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Regional Bank Update

When any turmoil arises, as it has in the banking sector this year, we begin our analysis with a deep risk assessment. Our conclusion: While we are not…

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When any turmoil arises, as it has in the banking sector this year, we begin our analysis with a deep risk assessment. Our conclusion: While we are not actively increasing the overall exposure to banks in our U.S. value equity portfolios, we continue to use the market’s short-term volatility as an opportunity to potentially upgrade the quality of the portfolios’ holdings.

Entering the Year

Banks have been well represented across the value indices. Going into the start of the year, they made up about 18% of the Russell 2000 Value Index, 11% of the Russell 2500 Value Index, and 6% of the Russell Midcap Value Index.

But the composition changes between the size of the indices. The midcap value index tracks about 30 super regionals. But smaller regional and community banks—more than 300 of them—dominate the small-cap value index.

The sheer number of banks in the small-cap value index tells us that U.S. banking is still a regional, relationship-based network serving local communities. And while consolidation and roll-ups are likely over time, we believe regional banking will still have a role to play. In other words, the United States is unlikely to look like Canada or Europe, with only a few dominant players. The U.S. economy is much more heterogeneous than the rest of the world, and smaller banks play a role in supporting the diverse local economies in which they reside.

As we started 2023, we were underweight the banking subsector of financials across our Small Cap Value, Small-Mid Cap Value, and Mid Cap Value strategies. This underweight was most pronounced in our Small Cap Value strategy, which had a 15% allocation to banking vs. 18% in the Russell 2000 Value Index.

While our underweight positioning has contributed to relative performance, we by no means were predicting a run on several midsize lenders. So why the underweight?

While earnings pressure and regulation could weigh on returns, we believe most banks should be well equipped to exceed their costs of capital and live to see another day or cycle.

We entered the year cautious about banks because the drivers of their fundamentals didn’t look overly attractive to us. What really drives banks’ share price is loan growth, net interest margin (NIM, which is the difference between deposits rates and other capital costs and the interest rates the bank gets on loans), and credit quality.

As we entered 2023, the first of those fundamentals—loan growth—was still healthy. However, banks took in enormous sums of deposits during the pandemic (due to excess stimulus and the surge in M2[1]), and we believed loan growth would not be able to keep pace. As their deposits grew, some banks responded by purchasing long-dated U.S. Treasurys as their loan-to-deposit ratios were out of whack. Unfortunately, some failed to properly hedge their interest-rate exposure and were forced to mark these assets down as nervous depositors sought liquidity.

Just as important, we believed NIM expansion was peaking or had limited upside—in part because there is now much more competition for deposits. After a decade of not considering an alternative to a checking account rate, investors and savers have more attractive options in money markets or short-dated fixed income. We don’t believe banks will lose all their deposits; they will likely just have to pay more to retain them.

Lastly, credit quality has been pristine to this point, and only has one direction to go if we are entering a period of economic weakness.

So, we entered the year underweight banking, and remain underweight today.

Where Are We Today? 

Immediately after JP Morgan Chase rescued First Republic Bank (FRC), market skepticism shifted to the next-most-exposed banks based on deposit risk and liquidity concerns (such as PacWest). Since the U.S. Federal Reserve (Fed) and Treasury were willing to take FRC into receivership and effectively wipe out the equity, short sellers and other market participants have recently bet heavily against other banks that look similar to those that failed.

As patient, long-term value investors, however, we don’t believe all regional and smaller banks should be tarnished. Yes, some of these banks in the crosshairs have similar profiles, but in general, we believe regional banks’ troubles are earnings issues rather than liquidity issues. And from a longer-term perspective, while earnings pressure and regulation could weigh on returns, we believe most banks should be well equipped to exceed their costs of capital and live to see another day or cycle.

And that’s what we’ve heard from the banks we own in our portfolios. The majority have reported first-quarter results—some have shown deposits down by the low single digits, while others actually have witnessed deposit growth. The first quarter was all about the vector of deposits, and for the banks we own, so far so good. As of the week ended in May 10, the latest H.8 data from the Fed (which presents an estimate of weekly aggregate balance sheets for all U.S. commercial banks) indicates that the pace of deposit outflows seems to have stabilized, although it is still falling, since the turmoil began in March. In fact, most of last week’s outflows were concentrated in large banks, not the smaller regionals. Now, that refers to absolute deposit dollars; however, the mix of deposits is clearly changing, with non-interest-bearing deposits coming down as deposits move to higher-yielding alternatives within banks, such as CDs or money markets.

This should continue to pressure NIMs. In terms of their outlook, all of the banks we heard from assumed that the Fed would raise rates in May, further impacting NIM compression in the second quarter (albeit not as much as we have already experienced). But the banks are expecting that situation to stabilize as the Fed is predicted to pause in the second half of the year.

It is important to remember that in the bank universe, not all commercial real estate is created equal.

In terms of loan growth, thus far we are still seeing positive growth. Still, the pipeline has been shrinking over the last several quarters and will likely continue to shrink. Fed Chairman Jerome Powell explicitly called out the recent turmoil in the regional banks, noting that the banks’ initial reaction would be to cool loan growth and tighten credit lending standards, which in turn should help fuel the Fed’s mission of slowing the economy. This pullback was all but confirmed in the recent release of the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) data, which showed waning demand and tighter underwriting standards.

Credit, meanwhile, has been pristine thus far. Many banks have called out their commercial real estate exposures—specifically office space, as it is widely expected that this may be the next shoe to drop from a credit perspective. In addition, banks are tightening in construction, hospitality, and senior housing. But they are getting more granular, looking beyond what percentage of their loan book is allocated to office space and adding some color around their loan-to-value (LTV) ratios, occupancy levels, and debt service coverage ranges.

It is important to remember that in the bank universe, not all commercial real estate is created equal. There are many suburban medical offices in the Sunbelt that are thriving, for example. And thus far, in many places, credit issues remain benign. Banks as a whole are more diversified now than they were during the Global Financial Crisis (GFC), and underwriting standards have improved. It is also worth noting that while small banks have greater exposure to commercial real estate than large banks, much of the market is now owned by insurance companies, private loan funds, or syndicates. Nevertheless, if commercial real estate is the next source of turmoil, we believe it will materialize slowly.

Another area to consider is multifamily, which banks are still loaning into, highlighting the strong rental rates in select markets. In some areas activity is weakening, but in the Southeast activity is still humming as population migration out of the Northeast and West to the Southeast continues.

So far, then, the outlook has been better than expected, but we remain cautious given how quickly the recent turmoil ensued.

Near-Term Outlook

If all goes well, we will soon return to worrying about “normal” things like a recession as opposed to runs on banks.

Regarding valuations, some banks are currently trading below or at tangible book value (TBV), and we believe that is where we will start to see opportunities, as banks typically bottom before a recession and then begin to outperform once a recession hits.

We believe there are likely to be high-quality banks that are unfairly punished.

That’s because one thing banks tell us about the future is provisioning for loan losses, and banks typically start making those provisions (which they are ramping up now) before a slowdown occurs. These provisions impact earnings now but serve as a leading indicator of where we are headed. Banks tend to experience a “credit migration” (where classified loans on their books move to non-performing), but by the time they actually start taking the charge-offs, they have already reserved for them. And that is the time when their earnings headwind typically starts to abate. In our view, that’s when you really want to go on offense, as that’s also the time the Fed is likely cutting rates.

For banks our preferred valuation metric is price to TBV (P/TBV). Small-mid cap banks currently trade at about 1.1x P/TBV. Historically, the average for smaller banks has been 1.5x P/TBV, with the low end of valuation right at TBV (during most cycles, excluding the GFC). So, today, on an earnings basis, we are below long-term averages, but we believe TBV may have a bit more room to compress as we get closer to a possible recession, especially if it is a deeper recession than most are predicting.

One wild card is how the regulatory picture pans out. Clearly, more regulation is likely to occur as a result of the recent turmoil. We believe this will be focused on banks with assets of $100 billion or more. But even small-cap banks below that asset level usually have some additional burden placed on them as well.

So, it is yet to be seen how regulation will impact the profitability of banks. This likely precludes any merger-and-acquisition (M&A) activity until there is more clarity. Federal Deposit Insurance Corporation (FDIC) rates are likely headed higher, depending on the type of lending and deposits, which will vary. All that will factor into the future profitability of banks and what return on their assets they can generate.

Our Strategy

When any turmoil arises, we always start with a deep risk assessment. In this case we started with liquidity, uninsured deposits, deposit concentrations, and commercial real estate exposures, among other metrics.

After re-underwriting the names in our portfolios, we quickly pivoted to looking for opportunities, as we believe there are likely to be high-quality banks that are unfairly punished.

We are seeking top-quality banks trading at discounts to their peer groups and their own trading history. There are also banks that are just now starting to look interesting—ones with top-notch, sticky deposit bases in specific geographies (namely, northern California or the Southeast). We are also starting to identify a few banks that we would not have owned in the past, because they had premium valuations, but are now coming in more in line with the valuation of their peer groups.

These banks’ earnings may be suppressed over the short term, but we are willing to be patient by coming up with conservative valuations that we believe possess limited downsides before starting to nibble.

So, while we are not actively raising the banking weight in our portfolios, we continue to use the market’s short-term volatility as an opportunity to potentially upgrade the quality of the portfolio’s holdings.

Greg Czarnecki is a portfolio specialist for William Blair’s small- to mid-cap value equity strategies. 

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[1] M2 is a measure of the money supply that includes cash, checking deposits, and other types of deposits that are readily convertible to cash, such as certificates of deposit.

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Four burning questions about the future of the $16.5B Novo-Catalent deal

To build or to buy? That’s a classic question for pharma boardrooms, and Novo Nordisk is going with both.
Beyond spending billions of dollars to expand…

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To build or to buy? That’s a classic question for pharma boardrooms, and Novo Nordisk is going with both.

Beyond spending billions of dollars to expand its own production capacity for its weight loss drugs, the Danish drugmaker said Monday it will pay $11 billion to acquire three manufacturing plants from Catalent. It’s part of a broader $16.5 billion deal with Novo Holdings, the investment arm of the pharma’s parent group, which agreed to acquire the contract manufacturer and take it private.

It’s a big deal for all parties, with potential ripple effects across the biotech ecosystem. Here’s a look at some of the most pressing questions to watch after Monday’s announcement.

Why did Novo do this?

Novo Holdings isn’t the most obvious buyer for Catalent, particularly after last year’s on-and-off M&A interest from the serial acquirer Danaher. But the deal could benefit both Novo Holdings and Novo Nordisk.

Novo Nordisk’s biggest challenge has been simply making enough of the weight loss drug Wegovy and diabetes therapy Ozempic. On last week’s earnings call, Novo Nordisk CEO Lars Fruergaard Jørgensen said the company isn’t constrained by capital in its efforts to boost manufacturing. Rather, the main challenge is the limited amount of capabilities out there, he said.

“Most pharmaceutical companies in the world would be shopping among the same manufacturers,” he said. “There’s not an unlimited amount of machinery and people to build it.”

While Novo was already one of Catalent’s major customers, the manufacturer has been hamstrung by its own balance sheet. With roughly $5 billion in debt on its books, it’s had to juggle paying down debt with sufficiently investing in its facilities. That’s been particularly challenging in keeping pace with soaring demand for GLP-1 drugs.

Novo, on the other hand, has the balance sheet to funnel as much money as needed into the plants in Italy, Belgium, and Indiana. It’s also struggled to make enough of its popular GLP-1 drugs to meet their soaring demand, with documented shortages of both Ozempic and Wegovy.

The impact won’t be immediate. The parties expect the deal to close near the end of 2024. Novo Nordisk said it expects the three new sites to “gradually increase Novo Nordisk’s filling capacity from 2026 and onwards.”

As for the rest of Catalent — nearly 50 other sites employing thousands of workers — Novo Holdings will take control. The group previously acquired Altasciences in 2021 and Ritedose in 2022, so the Catalent deal builds on a core investing interest in biopharma services, Novo Holdings CEO Kasim Kutay told Endpoints News.

Kasim Kutay

When asked about possible site closures or layoffs, Kutay said the team hasn’t thought about that.

“That’s not our track record. Our track record is to invest in quality businesses and help them grow,” he said. “There’s always stuff to do with any asset you own, but we haven’t bought this company to do some of the stuff you’re talking about.”

What does it mean for Catalent’s customers? 

Until the deal closes, Catalent will operate as a standalone business. After it closes, Novo Nordisk said it will honor its customer obligations at the three sites, a spokesperson said. But they didn’t answer a question about what happens when those contracts expire.

The wrinkle is the long-term future of the three plants that Novo Nordisk is paying for. Those sites don’t exclusively pump out Wegovy, but that could be the logical long-term aim for the Danish drugmaker.

The ideal scenario is that pricing and timelines remain the same for customers, said Nicole Paulk, CEO of the gene therapy startup Siren Biotechnology.

Nicole Paulk

“The name of the group that you’re going to send your check to is now going to be Novo Holdings instead of Catalent, but otherwise everything remains the same,” Paulk told Endpoints. “That’s the best-case scenario.”

In a worst case, Paulk said she feared the new owners could wind up closing sites or laying off Catalent groups. That could create some uncertainty for customers looking for a long-term manufacturing partner.

Are shareholders and regulators happy? 

The pandemic was a wild ride for Catalent’s stock, with shares surging from about $40 to $140 and then crashing back to earth. The $63.50 share price for the takeover is a happy ending depending on the investor.

On that point, the investing giant Elliott Investment Management is satisfied. Marc Steinberg, a partner at Elliott, called the agreement “an outstanding outcome” that “clearly maximizes value for Catalent stockholders” in a statement.

Elliott helped kick off a strategic review last August that culminated in the sale agreement. Compared to Catalent’s stock price before that review started, the deal pays a nearly 40% premium.

Alessandro Maselli

But this is hardly a victory lap for CEO Alessandro Maselli, who took over in July 2022 when Catalent’s stock price was north of $100. Novo’s takeover is a tacit acknowledgment that Maselli could never fully right the ship, as operational problems plagued the company throughout 2023 while it was limited by its debt.

Additional regulatory filings in the next few weeks could give insight into just how competitive the sale process was. William Blair analysts said they don’t expect a competing bidder “given the organic investments already being pursued at other leading CDMOs and the breadth and scale of Catalent’s operations.”

The Blair analysts also noted the companies likely “expect to spend some time educating relevant government agencies” about the deal, given the lengthy closing timeline. Given Novo Nordisk’s ascent — it’s now one of Europe’s most valuable companies — paired with the limited number of large contract manufacturers, antitrust regulators could be interested in taking a close look.

Are Catalent’s problems finally a thing of the past?

Catalent ran into a mix of financial and operational problems over the past year that played no small part in attracting the interest of an activist like Elliott.

Now with a deal in place, how quickly can Novo rectify those problems? Some of the challenges were driven by the demands of being a publicly traded company, like failing to meet investors’ revenue expectations or even filing earnings reports on time.

But Catalent also struggled with its business at times, with a range of manufacturing delays, inspection reports and occasionally writing down acquisitions that didn’t pan out. Novo’s deep pockets will go a long way to a turnaround, but only the future will tell if all these issues are fixed.

Kutay said his team is excited by the opportunity and was satisfied with the due diligence it did on the company.

“We believe we’re buying a strong company with a good management team and good prospects,” Kutay said. “If that wasn’t the case, I don’t think we’d be here.”

Amber Tong and Reynald Castañeda contributed reporting.

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Petrina Kamya, Ph.D., Head of AI Platforms at Insilico Medicine, presents at BIO CEO & Investor Conference

Petrina Kamya, PhD, Head of AI Platforms and President of Insilico Medicine Canada, will present at the BIO CEO & Investor Conference happening Feb….

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Petrina Kamya, PhD, Head of AI Platforms and President of Insilico Medicine Canada, will present at the BIO CEO & Investor Conference happening Feb. 26-27 at the New York Marriott Marquis in New York City. Dr. Kamya will speak as part of the panel “AI within Biopharma: Separating Value from Hype,” on Feb. 27, 1pm ET along with Michael Nally, CEO of Generate: Biomedicines and Liz Schwarzbach, PhD, CBO of BigHat Biosciences.

Credit: Insilico Medicine

Petrina Kamya, PhD, Head of AI Platforms and President of Insilico Medicine Canada, will present at the BIO CEO & Investor Conference happening Feb. 26-27 at the New York Marriott Marquis in New York City. Dr. Kamya will speak as part of the panel “AI within Biopharma: Separating Value from Hype,” on Feb. 27, 1pm ET along with Michael Nally, CEO of Generate: Biomedicines and Liz Schwarzbach, PhD, CBO of BigHat Biosciences.

The session will look at how the latest artificial intelligence (AI) tools – including generative AI and large language models – are currently being used to advance the discovery and design of new drugs, and which technologies are still in development. 

The BIO CEO & Investor Conference brings together over 1,000 attendees and more than 700 companies across industry and institutional investment to discuss the future investment landscape of biotechnology. Sessions focus on topics such as therapeutic advancements, market outlook, and policy priorities.

Insilico Medicine is a leading, clinical stage AI-driven drug discovery company that has raised over $400m in investments since it was founded in 2014. Dr. Kamya leads the development of the Company’s end-to-end generative AI platform, Pharma.AI from Insilico’s AI R&D Center in Montreal. Using modern machine learning techniques in the context of chemistry and biology, the platform has driven the discovery and design of 30+ new therapies, with five in clinical stages – for cancer, fibrosis, inflammatory bowel disease (IBD), and COVID-19. The Company’s lead drug, for the chronic, rare lung condition idiopathic pulmonary fibrosis, is the first AI-designed drug for an AI-discovered target to reach Phase II clinical trials with patients. Nine of the top 20 pharmaceutical companies have used Insilico’s AI platform to advance their programs, and the Company has a number of major strategic licensing deals around its AI-designed therapeutic assets, including with Sanofi, Exelixis and Menarini. 

 

About Insilico Medicine

Insilico Medicine, a global clinical stage biotechnology company powered by generative AI, is connecting biology, chemistry, and clinical trials analysis using next-generation AI systems. The company has developed AI platforms that utilize deep generative models, reinforcement learning, transformers, and other modern machine learning techniques for novel target discovery and the generation of novel molecular structures with desired properties. Insilico Medicine is developing breakthrough solutions to discover and develop innovative drugs for cancer, fibrosis, immunity, central nervous system diseases, infectious diseases, autoimmune diseases, and aging-related diseases. www.insilico.com 


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Another country is getting ready to launch a visa for digital nomads

Early reports are saying Japan will soon have a digital nomad visa for high-earning foreigners.

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Over the last decade, the explosion of remote work that came as a result of improved technology and the pandemic has allowed an increasing number of people to become digital nomads. 

When looked at more broadly as anyone not required to come into a fixed office but instead moves between different locations such as the home and the coffee shop, the latest estimate shows that there were more than 35 million such workers in the world by the end of 2023 while over half of those come from the United States.

Related: There is a new list of cities that are best for digital nomads

While remote work has also allowed many to move to cheaper places and travel around the world while still bringing in income, working outside of one's home country requires either dual citizenship or work authorization — the global shift toward remote work has pushed many countries to launch specific digital nomad visas to boost their economies and bring in new residents.

Japan is a very popular destination for U.S. tourists. 

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This popular vacation destination will soon have a nomad visa

Spain, Portugal, Indonesia, Malaysia, Costa Rica, Brazil, Latvia and Malta are some of the countries currently offering specific visas for foreigners who want to live there while bringing in income from abroad.

More Travel:

With the exception of a few, Asian countries generally have stricter immigration laws and were much slower to launch these types of visas that some of the countries with weaker economies had as far back as 2015. As first reported by the Japan Times, the country's Immigration Services Agency ended up making the leap toward a visa for those who can earn more than ¥10 million ($68,300 USD) with income from another country.

The Japanese government has not yet worked out the specifics of how long the visa will be valid for or how much it will cost — public comment on the proposal is being accepted throughout next week. 

That said, early reports say the visa will be shorter than the typical digital nomad option that allows foreigners to live in a country for several years. The visa will reportedly be valid for six months or slightly longer but still no more than a year — along with the ability to work, this allows some to stay beyond the 90-day tourist period typically afforded to those from countries with visa-free agreements.

'Not be given a residence card of residence certificate'

While one will be able to reapply for the visa after the time runs out, this can only be done by exiting the country and being away for six months before coming back again — becoming a permanent resident on the pathway to citizenship is an entirely different process with much more strict requirements.

"Those living in Japan with the digital nomad visa will not be given a residence card or a residence certificate, which provide access to certain government benefits," reports the news outlet. "The visa cannot be renewed and must be reapplied for, with this only possible six months after leaving the countr

The visa will reportedly start in March and also allow holders to bring their spouses and families with them. To start using the visa, holders will also need to purchase private health insurance from their home country while taxes on any money one earns will also need to be paid through one's home country.

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