Stig Brodersen 1:14

We asked you to come here on the show to pitch First Republic Bank for our audience. Before we talk about this specific stock, could you first orient those who are not familiar with you or Ensemble Capital? Please elaborate on your investment strategy first.

Sean Stannard-Stockton 1:28

We take most of our inspiration from value investors who have been successful over time. We really focus on investing in competitively advantaged businesses. We think that businesses on average don’t have competitive advantages, and they can do fine. The stocks can do well, but they’re really hard to value because at any given time, in order to have–competition can come in. Every time something gets going well, competitors notice, and they go after those profits. We look for businesses that have something structural about the business that prevents competitors from coming after them. And First Republic’s a really good example of that. But the core of the investment strategy is kind of six concepts that we look at for a stock.

The first two is we look for businesses that have a competitive moat: both something structural that prevents competition; and also, that it is protecting something that will be valuable over the long term; that will stay relevant to its customers. Then, we look for management teams that are fantastic at generating economic value; and then also, allocating that excess capital that they generate to their shareholders in an appropriate way. And finally, we look for businesses that are intrinsically for castable to one extent or another. Some businesses are so erratic. Think about like the oil and gas business, it’s really hard to have any sense of what the long term cash flows are. And then finally, on that level of understanding, we want to make sure that our team has the domain expertise to understand the business. Sometimes we pass on a company because we say this is an understandable business, just not to us, or at least not on a relative basis to other market participants. So first of all, we have what we think is a really good illustration of a company that answers those six core questions really well.

Preston Pysh 2:56

All right, Sean. So let’s be specific here. Talk to us why FRC first came on your radar, and why you considered it to be a retail business with a superior franchise more than a traditional bank?

Sean Stannard-Stockton 3:08

That’s right. So every business, you need to understand what is it that they’re actually selling. And so banks–as an industry–are in the business of buying and selling money. It’s the ultimate fungible commodity, right? A dollar from JPMorgan is the exact same thing as a dollar from Bank of America. And so, the customers of banks, generally, are indifferent to which bank they put their money with and which bank that they borrow the money with. They just want the highest return on the money that they put in deposits, and they want to be lent at the cheapest level. And so the biggest banks have some competitive advantages around scale; about being low cost providers of banking services, but we just find all of the banking industry in general as uninteresting. And so it was with some surprise back in, I think, 2012 that I read some comments on First Republic by an investor named Shaun Kravitz of Esplanade Capital.

In his discussion of the business, he said, “Look, First Public is not a bank.” And I’m thinking, “What do you mean it’s not a bank? It’s called First Public Bank, right?” And Sean goes on to say, “We consider First Republic a retail business with a superior franchise. In our investment process, one of things we look for is businesses that are idiosyncratic in nature; businesses that are just fundamentally different than any of their competitors. Because if you’re doing something different, then you don’t have competition–and that’s what allows you to generate strong, long-term returns. So that was the first comment that got us looking at the bank. And over time, we came to agree with that point of view: that First Republic is in the business of selling superior customer service to high net worth individuals. And so, if you are somebody of average economic means, you care primarily that the money you borrow is the cheapest as possible, and the money you put into deposits gets you the best return possible. But if you are a high-net-worth individual whose time is an expensive commodity, you want to make sure it’s as easy as possible to interact with your money. And bankings, banks is a–an industry, have a horrible reputation with consumers, right? Not all industries are like that. So saying you’re a customer service business first in retail or in the restaurant business, it’s like, “Well, yeah, everybody’s in that business.” But in banking, that’s just not the case. I’ll give you some stats on that in a moment.

Thinking about that customer service. Lots of companies say they have good customer service, but First Republic can actually prove it. The Net Promoter Score is an internationally recognized measure of how likely your customers are to recommend you to friends and family. It basically takes how many people would recommend you, subtract the people who would not, and get a Net Promoter Score. The banking industry overall has one of the worst Net Promoter Scores of any major business industry, whereas First Republic’s Net Promoter Scores are on par with Nordstrom’s, Apple, you know, The Ritz-Carlton; the top tier across all industries, right? They tend to be two times the rest of the scores of the rest of the industry. It’s not just Net Promoter Scores. So Gallup, a long time ago, focused on what do bank employees think about their banks. And most bank employees don’t actually bank with the bank that they work at, right? They think so poorly of the bank that they don’t actually bank there themselves, and they certainly don’t recommend it to their friends and families. And so one way to think about businesses that have a monopoly, and I mean that in a good sense, right?

In a way in which they monopolize their customers attention is that many banks have a monopoly in that they have trapped their customers. They feel like their customers have nowhere else to go like you’ve probably been with a bank, you have all of your online bill pay there. You don’t want to switch to someplace else. And even if it’s irritating, you’re like, “I’m stuck here,” right? You don’t like it. You’re not like, “Oh, I just love banking here.” Whereas, First Republic, it’s amazing. So when I first opened up my bank there, my personal bank, which I did after doing the research and realizing what a great business this was, I moved all my online bill pay. And one of them just wasn’t working. And so rather than calling a 1-800 number, and waiting on hold for half an hour, and talking to a service rep some place, I just emailed Rachel. Rachel was a personal banker, who was assigned to me when I signed up with First Republic. And about five minutes after I emailed her about the issue, she emailed back, and said, “No problem, Sean. It’s taken care of.” And I logged back into online bill pay, and it was corrected. So for somebody who has the economic means to pay; to buy back their own time, this is a really valuable offering.

Now, First Republic focuses on a pretty niche market, right, high-net-worth individuals, primarily in San Francisco, New York, and LA. That’s 80% of their business in those three metro areas. And then Boston, San Diego, Portland, and Palm Beach. This is not going to be a bank that you see everywhere. That’s just not what they’re trying to do. And most importantly, they focus on what they do best. And they actually have a slide in their deck of what they don’t do. They don’t do any proprietary trading. They don’t do anything in derivatives. They don’t offer credit cards. They don’t offer auto loans, and they don’t sell any of the loan servicing. So if you ever gotten a mortgage, you know that a couple months after you get the mortgage, you probably get a note from the bank saying,”We sold your mortgage to some other bank.” So if you need, you know, you need to change your online bill pay. Get it set up over here.

First of, they might like sell the underlying loan, but they always maintain the service relationship because they are in the business of selling customer service. This competitive advantage has really allowed them to grow the business quite rapidly. So a quickly growing bank is actually, generally, a very dangerous signal. In a commoditized industry, the way you grow a bank quickly is you compromise on credit quality, right? Or you underprice your loans. We saw banks grow quickly like in the first half of the 2000s before the housing crisis, right, where they were growing quickly because they were making loans that were literally never gonna be paid. First Republic has grown their loans and deposits at a mid to high interest (*inaudible*) rate for a very long time, despite having the best credit quality in the banking industry. Only six basis points of their loans are written off each year. This is about one-sixth the level of the overall banking industry. In 2009, they only wrote off half a percent of their loan book. Again, well below the industry. And the credit ratings that they require; the credit scores, they have a 60% loan to value. So when you buy a house, most people think in the United States, you put down 20%, right? So then you’d have an 80% loan to value.

During the housing bubble, so you could put down 3% or 5% or nothing down, right? So 100% loan to value. First Republic has a 60% average loan to value. On average, their clients hold as much cash in their First Republic checking and savings accounts as the size of their loan, so total coverage of the loan amount. Customers have top FICO scores. And so what all of this means is that they’re lending money to people who are great credit risks, and being very serious and diligent on underwriting. So they’re growing it through attracting people because of their outstanding customer service, not through just saying, “We’re gonna be cheaper, easier in our underwriting.” I talked in my kind of initial discussion around their investment process how important it is that management teams understand what’s best for shareholders. Think about managing this business during the housing boom, they recognized what was going on. They were able to participate in underwriting loans, and yet, they were not gonna compromise on quality. So what they do just before the bubble kind of peaked, they sold First Republic to Merrill Lynch at top dollar.

After the crisis, they bought it back at a HUGE discount to what they had sold it for. Now, they’ve gone right back to growing the business. And so what you see is a management team, who recognized that forces outside of their control had greatly elevated the value of their business; and their competition was acting irrationally; and they said, “Hey! In this kind of crazy environment, the best thing to do for our shareholders is to sell the bank,” which they did. But when everything crumbled, they said, “Hey! We know how to run this business,” and they came right back in, and start doing it really well. So one of the key things, as I wrap up here, is that historically they have used first mortgages as the product to win a new client. So somebody comes along; they buy their first house. This is the beginning of many people’s, especially historically, one of the big, first financial decisions in you–in your life as you become like an adult, right? You buy a house. But today, of course, in the United States, especially in their markets, people have delayed buying their first house. Used to be say in your mid 20s. Now, it’s maybe in more in your mid 30s. And instead, for a lot of higher earning Americans, the first major financial product you have is a student loan refinance.

Now, I’m not talking about student loans that just across the industry, which are tend not to be very good credits, right? And you have people who, who are new students and big loans. I’m talking about, you know, somebody who went to Harvard and graduates a quarter million dollar mortgage; goes to Google’s earning $300,000 a year. This is a good credit. This is someone who’s gonna make a lot of wealth over the long term. And so in recent years, First Republic hasn’t going out and acquiring kind of young, upwardly mobile professionals through refinancing student loan products. Bringing those people in early in their kind of life, and then they will win their first mortgage. So long term, that company still only has a mid-single-digit market share. The banking industry is stronger in their niche markets. They’re winning new clients in the tech industry with offices in, at Facebook and the Twitter’s campus, the new Hudson Yards in New York. And we think they can continue growing for a very long time.

Stig Brodersen 11:28

We’ve talked back and forth about this interview here for the past few weeks. I had a question about First Republic Bank and then reporting disappointing set of Q2 results, you know? As, as margin contracted and there was a new management guidance for week net interest margins, and the outlook for that. And then two days ago; two days before we recorded this interview, we re…recording now, October 17. Q3 results just came out and First Republic Bank repeating on earnings, and revenue, and the stock jumped more than 5%. So I had to change my question slightly here. What I was really trying to aim for with this question was, yes, Q2 might be a disappointing quarter, but how disappointing when news had to be? And how many bad news, or how long period of time, we need to be disappointing before you would reconsider your investment thesis?

Sean Stannard-Stockton 12:18

Yeah, and we are constantly re-evaluating our investment thesis and everything that we own. Your question was and still is relevant. So the bank basically grows their client base, right? They grow deposits. They make loans. And then, like all banks, they earn a net interest margin. So basically, the amount they earn from lending money minus the amount they pay on deposits is your net interest margin. And that has been quite weak because you basically lend longer term loans, right, so like a mortgage. And you bring in deposits that are overnight deposits. And so typically, long term rates are higher than short term rates, and you earn a spread between those two. But as your listeners probably know, the interest rates are low, but also the, the yield curve is flat, meaning longer term rates are in some cases are actually lower than short term rates. What we really want to focus on is business that focus on what they can control, and generally try to ignore those things they can’t control. So the bank cannot control its net interest margin in terms of where interest rates are. They do manage their loan book in a way that makes their net interest margin far more stable than a lot of banks. In other words, they’re not trying to take much risk. So you can manage your net interest margin, so it’s very cyclical. It shoots up and down. Or you can accept a somewhat lower level and accept a less volatile net interest margin. For surely (*inaudible*), it has done the latter. That interest margin in the most recent quarter was down as they had guided to in the second quarter. So the–what the disappointing aspects was what’s been playing out. But they grew their loans and deposits at a much faster rate than people expected. And so we think that the positive stock reaction was really people being reminded like, “Oh, yeah! This isn’t just a cyclical bet on where interest rates go. This is really about the organic growth of the underlying business.” We believe that net interest margins are going to move higher over time; that interest rates will rise some from current levels; and the yield curve will steep in some. But even if they stayed where they are now, we think the investment would still work. It may not be as good of an investment from these levels, but we do expect the interest margins to move higher over time. They’re currently at a historically low level.

Stig Brodersen 14:13

Banking has continuously been commoditized in recent years as you also mentioned before. It seems like the trend continues. We also talked about that traditional banking, perhaps, is not the market that First Republic Bank is primarily competing in. I’m curious to hear if you think that there will always be room for this specific niche for First Republic Bank? And how big is that niche? How much can they grow?

Sean Stannard-Stockton 14:38

It’s hard to measure exactly how much they could grow. They are still growing deposit base at about 15% per year in the most recent quarter, which that’s been kind of the trend for a couple years now. And 80% of their, their market is in San Francisco, New York, and LA. Those metro areas had much stronger economic growth than the rest of the country. These are the most vibrant economic centers of the United States. You know, they’re also now in Boston, San Diego, Portland, and Palm Beach. And they’re relatively nascent there, so they have more to grow there. Could they move in other cities? Yeah, of course, like there’s high net worth individuals in other cities as well.

From our perspective, when we make investments, we never count on ultra long term growth. We never say this is gonna grow 20% a year for a decade or more. Like it is a vanishingly small number of companies who are able to do that. First Republic like actually has grown at that rate over the last 10, 15, 20 years, but we’re not gonna count on it. From our perspective, the amount of growth that we expect is quite easy to achieve within the markets that they’re already in, right? You have more people becoming millionaires; becoming wealthy people every day if people moving into the United States. But, you know, over time this business is certainly going to mature, right? I mean, it’s not like we don’t want them to ever have a bank in every city in the United States. That would be a bad thing. So we think that growth can definitely persist for quite some time, and I think that the mid-single-digit market share kind of illustrates right there that they have plenty of room to grow.

Stig Brodersen 15:57

Let’s talk about the divide between big banks and small banks, you know? Especially now that, you know, more and more is moving online. And the big banks are building this infrastructure, where they really have… it seems like they have much more efficient features. And you don’t have your local advisor, you know, the way you used to have, unless perhaps you are high-net-worth, and Rachel will fix your problems for you, whenever you send her an email. Where are First Republic Bank in that, you know? They, they’re not the smallest bank, but they’re not the JPMorgan and Wells Fargo either. Do they become the middle?Is there not even a market they compete in? Or are they not affected about this divide at all?

Sean Stannard-Stockton 16:35

There are many, many small banks and, and it would be unfair to categorize First Republic as a small bank. I mean they’re like a mid-sized bank. They are dwarfed by the JPMorgan’s of the world. And yet they were the first and only bank to ever organically grow–exclude, they don’t do acquisitions–organically grow over $50 billion in, in deposits, and they are well above that level today. But I do think that there is the need to constantly reinvest in things like technology. So when we first invested in First Republic, I would say that their online presence was, was inferior, you know? I as somebody who’s used online banking was like they had it, but it wasn’t like a great experience. But they’re headquartered in San Francisco. They have lots of tech executive clients. They recognize what was going on.

I mentioned that they have a branch on Facebook’s campus and a branch in Twitter’s headquarters, right? Over the last 12 years, they’ve invested very heavily in their online presence. And so today, when I want to make it, you know? I, I get home. I open the mail. I have a bill in the mail. As I walk into the house, I pull out my iPhone. I touch the first ever (*inaudible*) like app. Apple’s face ID program logs me in. I go to online bill pay. I press, you know, the amount I want to pay, and then I approve it with a swipe of my finger. This is not an amazing technology. Other banks have that. This is not a business that needs to have cutting edge tech, but they absolutely need to have the expected level for their clients. So we think they’ve done a good job, and in fact, their operating margins today are lower than where we think they’ll be over the long term because this is a bank that very much does invest in their business. Because they know they’re going to be growing it over the long term.

Preston Pysh 18:03

So what would you say are the key metrics you’re looking at when assessing the performance of banks? And then how is FRC positioned on these metrics?

Sean Stannard-Stockton 18:12

So if you’re an investor who has not looked at a bank before, I would start with First Republic. They bank the way that people think of like, “What do banks do?” Right? They’ve got simple-to-understand deposits and simple-to-understand loans. And there’s not a whole lot of complexity there. I can’t give you the key metrics we look for in banks in general because we don’t own banks in general, you know? But I can tell you what we think about for First Republic. So one, like all banks, they need to be generating a decent return on their assets, right? And all that’s can be turned into a return on their equity, right?

So you as a shareholder have a claim on the equity of this business and the earnings they generate from that, you know? They generate returns on their equity that are solid levels, but banks can manipulate their return on equity through how leveraged they are. I mentioned earlier in the conversation that First Republic was bought out by Merrill Lynch, and then came back public again. But they were founded in eighty-five, 1985. When they came public, and they were considered a de novo bank; a new bank. And so they were required to keep their tier one capital ratio over 8%. The tier one capital ratio just means how much capital do you have relative to the clients of assets and deposits, right? They’re above 8% now, but after 2017, when that de novo period ended, they just need to be above 5% in order to be considered well capitalized. Today, they’re still at 8.5%. So I mentioned it’s a conservatively run bank. They have an enormous amount of room to lever up, but they’re choosing not to. It’s just not how they run the business. Making sure that you’re generating solid returns, but doing so in a conservative manner is kind of the key metrics of any bank.

And then for First Republic, we want to know: Are they able to keep growing quickly? What’s the growth rate? Most importantly are actually their deposits. So your assets are where you’re earning the money, but the deposits that people put on is the fuel that allows you to make loans. So you can always just go out and make more loans. It’s, it’s just, you know, you just lower the interest rate you charge, attract more customers. But it’s the deposits that come in that give you the fuel to do that, so we focus a lot on those deposits. Remember, they’re not acquiring these deposits. They’re not going and buying other banks. They’re just attracting it. And so about half of all of their new deposits come from their existing customers. These are individuals who are economic value wealth creators themselves, right? They’re creating wealth. And so they put that wealth in First Republic’s balance sheet. Another quarter of it comes from referrals from their own customers, so their customers love them. And a quarter of all their new business comes as a referral. And the last quarter just comes from more direct marketing in that they run advertisements in the market. People walk into a branch. Whatever it might be.

Stig Brodersen 20:38

It’s interesting the way that you talk about customers love them because, you know, as you also said there in the beginning, people don’t love banks. They put up with them and…

Sean Stannard-Stockton 20:45

Yeah.

Stig Brodersen 20:45

Or, you know…they try to survive together with their bank. It’s interesting to hear how you talk about both as an investor, but also as a customer of the bank in the first place. One thing that we like to talk about here on the show is disruption. We talked about disruption in all industries, especially in the financial sector. We talked about here on the show, and also, a lot on a new podcast show, Silicon Valley. How do you see not only First Republic Bank, but banks over all be disrupted by FinTech over the next decade?

Sean Stannard-Stockton 21:15

So that’s a great, great question. And if I was invested in a traditional bank, I would be quite concerned about that, right? Because if all of the customer cares about–they don’t care about the relationship; they just care about buying and selling money as cheaply as possible–getting the best return. Any sort of kind of FinTech alternative that does that is a competitor. We think that customer service is a very distant threat for FinTech, right? You could talk about like a AI interface that can answer people’s questions easily and, and reduce the kind of frictions of working with the bank, but we think that’s really a ways off. But FinTech overall, we think is a really important trend. And we would note that in the late 90s, a lot of people thought the internet was going to disrupt the big banks. I even remember there was a bank called “The Bank of the Internet,” right? And there was all these ideas that, like, you’re gonna do away with branches, and everything was gonna be online. That was true. It’s just that the big banks leveraged internet technology to become online banks. Wells Fargo and BBVA are online banks now, right? And so you never saw that disruption actually play out.

FinTech is technology that the incumbents can adopt themselves. There’s also ways in which you can be used to disrupt the banks. So one of the things that we really look at closely is trying to understand: Of the different disruptive changes that are happening, what are those that can be embraced and leveraged by First Republic or the banking industry? And which are those that for one reason or not that they can’t? So we also have an investment in MasterCard; we’ve known (*inaudible*) for a long time. And when we first invested, there was a lot of worries that there was going to be disruption to credit cards, right? That so, for instance, you could just pay with your phone, right? Or you could pay with your Apple Watch. Although, at the time it hadn’t been invent–invented yet. And all of that was right. You could do all of that. But what is Apple Pay? It’s just a way to use your credit card. You load your credit card into, into your iPhone, and then you can wave your phone, right? What’s PayPal? A way to use your credit card online. What’s Google Pay and Amazon Pay? Ways to use your credit card or debit card online. So that technology was very real, but it did not disrupt MasterCard, right? And so we have the same sort of analysis on banks. With First Republic, it’s an area that we just don’t worry that much about because the value proposition is around relationships and customer service.

Preston Pysh 23:18

So, Sean, something that’s getting a lot of attention right now is the low interest rate. How do banks typically perform in low interest rate environments? And then, what’s your opinion on how FRC is going to perform in an environment like that?

Sean Stannard-Stockton 23:31

That’s a complicated question because the market’s forward-looking, right? And so if you were just to run an analysis to say when rates are low, how do banks do? You may find that banks do very well. And that may well just be because when rates are low, they’re more likely to mean revert higher in the future. And so low, and especially negative, or negatively sloping yield curves are all bad for banks. At the end of the day, if you’re a bank, you want to be able to pay your depositors as little as possible, and lend the money out as at high rate as possible. That’s that net interest margin we talked about. So if you get into actually negative rates, a lot of the math kind of turns upside down. One of the reasons that we don’t think that negative interest rates will persist over the long term. I mean, they’re not here in the US now. But the reason we don’t think they’ll persist globally in the long term is that they end up breaking the banking sector, but the global economy is a bank-based system. It needs the banks to survive and thrive, right? And so if you just extinguish the profitability of banks, you also extinguish the global economy, and over the long term. I don’t mean, you know, a couple quarters a year of negative rates, right? It’s just that, that structurally, you, you change things. So we think it’s basically impossible for interest rates to stay negative over the very long term.

So with rates where they are now, I mentioned First Republic, you could take our valuation model and just assume that the net interest margin stays where it currently is for good, and you would find that the stock is still worth, in our opinion, more than the current market quote. Not quite as much as it would be if net margin moves back up to where it has been historically for, for First Republic. First Republic has this great chart where they show the Federal Reserve rate over the last 20 years, right, which has bounced up and down over, over time and shown that their net interest margin, while it has moved up and down, has stayed in a relatively narrow range. And so that’s one of the reasons we have confidence as we sit–can say like we can look at when Fed rates were zero, and when they were near their highs before the housing crisis. And look at what interest margins were in both of those environments, and find a range that we’re comfortable with. And I think that’s an important thing for investors to understand is that there are no precise estimates about the future. You’re never gonna say, “Well, they’re gonna earn exactly this net interest margin in the year 2025.” But if you can get comfortable with a range…I talked about forecast stability, intrinsic forecast stability, right? With First Republic, we think that there is a range that we can be very comfortable that they’re gonna earn almost no matter what happens with interest rates, you know, within a reasonable range over the long term.

Preston Pysh 25:54

So Sean, it’s no surprise to anyone that recently the Fed Chair Jerome Powell announced that the Fed is about to start buying $60 billion of treasuries every single month. How do you expect this to impact the stock market and banks in particular?

Sean Stannard-Stockton 26:11

That particular move is primarily about keeping short-term money market rates contained and market’s functioning. So the Fed has so many different jobs with the market, right? They’re kind of most famous for setting the rate of short-term interest rates. People often talk like the Fed controls interest rates; they don’t. It’s the federal reserve over night rate they control. They don’t control like the 10-year bond, right? It influences it by short term rates, of course. But they also need to make sure that credit is flowing, right, not just the rate that people are paying, but that it’s flowing. A lot of what they do is around trying to maintain that kind of flowing of the market. We honestly don’t pay that much attention to the machinations of kind of the day-to-day credit flowing aspects. It’s almost kind of beside the point. You need to avoid a crisis. But there will be crises in the future, right? And, and the Feds gonna make mistakes in the future like they have in the past. And so one of the things that we care a lot about is having a very conservative balance sheet as we know First Republic has, right? If the Fed mishandled something, and you are over leveraged, you get into real trouble.

We saw that in the financial crisis, right? But if you’re not over leveraged, then even when the Fed makes some mistakes, you can muddle through. And importantly, if you’re in an industry that’s being hurt very badly by whatever the conditions are, and you are relatively better positioned, you’re in a position to take advantage of your competition, right; to go after their customers, and to make investments others can’t. We believe on the Fed over time that they’ll be bringing interest rates higher again, you know? Just a year ago, Jerome Powell, when the Fed rate was 50 basis points higher than it is today, said that, he said–thought “we were a long way from neutral.” And what he meant was that he thought we were a long way from kind of the long-term average rate of Fed funds. Now he’s had to bring interest rates down a couple clicks since then, and so somebody else will say, “Well, clearly he was wrong.” But since he made those statements, there’s been real weakness in China. There’s been the whole trade war activity. And Federal policy is about: What is the right interest rate for today? Not necessarily, what should it be forever? And so they’ve brought in straights down to provide some cushion to the global economy. But honestly, we think that they will start moving higher again; that we’ll see before the next recession, Federal Reserve rates that are higher than their peak a year ago.

Stig Brodersen 28:20

Let’s talk about that. Because one of the concerns that we get from our listeners; that we really hear often is that they have this fear that we will soon encounter a crisis like the one we had in 2008. You already briefly touched upon some of those items. But how did First Republic Bank make it through the great financial crisis back in 08 that hit banks specifically hard? And how do you think that they’re positioned for the next crisis?

Sean Stannard-Stockton 28:45

Before I talk about First Republic, I want to zero in on a little part of what you said. You said your listeners are worried about the next crisis. There will be a next crisis. I am certain of that. But then you said “like the 2008 crisis.” So the 2008 crisis was truly like a once-in-a-hundred-years sort of crisis. That doesn’t mean that we won’t have another horrific crisis, but the last recession was not normal. So a lot of people don’t recognize that. In a normal recession, the US stock market declines more like 20-30%. It declined 20% in the fourth quarter of last year, right? We just went through a decline in the market that wasn’t dissimilar from a recession. But I think a lot of people today–especially, people who maybe haven’t been in the market for more, since much earlier than the financial crisis–have this idea that like, “Oh! When a recession comes, everything gets destroyed,” right? That the economy goes off the rails. The market falls 50% plus, and that does happen sometimes, right? It happened in the Great Depression. It happened in the financial crisis, but this is not like a every 7-10 years sort of event, right?

Well, you know, I certainly don’t want to come on your show, and say we’re just not going to have a big crisis. I mean, we don’t know! I don’t think that historically, do we not say that the probability, way of looking at crisis would not suggest that the next one is gonna be a total and utter disaster, right? But there will be a recession. We just don’t know when. As far as First Republic, so I mentioned that they actually sold the bank just before the crisis and bought it back after the crisis, which means we don’t have as much visibility into kind of what went on during that time. But they do show the level of right offs of their loans, right? And so that, that what happened during that period. Core to our thesis is that this is a bank that makes loans that will get repaid. The loans that other banks were making during the, the bubble, the financial bubble could not be repaid.

First Republic keeps all of their loans; of the servicing on their own balance sheet, like they’re only lending to people, who they expect to get repaid from it. What an amazing concept, right? We only loan to people, who we think are actually going to pay us back, right? That’s how the banking industry should work, and it’s how First Republic like does work. So we know that only about half a percent of their loans were written off in 2009, right? 99.5% were money good loans. And we also can look back during the .com bust, when they were much more concentrated in the San Francisco Bay Area, and they had zero write offs during that time period. They didn’t lose. Any of their loans did not go bad. You know, when you only lend 60% against the value of the home, you know, home prices didn’t fall 40% in the Bay Area during the financial crisis. If you had a 60% loan to value, so you have a, you know, a million dollar house. You lend $600,000 against it. The thing falls in value to $600,000. That borrower defaults. You get the house. You sell the house. You get your money back! That’s why the loan to value is such an important issue, right? And why when banks were doing no down payment loans, they were saying every 1% drop in home prices if it gets foreclosed on, we take a haircut on our loan value. With the 60% loan to value that First Republic has across their loan book, they have an enormous cushion to take reductions in prices and still have the house you know, pay off their loan.

Preston Pysh 31:41

So, many investors use the price to tangible book to value banks in particular. Could you please elaborate on why this is such a popular metric? And if you think that it has applicability to FRC.

Sean Stannard-Stockton 31:55

Yeah, absolutely applicable. And it’s an important metric to track. So the tangible book value of a bank is just the value of its assets minus liabilities, right? And so for a bank, which is in the business of borrowing and lend or lending money, and they’re in the business of using the assets they have lending them out and earning a return on that. That tangible book value is really critical to the valuation. Now, you might wonder, “Well, why isn’t it critical to say like a Google?” Tangible book value is like hard assets, which for a bank, cash is like a hard asset, right? But for many modern businesses, their book value is almost irrelevant because what they’re–driving their growth is based on customer relationships, and brand value, and all of these things that are not necessarily showing up on the balance sheet. But for banks, it’s really important.

Prior to the crisis, if you look back over the very long term, a lot of banks traded at about two times tangible book value. You can look at why because if you earn a ROE, return on equity, right? Return on that tangible book value of about 13%, which is what banks had earned historically for a long time, and you generate kind of GDP like growth. Then two times tangible book value generates about 15 to 16 times P/E ratio. And you know, that you can tell that’s kind of a fair valuation, and you can do all the math, and recognize, “Oh, at that level, this asset will generate about 9% annual returns.” The equity will generate those sorts of returns, which is the market level of return. First Republic and a lot of other banks have not returned to pre-crisis levels of profitability or of valuation, but their businesses are fundamentally changed by the crisis, right? We think a lot of big banks are almost like regulated financial utilities at this point.

Whereas, for First Republic, their business still looks like the banking industry looked for 100 years prior to the crisis, right? And so, when you look at valuation, you could say, “Oh, well, about two times tangible book value would make sense for this business.” But remember, I said that was based on about GDP-like growth. And First Republic is growing much, much faster. So in our view, we think that the business is worth much closer to three times tangible book value, say 2.7, 2.8 times, and we think that this provides about 30% upside from where the stock is trading today at around $100 a share even after the rally that we had from earnings. And so we think this is a bank that can expand its multiple, you know, while it keeps growing quite rapidly. Now, another investor might look at this and say, “That’s a big premium to the average bank, right? Why is it worth so much”? And it has to do with the quality of the asset base and this growth opportunity. So to believe in that level of valuation, you have to believe in the level of growth that they can produce can keep persisting. And you have to believe that that growth is being fueled through providing true economic value to their customers, not through low credit quality and kind of buying growth through giving away their loans.

Stig Brodersen 34:35

It really makes me think of this great quote by Charlie Munger, and he said that, “The easiest thing in the world is to get a 30% R.E. (*inaudible*) in banks. You just need to make 1.5, and then that works (*inaudible*) 20 times.”

Sean Stannard-Stockton 34:47

There you go!

Stig Brodersen 34:47

And I absolutely love that quote. And you could almost just hear, you know, Charlie Munger, you know, say that! It’s not as easy as he makes it sound, of course. But I think, do think he has a, he has a point. So for the investor, what is the main leverage ratio to look at the banks? Because there’s so many ways to look at leverage and banks. What are the key thing for you to look at whenever you’re looking at a bank like First Republic Bank?

Sean Stannard-Stockton 35:12

Yeah, we focus on tier one capital ratio, whichever bank reports required by the Federal Reserve. It’s common across all banks. And we think at the end of the day, there are a lot of metrics that you can look at. Remember in the initial discussion around investment strategy, one of the things we talked about is we need to trust management. They’re the ones running the company. We’re just passive shareholders, right? In trusting a bank management team, you need to trust them to make the right decisions about their leverage ratio. So if you find yourself second-guessing the level of leverage at a bank, I just say don’t own it at all. I think some investors feel like, “Well, you can’t trust management.” I agree. You can’t trust all management teams. They need to earn your trust. But if you exclusively invest in businesses that for one reason or other deserve your trust, it makes your job a whole lot easier. This doesn’t mean you can’t kind of keep revaluing what they’re saying. Are they actually being consistent? Are they following through on their promises? When they make mistakes, do they come back and tell you about them? All that stuff’s important. It’s like the “trust-but-verify” sort of approach. But I think that if you are looking at banks in general, and you have any question about whether or not they’re being managed conservatively enough, just go on to the next one. Find something easier. Don’t waste your time investing in management teams you don’t trust.

Stig Brodersen 36:25

Now, you already talked about the potential upside and how you look at the valuation of the stock. If you could just get like the short version of what we already talked about, how do we assess the intrinsic value of First Republic Bank? What is it worth? And why?

Sean Stannard-Stockton 36:41

Today, we think First Republic is worth somewhere between $130 and $140 a share. That’s about 2.8 times tangible book value. That’s quite elevated to kind of–the two times level that I talked about earlier, but that’s because of their high level of growth right now. So over the long term, we do think that the valuation that multiple tangible value will come down as their growth slows. So in thinking about valuation, we think it deserves that high valuation because of the high growth ahead of it. But as they grow that will be offset by the lowering of the multiple. So when you kind of run all that math, we think it’s worth that 2.8 times tangible book value, or about $135 a share today.

Stig Brodersen 37:18

Thank you, Sean! Very concise answer. And thank you so much for coming here on the show to educate all of us about how to value stocks and how to value specifically this stock pick. Where can the audience learn more about you and Ensemble Capital?

Sean Stannard-Stockton 37:33

Absolutely. So you can find us online at ensemblecapital.com, and we also author a blog regularly called intrinsicinvesting.com in which we write about a lot of our holdings and our overall philosophy. And you can follow us on Twitter @EnsembleCapital.

Preston Pysh 37:48

Sean, thank you so much for taking time out of your day to talk with Stig and I. I know I learned a ton. And I’m sure our audience learned a ton. So thank you so much.

Sean Stannard-Stockton 37:58

Thanks so much for having me.

Stig Brodersen 38:00

All right, so at this point in time of the show, we’ll play a question from the audience. And this question comes from Rick.

Rick 38:07

Hey, Preston and Stig! This is Rick from Florida. I love the show and greatly appreciate everything you offer to the community. My question is what is the most effective approach to determining whether a company is worth investing your time and money in? I started by reading the annual reports of companies, but it takes so long to read the reports for every single company I’m interested in that I don’t ever think I’d get through my list of businesses I’m interested in. I recently started looking at the financials first and putting financially strong businesses into a basket to be evaluated further. However, I noticed that I’m missing out on the details. If a company has a bad year or two and isn’t showing consistent growth, it’s hard to know whether the moat isn’t strong, or whether they’re investing that money to better position themselves for the years that follow. I work a full time job, so I’m curious what you feel is the best and most efficient way to know which companies are worth a deeper dive and which aren’t? Thank you so much.

Stig Brodersen 38:53

So Rick, this is a fantastic question. And I love it because I think it’s applicable for almost all of our listeners. And surely it was applicable to myself, whenever I first started investing, and before I went full time here on TIP. Because most of us have full time jobs on the side, and just don’t seem to have enough time to dig into the very best investments. So to your comment about companies that might have a bad year, that then would fall out of your screener, I would say that you shouldn’t worry too much about it. If you don’t have a lot of time to do invest in research. You would either consider a broad ETF, or if you want to invest in individual stocks, I would recommend that you only invest in very strong companies. And you don’t do any type of special situation investing of a stock where you as an investor think you see something that the market does not see. So I would recommend that you use a screener in the beginning of your process, and then set up very conservative metrics to the valuation and the performance of the company.

So two criteria to include would be a growing top line and stable at growing margins. If a company does not have that, even at a good price, you can just decide to move on. Now that specific company might still be a great investment, but companies with shrinking revenue and margins are just a little harder to figure out. And remember, you don’t have that time. So you’re not looking for screener with a criteria of more than 100 names. Then, also remember to look away from industries you don’t understand. For instance, you might have a hard time understanding balance sheets of banks, which is just very different than other balance sheets. And that would just give you another criteria and even fewer names on your list. So you end up within your circle of competence, and perhaps a watch list of only 30 to 40 stocks. Perhaps even fewer than that. And now I would just then select a handful to invest in, assuming they are trading at a good valuation. So to sum up, there is more here, and if you don’t have time, you shouldn’t give up on thorough research, but just limit your investing universe. So only spend time on the investments within your circle of competence. And then, perhaps diversify into a little broader for the vast majority of your portfolio.

Preston Pysh 41:14

Hey, Rick! So my answer is going to sound self-serving, but it’s definitely not intended to be interpreted that way. So I had this same problem whenever I first started investing. How can I quickly filter through these countless, endless array of businesses that are out there on the stock exchange, and only narrow it down to a few picks that I can then invest all my time and energy into really understanding? So when I originally made the Buffett’s Books videos, I used the stock screener that was provided for free online by Google. Well, it was a great screener, but Google did away with it. After learning about the back testing that West Grey, Toby Carlisle, and some others had conducted, they found that when you look at companies from the total market cap with the debt included; like you’re going to buy everything, and this is known as the enterprise value. And when you compare that figure to the earnings of the business, you can quickly filter through businesses that have good financial standings, while also finding businesses that have strong earnings power. Now, when you filter the results this way, you can get a little bit skewed because you’re dealing with the results on the earning side for just the past year, so you, you have to definitely dig into it more. You just can’t rely on that filter giving you the results for what they are. But it definitely helps you sort and find companies that have great value.

After I filter those results by this valuation approach, I then look at how the company’s long term momentum characteristics look. Now the reason we built this filtering mechanism into our site is because I haven’t found anywhere that combines both of those metrics, where you get the value side, and you also get the momentum side. Of those two factors, I would tell you that the valuation side is paramount. That is absolutely, you know, if I can only pick one or the other, I would take the valuation side every single time. So Rick, here’s where I’m excited to tell you that Stig and I are going to give you a full year of access to our filtering tool that’s on the TIP Finance page of our website, so you can quickly find these companies in the manner that I just described for you. Not only that, but we’re also going to give you access to one of our paid courses called the Intrinsic Value Course. And this will be really helpful for you. After you filter your results, you’re going to be able to go in there, and do the math on the intrinsic value; how to determine the intrinsic value. That’s what we teach in the course is how to do that math, and how to take those future free cash flows and discount them back to the present day value to, to figure out what they’re worth. And so if anybody else out there wants to get a question played on the show, and get out access to the course and the TIP Finance filtering tool, just go to asktheinvestors.com. You can record your question there, and if it gets played on our show, you get access to these awesome tools that Stig and I have created.

Stig Brodersen 44:13

Before Preston and I let you go, we’d like to play a few minutes of an amazing interview from our show, Millennial Investing hosted by Robert Leonard. Robert is having a very insightful conversation with a good friend of The Investor’s Podcast, Jesse Itzler, who has been a recurring guest here on the show. Jesse is best known as one of the owners of MBA’s Atlanta Hawks; having founded Marquis Jet, which is sold to Warren Buffett’s Berkshire Hathaway, and being a partner at Zico Coconut Water, which is sold to Coca- Cola. Here’s the show segment of the conversation between Jesse and Robert that was published just two days ago.

Robert Leonard 44:50

I personally have enjoyed many, many things that you’ve written about or talked about. I’m a big fan of yours. But one of the favorite things that you talk a lot about is this idea of the number of times you have something left. And that was something that was in the back of my mind as you were talking about how busy your day was. And whether it be going on a trip or like you’ve talked about going to visit your parents, you often break down the number of times you truly have left of each activity. Can you talk to us more about this idea and why it’s so important to you?

Jesse Itzler 45:17

My relationship with time is, when we think of relationships, we think of it in terms of people. How’s your relationship with your dad, or your mom, or your kids. And that’s super important. I also think your relationship with time is very important. I think for a lot of people, we think the notion is we have a ton of it. And the reality is we don’t even know if we have tonight, you know? But no one thinks like that. If they did, they’d have their graveyard picked out. They’d have their pass codes handed out to their loved ones, but no one thinks it’s going to happen anytime soon. So my relationship with time is I’m very aware of my mortality. I’m very aware of how long the average American lives to which is 78. I’m very aware of that. So it’s created a lot of urgency in my life, but more importantly, it forces me need to focus on moments, not minutes, or hours, or days. So I mark my moments. I’m always saying to my friends, “Remember this right now. We might not ever jump in this lake again. We might not ever run this race again. We might not ever be in this room brainstorming this business idea. Mark this moment in your head as a moment that we remember.” I say it all the time. I’m an encyclopedia of moments. That’s how I look at it, you know? I look at my parents, you know, about to be 90. And my dad or my mom live five more years. I hope they live forever. And I see them twice a year. I don’t know in five years, I’ve 10 visits. So that’s sort of how I put it in a box. Now, Millennials, young cats out there are invincible. This might sound like a little bit crazy. But as you get older, you’ll start to realize, people tell you it goes fast all the time. You don’t need me to say that life goes fast, but the younger that you realize how important those experiences are, and you take advantage of them at a young age, then the more rich your life will be because you’ll have more experiences and memories. And at the end of the day, what more do you want than that?

Stig Brodersen 47:01

If you want to hear the rest of the interview with Jesse Itzler, make sure to check out Robert’s show. We have a direct link in the show notes. Or even better, make sure to subscribe to Millennium Investing by searching directly for The Investor’s Podcast on iTunes, Spotify, or wherever you listen to a podcast. But guys, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We see each other again next week.

Outro 47:26

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