In a world where financial titans command the game board, few moves are as intriguing as those made by the legendary Michael Burry (Trades, Portfolio). When he swiftly pulled back the curtain on his bets in Capital One Financial Corp. (COF, Financial) and Western Alliance Bancorp (WAL, Financial), Wall Street tilted its collective head in curiosity.
The assessment of his event-driven approach suggests Burry was betting on the scenario where the Federal Reserve starts to reduce benchmark rates (in the short run), and the progressive quantitative easing would boost positive investor sentiment toward banking stocks.
However, during the recent Federal Open Market Committee meeting, the Fed clarified its hawkish stance with a higher for longer setup until U.S. inflation settles below the target level of 2%.
These developments pose the possibility of a recession. In this context, banking institutions are at the edge while facing adverse macroeconomic impacts in a recessionary environment.
Burry may find a substantial valuation decline and no fundamental edge in these stocks; therefore, he exited the long positions with a negative return on investment of -4.35% in Capital One and -43.41% in Western Alliance (a major loss).
Source: tradingview.com
Capital One in the crosshairs
Examining Capital One through the lens of Burry's strategy reveals several areas of misalignment. Burry's key focus is the macroeconomic environment, particularly interest rates. The Federal Reserve indicated a relatively hawkish "higher for longer" stance, which includes expectations of interest rate hikes and a less accommodating monetary policy. Such a scenario can negatively impact financial institutions like Capital One.
Currently, the federal funds rate stands at its highest level in 22 years, within a range of 5.25% to 5.50%. This suggests tighter monetary policy, which can lead to higher consumer borrowing costs. Such an environment could reduce credit card usage and deteriorate profitability for Capital One. These impacts are already integrated into growth metrics and the street's earnings per share revision trends.
Additionally, the Fed's projection of a higher gross domestic product growth rate (2.1%) may be considered inflationary. Burry's concerns about inflation and its potential impact on asset prices may make him cautious about investing in Capital One.
Burry's financial forensics: Decoding red flags in banking health metrics
Strategically, Burry strongly emphasizes fundamental details (such as credit quality) and the overall health of an institution while making investment moves. Capital One's charge-off rate in its domestic card business has significantly increased, rising by 2.12% year over year to 4.38%. Such a substantial increase can indicate deteriorating credit quality among cardholders, potentially leading to higher defaults and losses for the company.
In detail, rising interest rates lead to higher borrowing costs for consumers and businesses. This can reduce loan demand as borrowers are discouraged by higher rates, potentially leading to slower loan growth for the bank. Moreover, higher interest rates can negatively impact the profitability of Western Alliance's existing loan portfolio.
At a broader level, as interest rates rise, the bank may find it challenging to earn higher interest income on its existing fixed-rate loans, which could compress its net interest margin and impact return on equity growth.
Further, the second-quarter loan-to-deposit ratio was 94%. This ratio measures the bank's reliance on deposits to fund its loans. A higher ratio may indicate increased lending risk if deposits do not keep pace with loan growth. Similarly, special mention loans increased to $694 million, accounting for 1.45% of funded loans. This suggests potential credit risks in the bank's portfolio.
A balancing act
While Western Alliance has outlined a strategy to reposition its balance sheet, this endeavor has risks. The bank mentions asset dispositions, including a significant loan reduction, which could affect its ability to generate interest income. Selling off assets and reducing loan exposure may be part of a risk mitigation strategy, but it can also limit the bank's revenue potential in the long term.
If the bank reduces certain types of loans, it may miss out on profitable lending opportunities, especially if economic conditions improve. Striking the right balance between risk management and revenue generation is crucial, and any missteps in this regard could weaken the bank's performance over the long term.
For instance, classified assets increased to $145 million, equal to 0.89% of total assets. A significant portion of this increase was driven by a single office loan in downtown San Diego, which poses a concentration risk.
Further, the 30-plus delinquency rate has also increased to 3.74%, surpassing its level from June 2019. Elevated delinquency rates can be a red flag for investors assessing credit risk. If Burry identifies this trend as a potential harbinger of future problems, he may be inclined to avoid investing in Capital One.
In the same direction, Burry's investment strategy often involves deep diving into data like the company's loan portfolio. It is essential to highlight that Capital One has experienced a decline in ending loan balances for its consumer banking business, down approximately $4.3 billion (5% year over year).
Additionally, the Commercial Banking segment has witnessed a decrease in loan balances, partly attributed to loans being moved to "held for sale" as a risk mitigation measure.
Capital One's balance sheet ballet and the quest for true value
From Burry's perspective, this is a sign of weakening loan demand or potential issues with loan quality. A shrinking loan portfolio can impact a bank's profitability and growth prospects, which could deter an investor with a value-oriented strategy. While Burry appreciates the importance of understanding a company's long-term strategy, he also scrutinizes expense management.
Capital One's financial data reveals an increase in non-interest expenses by 8% year over year in its domestic card business. While some of this increase is attributed to marketing expenses, Burry might have differing views that these investments deliver the expected revenue growth and cost-efficiency results.
The company has been making substantial investments in its technology infrastructure. However, the investor's discerning eye might question the return on these investments, particularly if expenses rise without commensurate revenue growth.
Finally, Capital One's current financial indicators and macroeconomic environment may need to align better with Burry's investment strategy. Factors such as rising interest rates, credit quality concerns, declining loan balances and increasing expenses could make Capital One less attractive to an investor with a value-oriented and contrarian approach like Burry.
Navigating Western Alliance in the tempest of rising rates
Similarly to Capital One, Western Alliance and Burry's strategies needed to be aligned with the Fed's actions and interest rate projections. The Fed's outlook is leaning toward more restrictive policy and higher-for-longer interest rates. For Burry, these data points would be of interest.
Specifically, he would consider how Western Alliance's net interest margin responds to changing interest rate environments. One of the company's fundamental weaknesses is its vulnerability to interest rate fluctuations.
The Fed has been signaling its intention to raise interest rates, which can significantly affect banks. As a regional bank, Western Alliance is particularly sensitive to interest rate movements. As of the second quarter, a return on average assets of 1.23% does not possess a significant margin of safety. In this context, Wall Street's earnings per share revision trends are not favorable.
Source: Earnings presentation
Takeaway
In conclusion, Burry's decision to sell his long positions in Capital One and Western Alliance appear to be a well-considered move in light of the evolving “higher for longer” macroeconomic landscape. Burry's investment strategy, deeply rooted in data and fundamentals, clashed with the Fed's hawkish stance on interest rates and inflation.
Both Capital One and Western Alliance may face challenges related to rising rates, credit quality concerns, declining loan balances and increasing expenses, all of which do not align with a value-oriented and contrarian investment approach.
