David Hendler interview - highlights from Friday Webinar on July 14, 2023

David has always brought a very deliberate, rigorous, intelligent approach to securities analysis. I'm really excited to be able to connect with David again and have him here with us.

Thanks for the intro, Dave. I was on the buy side for 4 years, and really that's where I got a lot of my conservative ways of Investing and doing the analysis. And then I went to the sell side for probably 15 years at various firms and created research reports that helped to sell securities, mostly debt. Then I did a stint, 2 or 3 years in equity where I met Dave Trainer. He was on the economic value-added team and got me to understand that as he was one of the big proponents and distributors of that information. And then when I thought I knew something enough to go out to a startup, I went to Credit Sights. I was an early-stage employee. I was there for about 15 years. 2 years ago, it was sold to Fitch. Then I decided I want to do everything on my own, so I went Started Viola Risk Advisors. I focused on the banking industry, integrating regulatory risks and counterparty credit risk, which is big for trading banks. Who's going to trade with who, how much, and then how long. Those 4 major factors gives you the holistic risk aspects of a bank. One influences the others. You really got to understand it all. There's not a lot of people who do. I would say I'm one of the only ones because I spent time either in debt equity or I interacted a great deal during the great financial crisis with all the major regulators in the US and even Europe and Asia. I also interacted with a tremendous amount of capital market credit analysts, and I've been selling into that network of investors, risk managers, stakeholders, stockholders for the last 10 or more years. So that's the background.

It's important to take a second to make sure people understand what you mean by capital stack. Capital stack means looking at all the capital in the business, not just the equity or the debt, but both, including preferred, convertibles, and other potential even derivatives. And what that holistic approach brings to the table is a much more intelligent understanding of the business, especially with banks. vis-à-vis their business competitive landscape, but also the regulatory competitive landscape, because the regulators are making things pretty tough for banks. What David did with Viola was really cool. How many other firms do full-stack capital structure analysis?

Nobody really does it. There's been decades of Wall Street trying to do it in-house, but there's all these rivalries, so they never get it done. They don't really want to get it done. lip service to the buy-side equity to try to do this. Some buy-siders try to do it, but nobody continuously does it. So it's not done strategically, and for a lot of entities, it doesn't make dollars and cents, so it's not done. We do it in the banks for the last 10 years, and you guys, new construction, really Your data is seamless and continuously generated, makes it possible because I have a few people helping me, but to have armies of analysts is too expensive. Even Wall Street has cut back on most of its debt research and even high yield research. We do it and we have expertise.

I want to go a little bit deeper on your comment around the internal politics or conflicts within a bank as to why they wouldn't do full capital stack research. Are you saying that There are priorities within an investment bank that conflict with doing complete research.

There's no unified vision and incentives to make it happen. A lot of times in an investment bank, trading bank, everybody's operating independently. Once in a while, the big shots, CEOs and board types says, oh, we got to do this. They knock some heads together. And then those heads wait for the top guys to forget what they said, produce their own money and their own bonus pool. And if they don't get paid, then they go to the next town.

They're all chasing the dollars for them right now, short term. And if it doesn't make them money, then they move on. In the pre-tech bubble times, some of these bigger and more established banks, at least they were a little more conscientious of their responsibility to be stewards of the capital markets.

Yeah, they were better gatekeepers. They had cultures that were developed from training programs and time and grade and learning system. But a lot of that's gone out the window, which is an opportunity for new constructs to do the work that they should be doing.

That does segue directly into what I've said before. There's just no incentive for anybody to do any real research if their goal is to make money for themselves. They're not out there publishing information that's going to help other people make better trades unless they get paid for that, which is only happening when they give that kind of information to a big buy-side client who they hope will in turn reward them. We had a nice question come in here, David. The question is, is there a segment of bank capital structures that typically has the best risk reward?

When things are calm and The industry looks stable. Your junior securities have the best spreads versus the potential downgrade risk. But as that changes in some dynamic, you gotta go up capital structure, trade up in quality to senior notes. You're varying between sub-debt, perpetual debt of some sort, perpetual preferreds. to senior debt, senior unsecured. Sometimes they're senior secured. The big swings are in the longer-term maturities, so 10 years and out, and the lower you are in the capital structure. For instance, in the latest contagion with those regional banks, First Republic, Silicon Valley, and Signature, As the regulators got involved, closed 2 of them down, auctioned off the First Republic. They wiped out not only equity, but perpetual preferred stocks got wiped out because under a regulatory regime, that's considered equity. The more junior you get, the more illiquid it is, although dealers on Wall Street have trading desks. specialize in that. They got wiped out. They went from par to zero in 2 years. So you have to figure out what are the tendencies toward that. I'm not saying it's easy, but new construct spotted things that could have helped you. Now, was it because of interest rates going up? Maybe. Is it also because Like you said, with Peloton, management was selfish and they were doing selfish short-term things that lined their pockets. Yes. Were the regulators asleep at the switch? Yes. Were the rating agencies also in a coma? Yes. Were the equity analysts typical on this, on Wall Street cheerleading it all on because of growth? Yes. So where was the sane person in this process? I would say New Constructs have the data. Who uses the data is another thing to understand and execute the trade, but at least New Constructs provides the data. That's what New Constructs does for me. It leverages my expertise to areas that I don't have enough people to break down all the balance sheet stuff, footnote stuff, and standardize it and do it every quarter. And compare it on an equal basis across the industry segment. So that's the beauty of new constructs. It amplifies your capabilities.

Quick summary of what you said is the more junior the debt, the better the upside until things get a little bit nutty where there's economic turbulence, and then you're going to wish you were higher up the capital stack. That's the classic Debt versus equity decision. I mean, debt's a lot safer. Equity's got more upside. I remember there was a few years ago you mentioned to me some new security that came out that was this really good deal, something on preferreds. Remember what I'm talking about?

That was the perpetual preferred. It looked really good in that unusually low interest rate environment, and there's different structures to it that It's highly interest rate sensitive. So when Chairman Powell of the Fed is on a yeehaw to raise rates 500 or more basis points in one year, that's going to crush the market. It's down 40% since when all those securities were issued.

It's one of those things where when things were great, hey, these things look awesome. And then of course they're based on the assumption that things are going to stay great.

And when things are no longer great, or are they going to stay in a zone where you can do things? I mean, what we're getting into is, is the Fed's policy so good for so many? And my quick take on it, they want to kill inflation, but they're also killing a lot of banks doing 500 basis points in one year. Nobody stress tests for that. It's too extreme. The regionals are having a hard time adjusting because it's unprecedented, such a rapid rise.

What you're bringing up is an interesting nuance. We all know inflation was a problem and maybe the Fed was behind the curve and they needed to catch up, but there's something to be said about doing it at a rate that would allow your constituents, particularly banks, to adjust their portfolios accordingly. And what it sounded like I heard you say is that Powell really stepped in it by number one, being a little bit late to raising rates and raising it at such an unprecedented fast rate that you caught a lot of your banks off guard and there was unnecessary destruction by the Fed.

A lot of companies, it takes time to readjust to the environment with banks and interest rates. It takes you a year and a half to 2 and a half years to really reposition the battleships for higher rates. You can't turn on a dime because the Fed wants to accomplish one goal.

You don't think he signaled for long enough that, hey, this was coming? Because it felt like there was a lot of worry.

There's also the struggle between Banks are run for shareholders. They want to see EPS growth. And in a low-rate environment, they can't just be in short-dated safe securities and meet your earnings per share targets. There's that push and pull between running a publicly traded company. You have to stand out. To be bulletproof, you would've had to have been 1-year treasuries, your whole balance sheet.

That's going to kill you. That's going to kill your stock.

You're not lending money and you're not helping the economy, and the Fed wants the economy to be strong. So there's all these oxymorons, but if you do it gradually, everyone gets time to readjust.

Most of our folks are equity investors, but they're all investors, David.

What advice would you have for folks with respect to what it means to be or how to be a successful Well, I believe, and I think it's across industries, that you have to understand each market and what it's telling you that might influence your investing area. So for a period of time, equity was liking the big banks before the credit crisis in the mid-2000s, late 2000s. But the CDS market, the credit default swap market, was saying something else. So there was a lot of belief that, well, the debt and credit default swap market, which is even a more liquid derivative index of what's going on in a company or an industry that was leading the risk deteriorating. Not as many equity people were following that, if any. And then it's the other way around. Even equity sometimes Usually more on the upside is forward-looking than debt. So that's where you could help each other out. New constructs. If you look at the last 3 banks that blew up, you can see the economic profit was deteriorating from 2020 to the end of 2022. So you had a negative trajectory from a really strong base, and then It really got ugly. You gotta look at different areas that can help you make a better decision, not just the one you traditionally look at.

I know you predicted the demise of Credit Suisse long ago. Was there another bank that you also were really pressing on having some troubles?

Deutsche Bank from 2016, '17, we were banging the table that it had a lot of risks. And it really deteriorated the debt and equity markets because of how they dealt with different types of derivatives. Wells Fargo in 2015, '16, we're noticing from a lot of your data, they were viewed as the strongest, most profitable bank, but on an economic profit basis, it was really not that much. It was deteriorating. It wasn't Anywhere near as strong as they claim. A lot of times you're a divining rod, you're a company in data to do further analysis. Look at the footnotes more, look at the strategies, talk to management if you want, model things a little bit differently, and then you'll get ahead of the curve. You want to be optimally ahead, I would say 12 to 18 months so you can sell at a better price and let everyone else In the investing world, hit the wall. It's not always that easy, but that's the goal.

When you say dividing rod, what I think you're saying, this is one of the bigger messages that's important for anybody who wants to be an investor is we all have a limited amount of time. We can't research everything. So we need to find things that are going to be good leading indicators as to where we should spend our time. I think what David is referring to when he says dividing rod, He's talking about that return on invested capital versus cost of capital spread, that economic cushion that other fixed income clients of ours have talked about as being a very strong indicator as to the eventual credit quality. So it doesn't always help for our models to tell you, oh my gosh, the credit quality of this business is terrible. You want to be able to look at the trend and understand where it's going to be, Not where it is. That's part of the reason why I'm really proud that we have fixed income investors and we got really rigorous, experienced folks like David and others who understand fundamentals and can say, listen, this is a tool to help me understand what's going to happen, not just where things are. That's an important point to make. A lot of our clients that are in the fixed income side of things, they look at that return on capital versus cost of capital spread, which is something we also consider to be the most important for an equity investor. We're just about out of time. Is there any other parting comments you want to make before we sign off on this Friday?

You got to constantly look at this stuff, the data from New Constructs, take it for what it is, and also compare and contrast it with other databases that you have. When all is said and done, the individual analyst has to make the call. So a lot of times we agree with New Constructs, sometimes we don't, but at least The New Constructs are covering all the bases. We know that, and that's what's really good.

That's the idea. We're not here to pretend that we've got all the answers. We're not here to tell people what to do. We're not advisors. We are publishers. We are researchers. We're here to try to make your job easier and help you make more informed decisions, but we're not at the steering wheel. Thanks for that, David. That was awesome.

Appreciate all the cooperation, teamwork over the years.

Absolutely. My pleasure.