ve already reserved 7% on these loans
  2. Loan to value is 55% to 60% on these loans
  3. They have already significantly discounted net operating income levels and property values
  4. Right now there are 0.2% delinquent, 3.5% non-performing
  5. 40% of the portfolio is single tenant, medical and government loans

I sat on this post for the last day thinking about what else could go wrong. I mean, there is always the possibility of a 2008 style liquidity squeeze, and of course if that happens, all bets are off on the stock.

But absent something truly systemic, I just can’t see why the stock would have another leg down. And if it doesn’t go down, it should eventually go up.

So we’ll see. I’m quite interested to see how this plays out. As much to see what I may have missed as to see if I’m right.

Latest Thoughts on Buying Bank Stocks

We are a month into this banking crisis.  I still don’t really know what I want to do about it.

It’s why I haven’t said much about it.  My opinion keeps waffling.  And it depends on exactly which banking crisis we are talking about.

What have I done?   Not much.  I’ve taken small positions in a few small banks – BSVN, SBFG and EQBK.  I’ve bumbled around a few times with the larger regional banks (KEY, MTB, RF) on a small scale, buying each on a couple occasions but chickening out of the positions within a day or two.

While many (including JPM head Jamie Dimon) are saying we are coming to the end of the banking crisis, I’m not sure enough that the coast is clear to buy confidently into these names just yet.

Dimon is likely right though – the acute phase is probably over.  At least this particular acute phase is over.  The rapid flight of deposits, of bank runs, maybe more importantly the fear of bank runs, seems in the past.

But I made this tweet about what I was more concerned about (flight not fight).

This situation makes me uncomfortable.  Maybe more uncomfortable than just watching SIVB and FRC wobble on the precipice over a weekend.

What I don’t like about the “drip” scenario is that there is really nothing imminent.  Its just what I said in the tweet – a drip, drip, drip of higher deposit costs for virtually every bank out there, acting like a frog in ever-warming water (is that really a thing?) leading to a slow boil on each incremental loan these banks make.

At least with FRC or SIVB someone had to do something.  But with this “drip” scenario no one is really going to care.  Except earnings at the banks are going to slip, loan growth will slow then stop and then loans overall will subsequently decline.  I’m not really sure where it goes from there except one of my key precepts is that things will turn out ok as long as credit grows and this situation isn’t good for credit which means it isn’t good for things.

As for the banks themselves, it’s really hard to forecast what their earnings are going to be.  Almost all the banks seem extremely cheap on last years numbers.  And many are now cheap on a Price/Tangible Book.  But forward earnings… well I just don’t know.

Banks always talk about deposit beta.  That is the portion of Fed Funds that is passed on to borrowers.  Last year betas got into the high-teens and low 20s.  Last quarter I was seeing estimates that betas would peak in the mid-30s.  That would mean on a 5% fed funds rate, deposit rates would get to 1.75%.

But this is for interest bearing deposits.  Most banks have a decent amount of non-interest bearing deposits as well.  I’m never really sure how the banks are factoring in non-interest bearing moving to interest bearing in their forecasts.  I wonder, with the events of the last month, how many non-interest bearing deposits have taken a closer look and realized they have options.

What I do know is that you can get some ugly earnings numbers by playing with higher beta assumptions and especially assumptions that non-interest bearing deposits move to the interest side. 

After what we’ve seen over the last month it is almost certain that deposit rates are going higher than they were before.  I don’t think 2.5% as a peak is out of the question.  That would still be way less than you can get in the money-market.

What does that mean for banks?  Well, here are 3 banks that I have looked at carefully over the last month.  I owned both KEY and MTB on two occasions but didn’t have the gumption to stick with them.

All I’ve done is taken the numbers from the 10-K, looked at the deposit distribution and added the additional interest expense from deposit rates going to 2.5%.

Of the 3, Comerica comes out looking the best.  Earnings per share only fall from $8.47 per share to $4.41 per share.  MTB sees earnings fall from over $11 per share to $3.48.  KEY goes negative.

Comerica looks the best because they have so many non-interest bearing deposits.  But is it really realistic that all these deposits stay in that bucket?  What if 25% of them go interest bearing?

Those numbers are getting ugly. Key has a loss.

If you really want to get negative, just assume the overall deposit costs get to 2.5%.  Each of these banks is suddenly deep in the red. Yikes!

Of course, whether that, or any of these scenarios, happen is up for debate. I’m simplifying a lot here – mostly on purpose to present just how sensitive these banks are to rising deposit costs.  But there is bound to be a lot more going on than just deposit betas.  And none of this happens overnight.  Its gotta be at least another year before deposit costs creep up to this level.

But what happens if this, relatively benign scenario plays out:  Inflation continues to come down but it is just a touch sticky.  We can’t seem to sustain 2%.  We start thinking 3% is best we can do.  The economy doesn’t fall out of bed, it does what it has been doing, which is performing pretty, pretty good.  The Fed funds is still at 5% in the summer of 2024 and there is no sign they are cutting any time soon.

Man, some of those bank earnings are going to look really bad if that happens.

And that makes me nervous.  Because that doesn’t seem like a world in equilibrium.

Getting Back To It

After taking a month and a half off, I am going to get back to writing more regularly again. I took time off of more than just the blog. I really didn’t do much at all in my portfolio (which I will have updated in the next day or two). I can count my trades on two hands.

In mid-December I took new positions in Coveo Solutions and Sentinel One. In early January I took positions in CRISPR Therapeutics, Intellia and Crowdstrike. And for a brief period at the end of December I owned Tesla, but I chickened out and sold before the stock took off. I also doubled down on Eiger (more on that at the end).

That is about the extent of it. I mostly have sat on my hands, both through the down move in late-December and the recovery we have had in January.

This is consistent with my view. The market is not really cheap or expensive, it is somewhere in between, and that until we have a big event in one direction or another the market will probably range listlessly (but violently) around.

With that being my guide, we are now back near the top of the “do nothing” range, which means I should be more inclined to sell than buy. I started to do last week and will continue to do this week. Not existing positions, but making them a bit smaller.

With not much new to discuss, let me talk for a minute about a couple of stocks I bought back in November. Impinj and Identiv. Both of these names are part of a bigger idea I have about digital tracking. Tracking product more accurately seems like a natural win for efficiency and new tech seems to be making that tracking more feasible. Since I bought the stocks, PI is up a bit while INVE went straight down for a month and has since stabilized. Both stocks have not been big winners thus far.

But RFID tracking appears to be gaining traction and that traction makes sense to me so I have held on.   Consider this bullish fireside chat with $PI from earlier this year.

PI has a platform for RFID called RAIN which includes one-time sales of their readers/scanners and recurring sales of RFID tags. About 75% of revenue is tags right now, 25% readers.

In the fireside chat Impinj talks about the opportunity. RFID in apparel/retail is about 25% penetrated. However about 95% of the companies are in at least early stage of deployment or better. In other words, most have started but few are at a mature stage of deployment. This bodes well for near-term demand as more companies ramp. Indeed, Impinj has had 6 quarters in a row where their demand has outstripped their ability to get supply of semiconductor chips needed to make their tags. While their mature customers are pulling back a bit with the economy slowing, this has been more than offset by the ramp of new customers. There are not too many businesses that can say they are legitimately accelerating right now.

Bigger than apparel is the supply chain opportunity, which is just starting to materialize. Supply chain is putting RFID tags on any goods or pallets along the supply chain. This is a $400 billion TAM vs a $80 billion for apparel/retail.  2023 will be the first year PI delivers tags for the supply chain vertical.

INVE manufactures RFID tags and readers, which is different than PI, which designs and develops a platform.  That means INVE is not really as good of an idea as PI, in fact I’m not sure they have much IP in this space that really sets them apart. Nevertheless, INVE is much smaller in terms of market cap (~$180 million) and I think its found itself in the middle of something that could grow quite a bit.

The idea here stems around a partnership they have with an Israeli company called Wiliot.   Wiliot has a lot of IP. They are a semiconductor designer focused on designing chips for RFID tags and they have come up with what seems like a prettybrilliant design.

Wiliot has figured out how to make an RFID device that works extremely well in the supply chain vertical. This device basically doesn’t need a battery and it doesn’t need a crystal, which makes it very tiny and also very independent. It is a sticker smaller than a postage stamp. It transmits and receives a bluetooth signal that allows it to communicate location, temperature, other important parameters.

They get into the whole idea of Wiliot, how they invented their product, which I think is totally fascinating, in this podcast called the Digital Supply Chain Podcast as well as on this interview with TechFirst.

While I’m still trying to figure this space out, I think that Wiliot is one of the early leaders in the supply chain tracking space.   And Identiv is their manufacturing partner. INVE gets high-20c per unit price for each tag:

At 25 million units, that isn’t a huge amount. But Wiliot is talking billions over time, so that could scale quite substantially.

One other thing I did was double down on Eiger. I know its crazy and only losers average losers, but I also know this company quite well and while I recognize that they could completely destroy what is left of their value with an ill-timed and priced share offering and that because this is a money burning biotech there is a tonne of room for error, I also know interferon-lambda worked in COVID, I know that it has worked in HDV, and I know they have an approved drug that should be able to reach $40 million in annual sales over the next few years.

My guarded optimism has been confirmed, at least to a degree, by recent purchases by insiders. Here is my thought experiment on those purchases. You are the CEO or Director of a small biotech firm. Your firm is burning about $20 million a quarter. It has about $100 million of cash. Your firm just released crappy results from its lead program. The other drug, which had big potential for COVID , was just rejected by the FDA and you will need to run a big, expensive, lengthy trial before it ever has a chance of approval. Your former CEO was just turfed. You don’t have a significant readout until at least the end of the year.

Do you buy shares in your firm?

I think the answer here is pretty obviously no. Even if you like the longer-term prospects, you are likely going to need money and you might as well wait for that raise to buy because it will either be lower or come with warrants.

So why did they buy?

There was also a recent article in the WSJ talking about the efficacy of lambda and the variant agnostic nature of its action. The article questioned why the FDA would not approve such a drug. That reason could be getting more attention in the near future – the Project Veritas expose on Pfizer should bring attention to it again. While some of the Veritas work seems pretty sensational and some of the commentary about what the Pfizer executive did or didn’t say seems to be more hyperbole/fearmongering than reality, what the Pfizer exec did say quite clearly is that there IS regulatory capture of the FDA by Pfizer. This, IMO, is the reason lambda was not approved. I increased by share count by 5x which in dollar amount was a double-down.