The financial crisis of 2008 taught investors many lessons, among them “banks are dangerous” and “buy when there's blood in the streets”. Years out from the worst of the collapse, however, investors can still can take advantage and, ironically, the opportunity lies in the epicenter of the crisis itself, the banks.
Brian Pitkin of URI Capital Management originally pitched a specialty trade capitalizing on this theme at a live SumZero event in November of 2014. The thesis has gained meaningful traction, as predicted, but there's much more available for investors who take the time to examine it. According to Pitkin, banks are doing well, considerably better than most people understand, but they are still trading at depressed prices due to broad disdain/distrust from investors dating back to 2008.
Pitkin’s weapon of choice in executing this thesis is the TARP warrant, a special crisis-era security issued by TARP-taking banks to the Federal Government. While Pitkin thinks common bank stocks could double in the medium term, he believes TARP warrants could more than triple. We sat down with Mr. Pitkin to discuss buying various TARP warrants, and specifically that of the largest US bank by assets JP Morgan Chase (JPM:US).
SumZero: Let’s start at the beginning. What part of the financial crisis necessitated the creation of TARP warrants?
Brian Pitkin, URI Capital Management: The TARP warrants were originally issued to the government when the Treasury provided capital to the banks and other institutions during the financial crisis. There are times when providing capital in the form of debt or preferred shares you may also receive warrants to participate in upside from ownership in the company and the Treasury took just this route to sweeten their investment. Eventually the Treasury was ready to sell their warrants to help in the recovery of taxpayer capital and they auctioned them to investors. The warrants now trade regularly on the exchange and thus can be bought and sold throughout the day much like a common stock.
In another warrant example outside of the TARP program, when Berkshire provided capital to Bank of America, Goldman, etc. he took preferred shares (some of which have been paid back) but he also got warrants which can convert into common share ownership. With some he has already converted to common, and with others he still holds the warrants.
SumZero: Ok so what is a TARP warrant and how does it work?
Brian Pitkin, URI Capital Management: A TARP warrant is a security that gives the warrant holder the right to convert into the issuer’s common shares at maturity dates ranging from October 2018 to January 2021.
The warrants work like options but they differ from options in two important ways. First, they are much longer dated than options. While they were issued with even longer maturities, these warrants still have between three and five and a half years left until maturity. That is much longer than even the longest available options.
Second, TARP warrants have dividend protection. Options do not have dividend protection and the value of dividends paid during the hold period are lost to the option holder. The TARP warrants are different in this way: when a dividend is paid above a threshold amount (which is different for each warrant) the terms of the warrants are adjusted. The strike price actually decreases when dividends above a threshold amount are paid. Also, at issue, each warrant allowed conversion to one common share, but over time the warrant holder may be entitled to receive more than one common share per warrant depending on the amount of dividends paid over time above the quarterly thresholds. This dividend protection has a very complex formula which I lay out in my larger summaries (it takes a couple pages to explain…) but it is very important as it will increase the return profile potentially substantially.
Their relatively long duration to maturity and partial dividend protection make them compelling investment opportunities for those who want to increase the return potential associated with large financial institutions. While they have added leverage to the upside, it should also be noted they also carry greater downside risks and tend to be much more volatile than the underlying common shares.
I would also point out that this dividend protection could become critically important in upcoming years. The large banks and AIG for that matter are generating a lot more capital than they can put to profitable use. They now are buying back stock but there may reach a time when they pay out large, one time dividends. If that happens, the dividend protection in the warrants will protect against that value being paid out.
SumZero: So a bet on TARP warrants is a bet on banks? Why not not just buy JPMorgan stock?
Brian Pitkin, URI Capital Management: I came to warrants indirectly. I have long studied and owned the large banks and I find them to be highly compelling investments for those with a longer term perspective. They face many challenges ranging from heightened regulatory burdens to persistent low interest rates. Yet they are generating tremendous amounts of current earnings even in this difficult environment and, as the headwinds fade, they are likely to generate more normalized earnings at levels much greater than today.
The large banks have also substantially increased their capital and liquidity levels. The much greater levels of capital and liquidity provide a fortress-like foundation to withstand market and economic stresses. Banks generally fail through a lack of capital or a lack of liquidity, and all the banks have much greater levels of both today making them much safer investments than they have been in the past. The risk profile of the banks individually and the banking system more broadly has declined dramatically since the crisis. In addition to substantially higher levels of capital and liquidity, there is only minimal short term funding amongst the large banks and they have exited many of the overly risky business lines and activities that contributed to the crisis.
Set against all these positive developments, the large banks trade at historically attractive valuations allowing for an investment in safer and enduring businesses at very good valuations. When we consider the much higher, more normalized earnings power of these businesses, the opportunity becomes unusually attractive and this is why they comprise by far the largest industry concentration in my core fund.
In following and studying the banks, I came across the TARP warrants which allow for amplified returns to the same underlying thesis of these banks returning to normalized earnings and normalized valuations.
When I spoke at the SumZero-Institutional Investor InvestPitch event last November, I spoke of how JPMorgan could double in price by late 2018, and given those same dynamics their warrants would increase by a factor of four--a tremendous opportunity over the then four years. Four times your money in four years. Since then they have gone up in price but not by much, and thus the opportunity remains. The opportunity was so unique in fact that I opened a second fund focused exclusively on TARP warrants to better take advantage of this opportunity which will not come around again.
SumZero: Do you think increased regulation has in fact helped banks become more profitable by requiring them to focus on safer core businesses? What about huge increases in compliance overhead that these regulations also necessitate?
Brian Pitkin, URI Capital Management: The increased regulations have certainly made them much safer and much more durable businesses. There is no doubt about their increased safety and soundness compared to pre-crisis. The regulations have come with increased costs which have hurt recent earnings but the banks are becoming more efficient, are reducing expenses dramatically, and remain very well positioned for much higher earnings as the banking environment and rates normalize.
The current headwinds have really forced banks to run their business much more efficiently than in the past. They are making changes as if the current banking and rate environment will not get better. They are making changes so they post strong earnings today but I believe this has also created is a coiled spring such that when the environment does improve, their already strong earnings will increase substantially. Investors will remember that banking is a good business and that there is tremendous operating leverage inside a bank. It takes the same banker to write a loan at 6% as it does at 4% but the per banker profitability is much higher at 6%.
Banking is a good and necessary business. It has been a profitable business for centuries and will continue to be a profitable business. The banks that survived the crisis operate at much greater scale than before the crisis. Everyone one of us as individuals and every institution requires a bank, and if you want to bank with someone with national or global scale your options are very limited. That universe is limited even further if you have more complex banking and financial services needs.
SumZero: Do you think investors still have a tainted view of banks and shy away from them irrationally?
Brian Pitkin, URI Capital Management: In a word, yes. People are overly fearful of a relapse of the crisis without realizing how different the businesses and the balance sheets of the large banks are compared to before the crisis. Capital and liquidity levels have increased dramatically making the banks able to withstand massive stresses.
The banking system is better capitalized and more liquid than it has been in the past 60 years. The average amount of equity to assets is the highest it has been since 1950. In addition to historically strong capital levels, the banking system is also incredibly liquid. At the end of 2007, the banking system had roughly $21 billion on deposit at the Fed (where banks hold their cash). In recent years the banking system has had over $2.5 trillion cash on deposit at the Fed. That is an extraordinary increase in cash levels throughout the banking system.
Investors also do not see the likelihood of much higher earnings as the banking environment and rates normalize. This may be due to shorter term view of most investors. In that sense, they may be right that much higher earnings are not right around the corner. But if you extend your horizon a bit and think years rather than quarters into the future, you can see much higher earnings. Most investors are not looking that far ahead and I don’t think investors fully appreciate how much latent earnings power exists inside the large banks.
SumZero: There are many TARP warrants out there. Have any others caught your eye besides those issued by JPMorgan?
Brian Pitkin, URI Capital Management: I also find the Bank of America Class A TARP warrants very attractive in addition to the AIG TARP warrants. Both of these companies still trade below book value today but have dramatically reshaped their businesses for better profitability going forward. As they return to more normalized earnings and normalized valuations, their warrants can increase in value quite substantially.
SumZero: Are these warrants still attractive to buy at today’s prices?
Brian Pitkin, URI Capital Management: I spoke late last year of a target price for the JPMorgan warrants of $78 by late 2018 which is significantly higher than their current price around $20. Similar potential exists in the Bank of America and AIG warrants.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
Brian Pitkin, URI Capital Management: With all our investments, I continually keep an eye on two things: the health of the business and the price of the stock. If I believe the business has deteriorated structurally and for the long term in any way, I will reassess our willingness to own that business. I also watch for the companies we own to move past my estimate of per share intrinsic value as that prompts a decision on whether to pare back or sell the position. If I continue to like the business and the stock price moves down, we will take those opportunities to increase our investment. In shorter form, I continually monitor the price I am able to pay versus the value I am receiving.
SumZero: Was execution difficult given that these are a more uncommon security type?
Brian Pitkin, URI Capital Management: The TARP warrants that are still outstanding trade daily on the exchange just like the common shares. They do trade with smaller daily volumes but there has been more than enough volume for us to build our positions.
SumZero: What were the biggest risks associated with the trade in your view?
Brian Pitkin, URI Capital Management: Time is the biggest risk factor in my opinion. When making an investment, I generally take a very long term perspective allowing whatever time is needed for my thesis to play out. By not worrying about nearer term performance, I can wait patiently for value to be seen and value to be created. The warrants, while somewhat long dated in nature, do present an added risk beyond those prevalent in the underlying business. With the common shares, so long as the businesses continue to generate appropriate returns, I am fine if it takes years and years for the market to recognize their value in the form of higher stock prices. Time is on my side. The dynamic is different with the warrants. Stock prices need to see the value I see sometime before maturity for my thesis on the warrants to work. While maturities ranging from late 2018 to early 2021 may seem like a long time for some investors, it is a pretty short time horizon from my perspective and brings incremental risk to the table since I don’t have unlimited time for the market to see what I see. That is why I limit their exposure in my core fund and believe they should play a smaller role in someone’s overall investment strategy.
SumZero: Is this thesis representative of the Brian Pitkin and URI Capital investing style?
Brian Pitkin, URI Capital Management: We seek to find great business when they are out of favor and available for great value. Importantly, we pair that seeking with an ability and willingness to own these businesses for very long periods of time which allows us to rise above the day to day, quarter to quarter, and even year to year nuances of the market. The warrants we own are in businesses where we have more significant positions in the common shares and thus they share the same underlying fundamental investment thesis. As described above however, the warrants do shorten our normal investment horizon, which I like to consider generational, and that does make them somewhat different from our core investment strategy.
SumZero: Where else do you see value in the market today?
Brian Pitkin, URI Capital Management: Value is increasingly hard to find. As you can obviously tell, I find the large banks and certain other financial institutions to be of great value today. I have also been studying the media space in great detail as I see good value amongst some of the broadcasters and other more traditional media companies.
SumZero: How has your approach evolved over the years?
Brian Pitkin, URI Capital Management: We study extensively but invest sparingly. We may only add one or two positions in any one year. We run a highly concentrated portfolio because I believe in focusing on our highest conviction ideas. We have become even more concentrated in recent years as finding value has become more difficult.
SumZero: Tell me about your investing background and investing mentors and heroes.
I come from a nontraditional background. I began my career in investment banking and then went to private equity before returning to Indianapolis to help grow a family-owned chemical distribution business. I have been a passionate and engaged investor since childhood and was reading news, research and annual reports all during my career before starting the fund I now manage. Eventually I decided to follow my passion for finding and owning great businesses. It sounds cliché but I have always read and followed Warren Buffett and other value investors who follow highly concentrated strategies. I think of the fund as if it were a perpetual family investment vehicle that just happens to own publicly traded companies allowing liquidity when and as needed. My background in both investing and managing businesses has contributed to my understanding of what makes for a successful business and thus a successful investment, when bought at the right price.
SumZero: What advice would you give to someone interested in pursuing investing?
Brian Pitkin, URI Capital Management: Never forget that you are investing in a business when buying a stock. Your thinking and processes should be no different than if you were buying the entire business. Stocks are not numbers moving up and down across a ticker. They are ownership in a business.
Remember that time is your friend when owning a great business. Most market participants are consumed by performance over ever shorter and shorter time horizons. If you can extend your horizon for years or even decades into the future, you have an undeniable advantage. Stock price declines become an opportunity instead of a problem. Where others see pain, you can see stronger long term returns. That temperamental advantage makes all the difference.
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