And Why I Favor WAL/PA and WBS in Particular
As I have described before, my approach is composed of a bottom-up analysis of individual securities, coupled with a top down approach of taking advantage of cycles.
One of my favorite type of investments is liquidity cycles — I enjoy providing liquidity to battered securities that have cyclical characteristics with high likelihood of coming back even stronger out of the cycle, helping these companies when they are going through difficulties, and profiteer from market’s coming into agreement with my assessment.
In March 2020, I invested almost my entire net worth in natural gas companies when they were indiscriminately sold with oil companies — the market failed to understand that the collapse of oil price is actually beneficial to gas price given that 1/3 of natural gas production in the US is from shale oil fields in the form of associated gas.
In March 2022, I concentrated my portfolio in Chinese ADRs liquidated by many Chinese overseas funds who are unable to take the heavy drawdown — in other words, the availability of liquidity allowed me to snatch up shares whose value made no sense. Momo had a net cash position of $7/share, generating a profit of $0.60/share, and returning $0.50/share, trading at $4.5/share. PDD’s GMV was growing at more than 40%, had $10 billion cash, would generate $4 billion of profit pro forma, yet was trading at $30 billion market cap.
In the summer of 2022, the biotech industry was decimated, and XBI traded down to $60/share. I am no expert in bioscience — as a matter of fact, I failed my biology exam when graduating from high school — but I do know if the cash hoard on the big pharma was sufficient to swallow the entirety of all the stocks in XBI, coupled with many stocks trading below net cash value, then biotech valuation was just dirt cheap.
In March 2023, Silicon Valley Bank failed. Over the last weekend, Signature Bank went into receivership as well. Both banks had customer concentration problem, the former with tech and VCs, and the second with real estate agents in the NYC area. This created complete havoc in the regional bank space, and this is a situation that I love. When there is panic, there are opportunities.
There are two specific opportunities that I love — WAL/PA, and WBS. The theses for both of them are relatively straight-forward.
Western Alliance Preferred A Series
WAL/PA is the preferred A-series of Western Alliance Bank.
Western Alliance is a regional bank founded in 1994, focusing on the California and Nevada area. It has a strong underwriting culture, with one of the lowest NCO (net charge-off) rate in the past five years among all its peers. After the financial crisis, it diversified away from Nevada and consumer loans, and expanded into the California region, compounding its tangible book value per share at a remarkable rate of 18.8% per year. Due to its tech and innovation loans which is 4% of its loan book and its geographical coverage similarity with SVB, it was killed by a panicky market. The stock traded down to $7/share, and after the management came out with a press release indicating it has sufficient liquidity ($25 billion cash reserve vs. less than $25 billion of FDIC uninsured loans), the stock more than tripled in a single day, and is currently trading at $32/share. SVB was insolvent, but WAL was not — the combined unrealized losses from AFS (available-for-sale) and HTM (held-to-maturity) assets was $570mm, compared with a tangible equity value to shareholders of $4 billion. SVB has exhausted its FHLB (federal home loan banks) credit line of $15 billion entering into the crisis, while WAL did not use any of that.
Its preferred series-A shares suffered heavy casualty, traded down to $8/share before rebounding to $11.57/share. A week ago, it was trading at $21/share, and at current price it delivers a 9.2% annual dividend.
Now that the market has come to understand that it is almost impossible for Western Alliance to go under given its ample liquidity reserve, soon enough the preferred should follow that understanding to a much higher price level. The preferred is also callable in 2026, so if it keeps languishing on the ground, WAL will call it and issue new preferred at a lower cost — while you collect a 9.2% annual dividend along the way.
This is an example where the layer of capital structure that you pick makes a difference. If you buy the stock outright, it will be very difficult for it to go up 50%, not to mention double. To double the current price to $64/share, it requires the price goes to pre-Silicon Valley Fiasco level. Based on my discussions with their customer service representatives disguising myself as a prospect, they did experience heavy liquidity drain on Monday when customers shifted a substantial amount of deposit out of the bank.
Most bank investors view the deposit franchise of individual banks as the most valuable aspect of the bank.
With 50% of the deposit uninsured, I’d imagine the $53 billion deposit base of Western Alliance taking a heavy hit — definitely not enough to put the bank out of business, but also not sufficient to warrant its stock price bounce back to pre-SVB levels. WAL did not do anything wrong, but the customers were scared once — and it takes a long, long time to rebuild that trust. In addition, the uncertainty surrounding the deposit makes it particularly difficult to ascribe a precise number to the bank’s equity value.
However, such is NOT the case with the preferred. The deposit flow has stabilized since Tuesday, and WAL has survived. Most customers, based on my conversations with their representatives, did NOT leave the bank. Instead, they simply shifted any monetary value above $250,000 to other banks to avoid risks. In the same vein, other banks’ customers (especially SVB’s) fled to WAL. The net is still an outflow, but WAL is not going out of business. As long as WAL is not a receivership target, there is very little uncertainty surrounding WAL/PA, and I figure the preferred trade back to at least the range of $16-18/share in the short to intermediate term, indicating a 38%-55% upside, all while you collect that healthy 9.2% dividend.
Webster Bank
I pass by the Webster Bank branch at Coolidge Corner located in Brookline frequently, and the yellow “W” embedded in that blue color left me with a deep impression.
The bank was founded by Harold Webster Smith back in 1935. Harold founded it in the depth of the Great Depression, one of the worst financial crisis in the history of human capitalism, to offer customized mortgage options to help people to own homes, to realize the American dream. Back then, Smith was only 24 years old, and he borrowed from friends and family to found the lending institution to serve Connecticut citizens. Later, through organic growth, WBS expanded into other New England states, particularly NY and MA. Now it is a $6.5 billion enterprise.
There are many things to like about Webster.
Webster Bank has HSA Bank, which is a dominant player in the rapidly growing Health Savings Account industry. HSA are tax-deferred. high deductible plans useful to rein in medical expenses, critical for the US healthcare system. Kerrisdale Capital has written a beautiful piece on the HSA growth prospect of Webster, and I would encourage readers to take a look at it to best understand this segment of WBS’s competitive advantage.
Unlike SVB and SBNY, which have customer concentration issues, WBS has one of the most diversified and resilient deposit base possible. With the acquisition of interLink, WBS will further reduce their funding costs and diversify their deposit base by replacing the $7.7 billion borrowings with interLink’s $9 billion brokerage deposits.
On a pro-forma basis, it guides to a net income of $1 billion, while growing loans and deposits at HSD (high-single-digit), trading at a mouth-watering 6.6x PE despite the strong organic growth of its local franchise and also HSA bank. Typically, a regional bank which may become an attractive acquisition target trades at 12-14x PE, indicating a fair value range of $69-81/share, implying an upside of 80-112%. It pays a 4.2% dividend as you wait for valuation mean-reversion.
There is still synergies to be realized for with Sterling Bank, which it acquired back in 2021. The bank has spectacular operating metrics. To quote a few, its efficiency ratio is 40%, its adjusted return on average tangible common equity is 22.4%, and its tangible book value per share currently is 29.07/share. This implies a yield of an eye-dropping 17.1%! No matter how high the interest rate is, this kind of yield for a 40% efficiency ratio powerhouse just does not make any sense to me.
It also does not have insolvency issues even at last week’s higher rates. Adjusting for all the unrealized losses for AFS and HTM securities of close to $1 billion, it still sports a tangible common equity value of $4 billion. Its CET 1 ratio stands at a healthy 10.7%, and management has stated their intention of maintaining the CET 1 ratio above 10.5%.
Last but not least, the main reason WBS is down so much along with the other regional banks is the fear of capital flight — in other words, investors worry that deposits at WBS is insecure, and opt to move the money elsewhere. I believe this is where my variant perspective is the strongest. I believe this crisis is not a threat to WBS, but an opportunity. Sooner rather than later, the market will realize this point. I visited 5 branches, and talked to 7 managers at Webster, ranging from the 3 branches in downtown Boston, 1 in Brookline, and 1 in Needham, and developed 2 strong impressions. Firstly, the managers I talked to know little about any risk associated with WBS. Only one of them even noticed the drop in WBS stock price. They are not feeling insecure, and no one is talking about jumping ship. As a regional bank that grew during the Great Depression and endured the Great Recession of 2008-2009, Webster is solid and deeply ingrained into the local communities; secondly, and as a result of its 87 years of operational excellence, they have uniformly experienced INFLOWS of capital over the past week! This makes sense, given that folks, feeling unsecured, would withdraw their money from smaller regional and community banks, and deposit the money into a trustworthy partner like Webster. Although the Greater Boston Area is only one data point, I can see the logic applies to other locales as well.
In sum, I believe WAL/PA and WBS present extremely attractive risk-adjusted returns for investors.
Disclosure: WAL/PA and WBS are both top holdings for myself and SMAs under my management. I have no intention of selling any of aforementioned securities in the next 7 days.
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