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Grandeur Peak Global Advisors' 2023 1st Quarterly letter
I recall GP Global Stahlwart fund was holding SVB and First Republic Bank in their top 10 holdings. Bad luck or poor stock picking? Also noted too most of GP funds are lagging this year.
Or they could hire CPA analysts who would know that a strong demographic customer base and conservative underwriting standards do not necessarily make a strong bank's balance sheet. Being too fixated on growth and not enough on balance sheet risk caused the problem both at these banks and for the fund managers/analysts invested in them. These banks took customer deposits and invested them badly, playing a leveraged bond duration game in a rising rate environment, probably not super hard to detect for anyone focused on the balance sheet instead of the income statement. This shareholder letter marks a significant strategic shift. A key excerpt:
In Financials, our banking tranche showed negative returns through the quarter and detracted significantly from performance in our global and US funds. Only one of the twelve banks we held at various points through the quarter contributed positively to performance, and First Republic Bank (FRC US)2 was the largest detractor.
Our very selective approach to investing in Banks led us to own First Republic at portfolio weights that expressed a high degree of conviction in the company’s risk-adjusted return profile. As you are likely aware, over the past month, First Republic experienced a significant crisis, as collateral damage from the Silicon Valley Bank (SIVB US) collapse, which resulted in a severe de-rating of the FRC share price. A fair question for anyone to ask is how to reconcile our very selective approach to investing in banks with a large position in a bank that has experienced a significant crisis. At a very high level, our investment thesis on First Republic was based in its application of a world-class client service model to arguably the world’s most attractive banking client markets (specifically, the high net worth and high-end professional services markets in urban coastal population centers across the United States). That strategy for First Republic had enabled the company to structurally grow earnings while preserving exceptionally conservative underwriting standards. In other words, while First Republic is a bank, we observed that its unique model and exposure profile largely neutralized most of the quality attributes that generally make banks less attractive and more risky. Put another way, an attribute-by-attribute analysis of First Republic, reinforced over its long successful track record, made us comfortable treating First Republic as we would treat best-in-class growth companies we discover in other industries.
However, after SVB Financial shared its post-close announcement on Wednesday, March 8th, highlighting elevated deposit attrition, the sale of available-for-sale securities at a material loss, and an equity capital raise, we spoke with First Republic’s CFO in order to confirm our knowledge of the company’s exposure to deposits from early-stage companies, net unrealized losses in available-for-sale securities, and other aspects of its capacity to avoid the negative feedback loop that SVB was beginning to experience. We left that balance sheet review confident enough to continue holding our positions. What destabilized our confidence was Friday’s announcement that SVB Financial would enter receivership and the recoverability of uninsured deposit balances at SVB was in question. As these revelations became clear, we concluded that the probability of contagion extending to First Republic depositors had become too high to justify continuing to hold our positions. In other words, we concluded that First Republic had ceased to be an investment opportunity and had instead transitioned to more of a pure gamble on which wagering our clients’ funds was unacceptable. We proceeded to exit our entire investment position in First Republic at the next opportunity (the Monday morning pre-market) as efficiently as we could without further pressuring the share price.
In the aftermath (at least the first stage) of this banking crisis, we have carefully reviewed our financial sector investment strategy. We have reinforced our commitment to finding and owning best-in-class growth companies in the capital markets ecosystem. Perhaps more importantly, we have further tightened our already strict standards for bank and real estate company investments. This specifically means that we will invest in fewer banks going forward. They are far too fragile to take large portfolio positions in. Those bank investments that we do own will be more tactical or opportunistic, and they will be held at even more limited portfolio weights. We are also currently focused on the negative implications from this banking crisis related to funding, credit, and regulatory costs for American banks generally. We are focused on the extent to which those issues could apply material stress to more cycle-sensitive borrowers. We are now even further underweight American banks than we were prior to the banking crisis, beyond simply exiting our First Republic position. Our real estate company investments remain focused on structural growth opportunities that exclude exposure to general commercial real estate classes. And we have increased our exposure to multiple best-in-class growth companies within the capital markets ecosystem whose upside scenarios we believe have become significantly more likely due to this banking crisis.
2 As of 01/31/2023, the Grandeur Peak Funds owned 221,572 shares of First Republic Bank and 47,006 shares of SVB Financial Group
Comments
Hopefully GP would make a sincere change on their investment strategy. As it is the company will continue to have carry these risk.