I used the downturn to reposition my portfolio. I just want to mention a few things that I did during that time. One of the most surprising things about that downturn was it quickly turned into a liquidity crisis and that is strange. We had a health crisis and all of a sudden the repo markets, the money markets froze up and a lot of firms that were funded in the wholesale funding markets just started going down precipitously.

There was a real opportunity there and I'm thinking about banks, mortgage REITs, especially mortgage REITs just got crushed and they couldn't roll over the repo funding. A lot of their preferred stocks went down to 40 or 50 cents on the dollar. The common stocks still had legitimate value.

I went through the mortgage rates and scooped up a bunch of mortgage REIT preferreds. It was investing under imperfect information because you didn't know that the mortgage REITs weren't bankrupt yet, but the common stocks still had hundreds of millions of dollars of value and the preferred were trading at 40 cents on the dollar. That was one thing that I did. Another thing that I did was, there were a few mortgage banks that were printing cash at that time. Mortgage banks make mortgage loans.

They sell the mortgage loans to Fannie and Freddy or to Wall Street and they earn a spread. The spread on a mortgage origination had blown out, starting in the fall of 19 so they were, they were printing money. Mortgage rates were going down. The volumes were high and there was one company in particular, PennyMac Financial Services, that had been in my office in the fall.

They were putting up great numbers and they announced the second week of March that they were going to earn four bucks in the first quarter. They had just announced, "We're earning four bucks this quarter and the stock dropped from 25 to 17." If you run rated four bucks a share per quarter at $16, I basically bought PennyMac at one times earnings. Those are a couple of smart things I did during that time.

Looks like we're heading into another pullback, I don't think we've bottomed. We have more downside to go. I would say, keep your powder dry. There'll be a better buy opportunity than Monday.

If for some reason Putin pulls back, which I see no reason he will, the market will rally, but I think that'll be temporary. I think there are a lot of stocks that are under heavy selling pressure. I think we're still burning off the speculative accesses from last spring. I just think I'm bullish in the market intermediate long term. The next month or three, not bullish. Just don't get too long right here.

The other thing I about during my speech. Two years ago was I gave a pitch on Pinnacle Financial. So I just want to close the loop on that. The idea was growth banks were undervalued. In 2017, growth banks... Growth banks are banks that grow faster than the rest of the banks. They have some specialization or they have a management team that very, very much incentivizes growth.

Here are 12 or 13 growth banks. I've flashed this slide up two years ago. If you did an equal way to basket of these growth banks two years ago, it would've turned out okay. I pitched Pinnacle Financial, which is in the right corner. You can't see it right really well in the slide. The idea is, you shouldn't trade growth banks based on your view of interest rates are because the volume growth outweighs any movement in their margins.

Growth banks growing 12 to 15%, the industry growth 6%. That 12 to 15% growth outweighs it. The growth banks at that time had lost their multiple premia to the rest of the market because investors thought that interest margins were going to contract. That happens, but the growth banks kind of grew through it.

If you look at the returns, the dark green line is Pinnacle Financial. The light green line is equal weight of the basket of the growth banks. They were all almost doubled from when I gave my speech, despite being down 35% that first month. Then the black lines, the S&P, ETF and, the gray lines, the regional bank ETF. I would say regional banks have performed in line with the market over those two years and the growth banks have outperformed.

Going back to the first part of what to do in a downtrend. The sell-off in March 2020 was unusual because the S&P bounced back so quickly and, not all parts of the market bounced back. You can see here, regional banks stayed depressed for six months until the Pfizer vaccine announcement in November 2020 came out, and then they ripped higher.

I think that downturn was really confusing. There were definitely some COVID beneficiaries. The big cap stocks got the benefit of a lot of liquidity flowing into the system. I think it was not a normal downturn, just given how quickly the big half stocks pulled back. One thing that I tried to say two years ago was go ugly early. Go buy the most beaten-down stocks at the beginning of the rally.

Do you view the beginning of the rally, April 2020 or do you view it as November 2020? If you say the Pfizer vaccine announcement in November was the spark of the light switch the rally started, definitely the ugly banks had outperformed. That's just kind of recap from 2020.

I want to pitch a stock. I cover financials and I do it because I worked at a big financial before business school and being on the buy side, it made sense for me to start covering financials and I've just developed this specialty. This is a junk financial. This is not a compounder. This is not something that we're going to hold 15 years, but it's a little cigar butt. Kind of built my firm on, little value trades like this.

Just want to run through it. Maybe you'll find it. We'll hear about it in the CIGM portfolio. Enact is a mortgage insurance company. Enact became public last September. It's parent is Genworth Financial.

Genworth has been around for a long time. It was part of GE. GE spun it off in 2003, and Genworth has had a troubled history over the past 20 years. They've had a troubled business in long term care insurance. They just spent about four or five years trying to get acquired by a Chinese firm and that merger finally fell through so Genworth is on its own. It's going to stay independent. So Genworth, to fix its capital structure, IPO'd, 18.4% of Enact last September. Enact is a mortgage insurer.

Mortgage insurance is an average business. There's no moat, right? There are six mortgage insurers. Just a little mortgage insurance 101. When you buy a home, you have to put 20% down if your lender's gonna deliver your loan to Fannie or Freddie. If you get a conforming mortgage, which if your mortgage is less $647,000, you have a conforming mortgage, your bank or your mortgage company is not going to hold onto that mortgage. They're going to sell it and deliver to Fannie and Freddie at the down payment of 20%. Most people don't save up 20% for a home. Instead, they put down 10% or 5% and they buy mortgage insurance. And the mortgage insurance protects Fannie and Freddie if you default. You have to buy it so first-time home buyers are the largest users.

When you refi your mortgage, if your house has gone up in value and your loan to value ratio goes down so that now you have more than 20% equity, you don't have to get mortgage insurance on the refi or if you make payments and your loan to value ratio, I think it gets below 75 or 70, you can ask to have the mortgage insurance rescinded.

It costs money on a monthly basis. It's just a cost of homeownership. The industry had a tough time in 2008. So they had left their credit box and they made a lot of insurance policies against no doc loans, which is just death. They're called liar loans. People don't document their income and it just came back to bite them.

The legacy mortgage insurers like Enact have old books of business that are not good, but since 2008, all the books of business have been very, very clean. Everything's fully documented. The housing market's been strong since 2008. No credit issues here. 2000 with COVID, forbearance programs kind of threw a wrench in things.

So the mortgage insurers had delinquencies, but they don't have claims yet because of the forbearance, so they have to put up reserves. I think that as the forbearance programs end, the reserves will come back in. There's been an improvement in mortgage insurance. The industry's using reinsurance now so they get capital relief from reinsurance companies by them taking some catastrophic risk. It has really improved the economics of the business.

One big concern that investors have: is pricing going to take a step down? It's six companies. As a home buyer, you don't care who your mortgage insurer is. Fannie and Freddie don't want the industry to consolidate beyond these six. They don't want it to go to four or five so the companies don't have any pricing pressure. They're playing friendly now. If one of the companies decided, I'm going to take share and lowers pricing, the whole industry's going to fall. That's why it's an average business because there are risks that the top that they have right now is going to collapse and pricing will go down.

It's been pretty stable for a long time. We're owners of mortgage insurance, despite knowing that's a potential issue and I don't want to overstate that. That's kind of background of mortgage insurance in that it's one of the six players. They have a high-quality book of business. They just recently came public. Genworth still owns 81% of them. Genworth has two other assets. They own a life insurance company, which is where their problems have been. They have long-term care insurance. We'll get into that in just a second. Then the third asset that Genworth has is they have a tax-sharing arrangement with both their subsidiaries Enact and their life insurance company.

Tax sharing we'll get into a little bit, but basically, they get cash payments because Genworth doesn't have to pay taxes to the federal government because of past losses so they have some cash coming into the holding company. Genworth life insurance... Genworth, this subsidiary probably has zero value, despite having $11 billion of equity and it's because of long-term care insurance.

Long-term care insurance is sold to 60-year-olds for when they potentially go into nursing homes at 85 so you're making a 25 year bet on how much your nursing home is going to cost in 25 years. Pricing of this has been systemically poor so Genworth has lost a ton of money on this and they have real problems. They've been raising rates for seven or eight years and the rate increases have been very aggressive.

There is a chance that five or 10 years from now that this subsidiary might have some value, but for owning Genworth right now, I assign zero value. If it does have some value in the future, it could be substantial that it's a $4 stock and the book value is $22. It's like a free call option, right? It's legitimately hot, a legitimate second source of value. We probably won't own Genworth when that happens, but we might benefit from other people getting excited about it. We're not excited about it now, but it's potential.

Enact is cheap. It's the cheapest mortgage of the six mortgage insurers. It trades 80% of tangible book. It's a book values like 25 and change. Enact is at 20. I think it's cheap because it's an unseasoned stock only 18% floats so there are only 350 million that floats or is traded in the market. A big firm can't really take a position in Enact. Then some other investors think that Genworth is going to spin off the rest of their shares to the market so they're like, "Ah, why should I buy Enact now? I'll just buy it when Genworth spins it off." I think those are the two reasons why in Enact is cheap.

I don't think Genworth is going to spin off Enact. I think it's more likely that they'll buy in their remaining piece five years from now. Because of the tax sharing arrangement, Genworth gets benefits from its 80% ownership of Enact. They will have a harder time with getting the cash flows from the tax sharing arrangement if they spin off Enact so I think that fear of them spinning it off is unfounded. I don't think the market's going to change its perception of that. Even as much as I talk about it, everybody's going to say, "Oh, but one day they'll spin it off." I think that's a real reason why Enact trades cheaply.

I think there are a couple things that are coming to Enact that are going to change the market's view of the value of Enact. One is they're going to announce a regular dividend. They're going to do about $3.40 this year. I think the payout ratio will be about 40% so that yields to about 6.6% dividend yield on Enact stock and I think that'll get people excited. Cheap stock, 6% dividend yield, dividends totally sustainable, 40% payout ratio. I think that could be a catalyst and I think that's coming. If it doesn't come in the Q1 announcement, it'll definitely come in the Q2 announcement. I think that's a potential catalyst.

One thing I didn't mention about Genworth is they have some holding company debt. Genworth had these subsidiaries, they had a bunch of debt at the holding company. They got stuck, they couldn't get cash out of the subsidiaries and they had all this debt. They've done a good job cleaning up the capital structure at the holding company. They're now down to less than a billion dollars of net debt. They have two debt issues remaining. One matures in 2034. Another one is a junior capital security that doesn't have maturity until, I think it's 2066, so with this net debt by owning Genworth, we have a little levered position on Enact.

This is kind of a little off-topic, but we like leverage. I know other people have talked about, we like overcapitalized companies or we like under leveraged companies. I'm not in that camp. I like a little leverage, like a little juice. Public and market investors, we want higher returns.

I'm here to get rich. I'm not here to stay rich. I'm trying to get rich. We want juice. We like the leverage bet on Enact through Genworth. Part of the math is, Genworth's share stock is, holdings of Enact like 2.6 billion with the $800 million in net debt. There are holdings of Enact, net holdings of Enact of 1.9 billion and that's about Genworth's market cap is.

That view about juice is the same thing that makes private equity so interesting, is its nonrecourse leverage. It's much more attractive to buy Genworth to get exposure to Enact than it is to buy Enact on margin debt. That's that tangent.

In addition to the future dividends of Enact, Genworth is going to start re-purchasing stock - I think they're going to make the announcement in March 1st. If you go back and read the transcript from a few weeks ago, Genworth said, "We're going to start returning cash to shareholders. We're going to make announcement Q1 and we prefer buying back stock." That is super interesting. I don't think anybody expected that and Genworth stock popped a little bit on the earnings announcement, but it's right back to where it was pre-announcement so I think that's super interesting.

I think like Stan and his talk about stock buybacks, I think Genworth's cheap. It's going to create value through these stock repurchases. I think that's good for us. Enact's valuation at $20, it's trading at 6.1 times earnings, super cheap. We think it can get to 1.3 times tangible book or $33 a share. I also think the longer it takes to get there, the higher that target price goes because they'll keep growing tangible book value and you'll keep earning the dividend.

Some of the parts valuation on Genworth, Enact right now is worth $5.40 per Genworth share. They have $1.63 net debt, zero value for the life insurance company, and then these tax-sharing payments.

I have a little bit of talk about the tax sharing payments. Genworth has past losses of about a billion dollars. As time goes forward, they don't have to pay taxes to the government until they recoup those losses.

They have agreements with the life insurance company, which is profitable, but they're not able to get cash out of it to... The life insurance company makes its tax payments to the holding company. And same with Enact, because Genworth still owns 80%, they consolidate tax returns. They pay their taxes to the holding company and the holding company just gets to keep it. Last year, Genworth got 370 million in tax sharing payments from the subsidiaries. This year, they're anticipating 200 million and I think they can get 200 million for the next five years so that works out to be about $2 a share.

You add all this up, I think some of the parts Genworth's worth 577, the stock's 402, if Enact gets up to 33, like I think then Genworth's, some of the parts goes up to nine. That's kind of your $4 stock to nine. Maybe there's a flyer on the life insurance company having some value. That's my pitch.

Here is a table showing the median Price-to-Tangible Book Value (“P/TBV”) of banks grouped by market capitalization. As you can see, the median P/TBV declines as the market capitalization declines. 

Source: S&P Global Market Intelligence

Not only are the median values higher for larger banks, but we can see the range of values is wider and higher.

The current distribution of bank valuations has important implications for bank mergers and acquisitions. With larger banks trading for higher valuations, they can use their stocks as currency in mergers and acquisitions, and the “merger math” will be attractive to investors. Here is a table comparing the distribution of bank valuations in 2021 to valuations in 2018.

Source: S&P Global Market Intelligence

As shown in the table, in 2018, valuations were more consistent across different-sized banks. The similar valuations made mergers more difficult because the financial benefits of mergers were less compelling.

We see two main reasons for the current distribution of bank stock valuations. In recent months, the stock market has been driven by the pandemic reopening trade. Ever since Pfizer announced positive news about their COVID-19 vaccine in November, stocks of companies that would benefit from the end of the pandemic, such as banks, have rallied. We believe non-traditional bank investors have moved into banks by purchasing exchange-traded funds and stocks of the largest, most liquid banks. This has led to the largest banks having higher valuations. 

A likely reason for the lower valuation of banks with market capitalizations below $250 million is the annual reconstitution of the Russell indices. Each June, the Russell indices are remade as stocks are shuffled in and out of the Russell 1000 and Russell 2000. This year is unusual because of the strong stock market rally and because of the large number of initial public offerings, so the minimum market capitalization for companies in the Russell 2000 is close to $250 million compared to $90 million in 2020. This means about 79 small-cap banks are leaving the Russell 2000 index on June 25th. We think this is widely known by small bank investors, so small-cap bank stocks are trading at lower valuations. 

Currently, we believe the best opportunity in bank stocks is among small banks because they trade at lower valuations.

Chase’s entry in the UK market with a digital-only bank doesn’t make sense for a variety of reasons:

1) There are several digital challenger banks in the United Kingdom already. The top seven banks in the UK control 92% of the market. UK banking regulators have been encouraging challenger banks to enter the market. Chase will face significant competition trying to capture consumers who are willing to leave the existing High Street banks.

2) None of the challenger banks have demonstrated sizable returns to date. Why bother with an investment where none of the existing players have earned excess returns?

3) JPM’s start-up digital bank in the UK will take years to positively impact the bank’s financial performance. JP Morgan Chase will make about $30 billion this year. For Chase’s new UK digital bank to represent 10% of the bank, it would require $300 billion growth in deposits and demand $15 billion in bank capital.

4) Chase’s brand in the UK market is unlikely to have the power it does in the US. The Chase brand is powerful in the US. Chase has had a long association with the Rockefeller family. In the U.S., Chase has national lending businesses such as credit cards, mortgage, and auto. So, even if Chase does not have bank branches in their city, many consumers are existing customers of Chase or are at least aware of the Chase brand. When Chase enters a new US city (like Washington DC) with branches to build deposits and small business lending, it generates strong growth because of the strong Chase brand. This same dynamic won’t exist in the UK because Chase’s brand is weaker in the UK. Although JP Morgan Chase has operated an investment bank in the UK for decades, Chase does not have the same presence in national lending businesses that it does in the US.

5) JPM doesn’t have the same need to enter the UK consumer banking market that Goldman Sachs did when it started Marcus UK a few years ago. JP Morgan has one of the best deposit franchises among US banks. In contrast, Goldman is mostly funded with wholesale liabilities at substantially higher rates. Goldman was able to enter the UK banking market with only a high-yield savings account offering. The deposits Goldman raised in the UK replaced higher-cost wholesale funding. JP Morgan Chase doesn’t have this same need for low-cost funding.

Instead of entering the UK with a digital bank offering, JP Morgan Chase should buy Barclays PLC.

1) Buying Barclays will immediately give JPM the #2 position in UK retail banking. Retail banking is a scale business due to technology costs and advertising efficiency. By immediately getting the #2 market share position in the UK, JPM will save decades of clawing for growth from its new digital bank in the UK.

2) Barclays’s stock is so cheap that acquiring the UK bank will provide JPMorgan Chase HUGE Financial Benefits. Even if JPM paid a 30% premium to Barclays’ current market price, JPM would reap gigantic financial benefits by acquiring Barclays. JPM trades at 13.5x 2022 estimated earnings per share (“EPS”) and 2.38x tangible book value. Barclays trades at 8.2x 2022 EPS and 0.68x tangible book value. We estimate that estimates for JPM’s 2022 EPS would increase from $11.43 to $12.00, and tangible book value would increase from $65.30 to $72.85. This estimate only assumes a 10% cost savings on Barclays’ expense base, which is very conservative.

3) Jes Staley, a former JPM executive, has been remaking Barclays since he became CEO in late 2015. He closed or sold operations in 12 countries. This has narrowed Barclays’ operations to mainly the UK and the US. Since Barclays has been restructuring for 5+ years under Staley, JPM would not have to exit many non-core businesses. Jaime Dimon knows Staley well as the two worked together for nine years.

4) JP Morgan is prevented from acquiring additional deposits in the US because the bank already has more than 10% market share for deposits nationally. JPM would be able to divest Barclays’ US deposits easily and still have the capacity to fund Barclays’ US credit card business.

5) JP Morgan would consolidate the US credit card market by acquiring Barclays, which is the 9th largest credit card issuer in the US. Barclays has important credit card partnerships with American Airlines, Uber, JetBlue, and Wyndham.

6) JP Morgan would also eliminate a competing Wall Street investment bank. Dimon has been resistant to buying another investment bank. Since most institutional customers and corporations do business with every firm on Wall Street, when two investment banks combine, their customers tend to do less business with the combined firm than the sum of what they did with each firm previously. I believe the big prize of acquiring Barclays is to get the #2 position in the UK retail banking business for below book value. I believe Barclays’s investment bank has been a drag on its returns and its valuation. If the Barclays investment bank shrinks as part of JPM acquiring it, I believe it would not result in a loss of value. There are at least two positives from combining the JPM and Barclays investment banks: 1) if the combined investment bank shrinks as a percentage of the overall bank’s revenue, investors may place a higher valuation on the overall bank, and 2) removing a large competitor will reduce the competitive intensity of the business. Within Fixed Income, Currency, and Commodities (“FICC”), JPM had a 19% market share in 2019, and Barclays had a 7% market share.

The main problem with my proposed plan is Barclays has to be a willing seller. Many stakeholders who may veto the deal: Barclays’s management, Barclays’s Board of Directors, and the UK government. However, I believe each of these stakeholders can be won over because of the strategic logic of the acquisition.

My proposal of JPM acquiring Barclays ignores a second objective of JPM’s digital bank in the UK, which is to create a de novo model in the UK for JPM to use as a template to enter banking markets in other countries. This is an attractive long-term benefit of starting a digital bank in the UK; however, I believe the short-term financial benefits strongly outweigh the potential benefits of perfecting a digital bank model to replicate in other countries. Also, my idea doesn’t preclude JPM from entering other countries with digital banks. It would make more sense for JPM to take this approach in countries where the banks are highly valued.

Even if JP Morgan Chase doesn’t acquire Barclays PLC, its entry into the UK via a digital start-up is a waste of resources. The most important wasted resource will be management attention. Even if the UK digital bank is successful, it will take decades to positively impact JPM’s financials.

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