After the financial crisis of 2008, investors with cash found incredible opportunity in stocks depressed far below their true power to earn in the long term. While many would say that opportunity is long past, Albert Luk of Privet Capital found a source of lingering mispriced value in online broker E*Trade (NYSE: ETFC). Luk noticed that E*Trade holds a significant portion of housing loans which were originated before the financial crisis.
While the market shied away from anything involving such “toxic” assets, E*Trade management has responsibly wound-down holdings in risky housing loans and maintained E*Trade’s profitable brokerage business. As regulatory bodies and the market in general have begun recognizing E*Trade’s achievements at de-risking, Luk’s long position has shot up over 30%. Mr. Luk thinks more is to come as E*Trade becomes stronger both as a business and an acquisition target.
SumZero: What about E*Trade initially caught your attention as a value investor. What was the market missing at the time?
Albert Luk, Privet Capital: I utilize both a “bottoms-up” and “top-down” approach to generate ideas and E*trade had both. From a “top down” perspective, I felt that the Financials sector, specifically banks and brokers, had yet to fully recover from the Great Recession. There was still an overhang on these stocks from poor quality loans originated before the credit crisis and interest rates were at historic lows due to loose monetary policy. Combined, these two effects were negatively impacting E*Trade’s earnings power and capital. From a “bottoms-up” perspective, E*Trade had brought on a new CEO, Paul Idzik, who has a great track record and is a very well respected leader. Then I discovered that his compensation structure gave him a significant incentive to improve E*Trade’s balance sheet and capital position which is one of the major points of my thesis.
At the time, the market was valuing the stock on a relative multiple of near-term earnings rather than on its long-term earnings power, which is significantly higher. Also, since the credit crisis, E*Trade has had a number of CEO’s come and go with little to show in terms of execution, so to the Street, it was a classic “show-me” story.
SumZero: So E*Trade is still suffering from the Great Recession?
Albert Luk, Privet Capital: E*Trade has two businesses, a Retail Trading business and Balance Sheet Lending business. The Retail Trading business earns money from retail customer trading commissions while the Balance Sheet Lending business earns a spread on these retail customers’ deposits, a business model similar to any retail or commercial bank.
Within the Balance Sheet Lending business there is a “bad bank”, a portfolio of poor performing mortgages and home equity loans which were originated just prior to the credit crisis. This “bad bank” portfolio has been significantly weighing down on the entire company’s financial performance and regulatory capital requirements. The size of the “bad bank” has declined dramatically from $32b in 2007 to $7.3b in 2Q 2014 (from 55% of assets to only 20%). At this point, the “bad bank” has hit an inflection point and the worst is behind us. As this “bad bank” continues to wind down, its shadow on E*Trade’s earnings and regulatory capital has lifted, allowing investors to appreciate the company’s long-term earnings power. This has also released excess regulatory capital reserves, which has be used to de-lever its balance sheet and return money to shareholders. Lastly, as the company sheds this overhang, I believe E*Trade will be an attractive acquisition target, especially to TD Ameritrade, one of its biggest competitors.
SumZero: How has E*Trade management reduced this “bad bank” debt portfolio?
Albert Luk, Privet Capital: The decline in the balance of these loans can be attributed to both a passive and active management of the portfolio. On the passive side, these amortizing loans are either slowly paid off by borrowers or abruptly paid off through refinancing as many homeowners are taking advantage of the low interest rate environment and government sponsored mortgage refinancing programs (e.g. HARP). As the US economy continues to recover (ie. home prices and employment trends improve) more and more of these borrowers will be eligible to refinance, which will accelerate the winding down of this “bad bank”.
On the active management side, in April 2014, management sold $800m worth of 1-4 family mortgages at a small gain. This is the first time management has ever made an active effort to sell down these loans and accelerate winding down the “bad bank”. Later, Investor Relations told me that they are actively looking to sell these assets if the “price is right”. Today’s market conditions are moving us in that direction (e.g. thirst for yield, improving credit trends, home prices, etc.). Any additional asset sales will accelerate the wind-down and will be welcomed by shareholders.
SumZero: Has E*Trade management's conservative approach and focus on winding down and off-loading “bad bank” assets led to smaller margins in their balance sheet lending business?
Albert Luk, Privet Capital: All else being equal, yes, winding down the “bad bank” assets will lead to lower net interest margins. These assets are high yielding loans originated in the higher interest rate pre-credit crisis environment. Replacing them with today’s lower yielding agency mortgages will mathematically dilute net interest margin. However, reinvesting in agency mortgages is a much lower risk investment strategy. Unlike the pre-credit crisis loans, these loans have negligible credit risks as they are backed by the government. To put some numbers to it, in today’s environment, management is reinvesting at a rate of 2-2.5% vs pre-credit crisis loans of 4%.
That being said, there are a number of benefits that more than offset this. These “bad bank” assets require E*Trade to incur elevated levels of loan loss provisions, servicing, and FDIC insurance expenses which all negatively impact earnings. In addition, the bank regulators require E*Trade to hold an elevated level of capital against these assets. Lastly, I believe E*Trade is a very attractive acquisition target. Over the years, there have been a number of rumors of a potential buy-out but buyers balked due to the concerns around the “bad bank” assets. Therefore, offloading these assets increases the probability of a buy-out. All things considered, despite the near-term lower reinvestment rate concerns, it would be a significant net benefit for E*Trade and its shareholders to offload these assets as soon as possible.
SumZero: Is E*Trade still attractive to buy at today’s prices?
Albert Luk, Privet Capital: Yes, I believe so. My original write-up has a $38 price target on a standalone basis so there is still some upside left. In addition, there are a number of additional positive catalysts that can push this stock even farther. For starters, management recently announced plans to free up excess capital and monetize the $10 billion dollars of off-balance sheet retail deposits which will be accretive to earnings. In addition, regulators are currently discussion raising the threshold that defines a systemically important financial institution from a $50 billion dollar balance sheet to a level north of $100 billion. Banks above this threshold face additional regulatory scrutiny and elevated regulatory compliance costs. Currently, E*Trade is operating just under this $50 billion threshold and for these reasons, does not want to grow above it. If the threshold is raised, it will allow E*Trade to grow its balance sheet and therefore its earnings potential. Lastly, as I mentioned earlier, I believe E*Trade will be acquired in the near future. Its franchise is very valuable to a strategic acquirer.
SumZero: What key metrics should investors be paying attention to as your thesis continues to mature?
Albert Luk, Privet Capital: There are probably three key metrics that I pay attention to every quarter to check that my thesis is intact and the risks are not. First, I check the performance metrics of the “bad bank” assets: delinquency, charge off and provisions. Second, I look to see if management has actively reduced the balance of high cost legacy liabilities. Progress on these two fronts means progress on both the asset and liability side of the balance sheet restructuring story. Lastly, I look at retail account growth metrics to make sure that the competitive risk mentioned before is at bay and competitors aren’t stealing away E*Trade’s customers.
SumZero: What are the biggest risks associated with the trade in your view?
Albert Luk, Privet Capital: There are a few key investment risks both from a macro and a micro standpoint. On the former, if the US economy turns negative and we enter into a recession, these “bad bank” assets would turn sour very quickly. Secondly, there was some noise around E*Trade’s practice of “payment for order flow”, which is a source of revenue for them. It’s a common industry practice and one that regulators have reviewed and approved but made the headlines when Michael Lewis’ book,Flash Boys, was released. Lastly, there’s a risk that the actual performance of these loans is below my expectations which would result in an impairment on E*Trade’s equity value. In this last case, I ran a number of what-if scenarios to model out the potential impairment and concluded that the upside potential was worth it while sizing the position appropriately to manage risk exposure. On the other hand, the first two risks could be mitigated through a hedging program.
SumZero: What about newfound competition in online investing and brokerages from Motif, Robinhood, Acorns, Wealthfront, and Betterment?
Albert Luk, Privet Capital: I agree that there is online or technological disruption risk for E*Trade and the other online brokers, however the same could be said for almost every other industry like Amazon for retail, Blue Nile for fine jewelry, etc. I believe E*Trade’s franchise shields it from these competitors. They have a devoted customer base resulting in sticky retail deposits. Also, these upstart online competitors provide limited investment research and tools for investors so they are targeting a different customer demographic than E*Trade’s. Lastly, in the financial services space, reputation and longevity are highly valued by customers since they’re entrusting you with their life savings.
SumZero: Is this thesis representative of the Albert Luk and Privet Capital investing style?
Albert Luk, Privet Capital: I’d characterize my thesis on E*Trade as a “cyclical long” or a “cyclical rebound” investment framework and is one of but not totally representative of my investment style. Additionally, I like to look for “soft special situations” and “long-term compounders” types of investments. “Soft special situations” include management change, turnarounds, shareholder rotations, spin-offs and hidden assets.“Long-term compounders” include acquisition platform stories and secular growth stories such as my more recent SumZero write up on Visa.
SumZero: Tell me about your investing background and investing mentors/heros.
Albert Luk, Privet Capital: I have a bit of a non-traditional investing background. I started my career in engineering, then worked as a management consultant before attaining my MBA at Columbia Business School to transition into a career as an investor. Throughout this journey, I was investing in the markets as an armchair investor. It was only during my time as a management consultant where I gained firsthand experience of the inner operations of a company and all the levers you could pull to deliver shareholder value that I decided to make the career switch. I decided to apply to Columbia Business School to help with the transition. My experience there has been the most influential to my development as an investor. Not only did I learn the basic toolkit (i.e., accounting, finance, economics) but was also able to learn from some of the best investors in the industry for whom I have a lot of respect. Legendaries such as David Einhorn, Daniel Loeb, Glenn Greenberg, Seth Klarman, Michael Price and Lee Cooperman spoke to our class on a regular basis. In addition, I’ve met some great mentors and teachers along the way. Both Mike Corasaniti and Gavin Albert were my professors and have really shaped and influenced my investment philosophy. Lastly, Lee Cooperman stands out for me. Not only was he generous in awarding me a scholarship, but he has a work ethic second to none which I have taken to heart.
SumZero: How has your approach evolved over the years?
Albert Luk, Privet Capital: I have always had a value-oriented approach to investing and that has not changed that much. What has changed is my definition of “value” and my definition of “risk”. Initially, I looked at statistically cheap stocks by using screens to identify stocks trading at low price-to-book or price-to-earnings ratios. Through this approach, I ended up buying stocks in bad businesses and losing money. From that experience and my readings of others’ experiences (e.g., Warren Buffett), I began to pay more attention to the quality of the business I was buying. I started looking more at margins, cash flow generation, returns and sustainable competitive advantages. I also started spending more time understanding and evaluating industry structure and how it may impact a business’ “competitive moat”. Learning from these experiences, I ended up buying stocks in better quality businesses but it didn’t come easy. Stocks of good businesses usually don’t trade at statistically cheap valuations so I initially had a hard time paying up for them. However, I discovered that although these stocks seldom trade cheaply, they are also seldom impaired. Therefore despite the more expensive valuation, they yield higher risk-adjusted returns.
I also learned what it means to be patient and use Mr. Market to your advantage because every now and then Mr. Market has a hiccup. Lastly, over time, I started understanding the value of a good management team and how they could create significant amount of shareholder value through disciplined capital allocation, strategic maneuvers, and corporate transactions. This is what got me into looking at special situations.
The approach I use today is the culmination of all of these learnings. I now use a three pronged approach; I look for a great business, led by a great management team and at a reasonable valuation. The first two criteria are the most important.
SumZero: Where else do you see value in the market today?
Albert Luk, Privet Capital: In general, it’s hard to find value in today’s market. I do think there’s value in some areas of the market whose fundamentals have yet to fully rebound from the recession or what I call “late cycle rebounders” (e.g., housing). Also, my above bullish comments on Financials are probably truer today than before as it looks more likely that the Fed will finally start the interest rate cycle. Lastly, I think “long-term compounders” are still very interesting. A few months ago at a Columbia dinner, Bill Ackman said that compounders, by definition, are perpetually mispriced. I couldn’t agree more.
SumZero: What advice would you give to someone interested in pursuing investing?
Albert Luk, Privet Capital: Over the last few weeks, a few recent Columbia grads reached out for advice and I shared with them my two strongly held beliefs: passion and platform.
One, this is a very competitive business so passion for the work is oxygen for success. If you’re in it for the money, you can only fake passion for so long so you’re not going to last. Find something else to do. Lee Cooperman isn’t picking stocks at his age for the money, neither is Warren Buffett; in fact, they both signed the Bill and Melinda Gates pledge to donate most of their wealth.
Two, I advise students to look for the right platform to join. I know a lot of students who graduate from school and want to work for this biggest and most popular hedge fund because they believe that’s the road to riches. I think differently. My advice is to join a firm that can provide you with the best learning environment and use that environment to absorb as much as you can. Learn as much as you can about businesses, industries, financial accounting, stocks and from other investors including your colleagues. Compounding capital is great but compounding knowledge is even better. The right home is where your firm has an investment philosophy that’s similar to yours and a work culture that you will thrive in. I embraced this advice when I was looking for a job while at Columbia. At Privet, I found a firm with an investment philosophy similar to my own, a great culture, and a group of people to support me in my development and I have been having a blast ever since.
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