Video Update: What Weakness in the Banking Sector Will Mean for Our Fortress Portfolio

The No. 1 thing on everyone’s mind right now is banking safety.

We continue to see the names of failed banks stack up. And that’s kicked up a frenzy of activity from players in private equity… the federal government… the bond market… and individual banks, too.

It can be a lot to process.

Fortunately, Chief Analyst Adam Galas will break down the entire situation for you. And we’ll have more updates for you in the coming days as things unfold.

The bottom line is: Fortress was built to withstand market turmoil. And as Adam will lay out, our risk-management guidelines ensure we keep ourselves safe from investments that can tank our wealth when things go south.

Click the image below to watch the video or scroll down to read the transcript.

Happy SWAN (sleep well at night) investing,

Brad ThomasEditor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Now, I’m sure some of you want to know about the jobs report. Others want to know about what’s going on with inflation. And next week, we’ll be sure to get to that.

But of course, this week, the number one thing on everyone’s mind is banking safety, specifically what’s going on with Silicon Valley Bank (SVB) as well as some other banks that have failed.

So let’s go through what’s happening with the mini banking crises of 2023, what the government’s doing to safeguard your money, the money in your bank, and what it means for the Fortress Portfolio.

So first, it’s important to remember banks normally fail at a rate of about two per month since 2011. We haven’t had any since 2020, and suddenly we had three in a single week.

Silicon Valley, of course, is the second biggest bank failure in U.S. history. So let me explain simply what caused this epic disaster. It all goes back to the pandemic.

Remember, we shut down the economy and the St. Louis Fed warned that if we did nothing, unemployment could soar to 50%, twice that of the Great Depression. So obviously, the government had to do something.

So they sent everybody checks. They borrowed a lot. They printed money a lot, including the Fed. Overall, $10 trillion in stimulus.

Well, all that money had to go somewhere. Specifically, $3 trillion in excess savings went to bank deposits, including Silicon Valley Bank. But it didn’t stop there. You see at Silicon Valley, 60% of their depositors were venture capital and tech start ups.

And remember what happened, interest rates were zero and the Fed was printing like there was no tomorrow.

People went tech crazy. Free money forever was the mantra. So we had speculative money and losing tech stocks soaring to the heavens.

Venture capitalists were happy to lend to fund companies that didn’t even have any revenue, much less earnings as long as they were growing their user base.

And they thought they would be funded forever. Well, that works as long as inflation remains near zero and interest rates never go up, which of course did happen in 2022.

So what happens? Tech stocks crash. IPOs go away. Venture capitalists suddenly don’t want to fund anybody.

So all these money-losing companies that were 60% of Silicon Valley’s customers, all the sudden have to use their cash on hand to survive.

So for over a year, they’re steadily pulling money to pay the bills and keep the lights on. Well, this brings us to the second issue.

Under current regulations, a lot of deposits have to be held in risk free bonds such as U.S. Treasuries. Silicon Valley, because of the pandemic boom created by the government and the Fed, saw its deposits triple in just two years.

They put $21 billion of that in bonds. Now, most banks use short duration bonds, or they did long duration bonds with interest rate hedges to protect themselves, not Silicon Valley. They wanted to maximize the yield, so they went long bonds with no hedges whatsoever.

Well, that created the problem because so many of their deposits were coming out that they needed to sell something at a loss, specifically their bonds, in order to meet the withdrawal demands of their clients.

Well, they sold some of their bonds and they took a $1.8 billion loss.

Then, Moody’s came to them and said, we’re going to downgrade your credit rating because you just blew a big hole in your balance sheet.

So Silicon Valley said, no problem, we’re going to sell $2.5 billion with a stock and preferred shares. But, there was a problem.

Their stock price was down over 50% from their high.

So when Wall Street heard this, they freaked out. The CEO came out and said, everyone stay calm, don’t panic. The bank is just fine.

Well, guess what happens when your bank CEO tells people not to panic? Well, venture capitalists, including Peter Thiel, told all their venture capital venture companies and start ups to pull their money out immediately. It was just too risky.

 So on Thursday, in a single day, $42 billion of deposits came out and suddenly the cash reserves fall to -$1 billion.

So obviously, with the stock price crashing about 85% in two days, they can’t sell new shares. So they try to sell the bank. But this is the 16th biggest bank in America. It’s very complex.

It would take weeks of due diligence to study the balance sheet, know what it’s worth and how safe it actually is.

Well, you can’t do that in a few hours. So they weren’t able to sell the bank.

Thus, they failed and the Federal Deposit Insurance Corporation (FDIC) had to take them over, and put them in receivership.

And something similar happened with Silvergate, which was almost a 100% pure crypto bank. Signature bank, which was 25% crypto, basically lots of money losing its tech startups that were having to withdraw money.

So what’s the government doing?

Well, the Treasury, the FDIC, and the Fed have all coordinated a response, specifically what I like to call a main Street bank bailout, meaning the only thing we care about is protecting depositors, the people and companies that held their money at these banks.

So the Fed, for example, is now willing to lend to these banks for one year at about 4.65%, all based on their risk free bonds at par value.

In other words, if you give me $100 and I’m a bank, I buy bonds that then fall 20% in value, I can go to the Fed and borrow $100 for one year at 4.65% using my bonds as collateral.

The good news is the CEOs that screwed up, they’re fired. The shareholders that and bondholders that took on the excess risk and should be punished according to the rules of capitalism, they mostly got wiped out.

But the real people like you and me and the companies that employ 50% of Americans, small businesses, their money is safe.

And the new program means that any bank that needs the money to protect all deposits, even those above 250,000, will get the money that they need.

So unlike the big bank bailout of 2008, where CEOs got to keep their jobs and even their million dollar bonuses, this time the guilty have been punished and the innocent protected.

So the good news is this should prevent another financial crisis.

However, it doesn’t necessarily mean that deep panic in regional banks is contained. For example, we’ve seen some regional banks fall as much as 80% in a single day.

And we’ve even seen big world class banks fall 20% in a single day.

The Financial Times is reporting a record amount of deposits flowing from regional banks to the big four banks like JPMorgan and Bank of America.

It’s going to take some time to see how far this goes. But the good news is the money at your bank is safe if insured by FDIC.

And we’re not headed for another Great Recession. Recession yes, but not Great Recession.

So what about Fortress companies? Well, the good news is that all these bank failures so far have been basically at venture capital and crypto focused banks, which essentially are not in any way connected to the Fortress companies.

They don’t bank with them. They’re not affected by them, and they remain safe. How can we know this, though?

Well, at Wide Moat Research, we have a 3000 point safety and quality model based on over 1000 metrics.

We also look at the rating agencies, all the analysts and even the bond markets, and real time fundamental risk assessments called credit default swaps. These can tell us in real time what is the fundamental risk of default for any company.

In other words, when news breaks, we can turn to the expert consensus and the bond market, and the smart money on Wall Street to see whether or not it changes the thesis.

FactSet sends me real time news reports for every company in the Fortress Portfolio, and Google News sends me news reports and analyst reports on all the companies as well.

Now, obviously, if say, JPMorgan downgrades or upgrades, a company based on 12 month price targets, we don’t care. But we do care if they upgrade or downgrade a company based on fundamentals and those are the fundamentals that we discuss in video updates and monthly issues.

For example, this month we’re talking about Toronto-Dominion (TD) and TC Energy (TRP), which did have some big headline news that came out, which ended up not changing the investment thesis, but we still covered it briefly just to make sure that anyone who owns them isn’t overly concerned.

So this brings us to the next subscriber question from Adam R. asking about V.F. Corp (VFC) vs. Brookfield Renewable Corp (BEPC). As a reminder, VFC is dividend cut at 40%. Now this of course was covered in a special report that you can find here. A couple weeks ago we recommended selling VFC and buying Brookfield Renewable Corp (BEPC) instead.

But Adam R. wants to know, if the dividend cut was basically already priced in. He also asked:

Well, VFC, of course, was a Dividend King. Back in Q3 of 2022, management raised the dividend for the 51st consecutive year.

Now, why do dividend streaks matter? Well, according to Benjamin Graham, Buffett’s mentor and one of the greatest investors in history, dividends earn dividends and dividend streaks are an important sign of quality and even excellence.

Why? Well, because, as I like to say, short term stock price is vanity. Cashflow is sanity. But dividends are reality.

You see, companies can manipulate earnings by a creative accounting, but cashflows cannot be manipulated and companies can still pay unsustainable dividends for a long time, but not forever.

So if a company is raising its dividends for 20 plus years, according to Graham, that is the sign of an excellent business.

VFC at 51 years was a sign of strong management confidence.

Now, of course, the company is going through some ups and downs. It’s not the ultimate ultra-SWAN (sleep well at night) investment that it was.

It was a high quality, deep value company. Management said so, rating agencies said so, bond investors said so, and analysts. Everything looked fine.

Then they cut the dividend by 40%. Now they say it’s out of an abundance of caution.

2023 recession is coming. Interest rates are rising. And interest costs are rising as well. They just want to make sure that they have enough money to make the turnaround succeed in this environment.

Well, that’s all nice and good. But remember, they’ve had 51 consecutive years of raising the dividends through the pandemic when they had to close all their stores, and through the Great Recession when their revenue fell off a cliff.

In fact, they were raising their dividend every year through seven recessions and inflation as high as 15%, interest rates as high as 20%.

So in effect what management is saying is in three months, our fundamentals went off a cliff and effectively the fundamentals of the company were worse than expected after just raising their dividend.

They’ve been crushing it for at least 51 years. Now, management and analysts and rating agencies and bond investors all think the turnaround will succeed and they will be able to return to double digit growth.

Again, that’s all well and good, but the reward to risk ratio shifted badly, and that’s why we sold and recommended that you sell as well.

Now, let me give you the specific facts. What do I mean by the reward to risk shifted? Well, since 1973, dividend cutters have annualized returns of -0.5%, not including inflation, while dividend growth is 10.7%.

What does that actually mean?

Well, consider this. In 1973, had you invested $1 in dividend cutters, including inflation? Today you would have $0.11. That’s an 89% loss.

Had you put it into dividend growers? It’s now worth $20.51 adjusted for inflation. In other words, 186 times more money. It’s simple math. When the dividend is cut, it’s time to sell.

So what about the dividend cut being priced in?

After all, if you’re down a lot, you don’t want to sell.

Well, consider this. AT&T a few years ago was a dividend aristocrat and they cut their dividend. And since then, including the lower dividend stock, it is down 10%. Intel recently cut their dividend by 66%. It’s down 10% since then.

In just the few weeks since VFC cut its dividend by 40% and we recommended you sell it, it’s down 26% more. Dividend cuts are very seldom actually priced in.

After the dividend cut is announced, the price does usually actually go up a bit because investors are somewhat relieved that the company will be able to save more money.

But remember that doesn’t usually last, so it’s a great time to exit and go with a stronger, thriving company such as BEPC.

Great questions.

As a reminder, please send us your questions so I can answer them in our monthly issues as well as these videos. Just keep in mind, I’m not legally allowed to give personalized investment advice.

Thank you for joining us for this weekly update. I hope you join us next week when we’ll be talking about that strong jobs report and what’s going on with inflation.

This is Adam Galas, wishing you safe investing and a healthy and relaxing week.