A Gem of a Thrift Conversion
Recently converted thrift trades at 65% of book value, has lots of excess capital, pristine credit quality, is buying back meaningful amounts of its stock, and has consistent insider buying
Peter Lynch was known as a growth investor but one of the most consistent contributors to his results over the years was his investment in mutuals (banks owned by depositors) that converted into publicly traded corporations.
The effect of these thrift conversions is that — because there are no selling shareholders — the book value of the bank often doubles overnight.
A simple example: let’s say a mutually held thrift with $1 billion in assets and $100 million in equity sells 10 million shares to the public for $10 each to raise money and convert to a public company. The IPO raises $100 million of fresh capital (10m shares at $10 apiece). We now have a bank with $200 million of equity and 10 million shares outstanding (remember, there were no shares outstanding prior to the IPO as this was a mutual). Book value went from $100 million to $200 million and the book value per share is now $20 vs our $10 IPO price.
The book value doubled overnight because there are no selling shareholders: the money doesn’t accrue to owners but rather to the corporation itself.
In Beating the Street, Lynch summarized these thrift conversions using a metaphor:
“Imagine buying a house and then discovering that the former owners have cashed your check for the downpayment and left the money in an envelope in a kitchen drawer”.
You got all of your cash back and you still own the house. That is essentially what happens when a thrift converts: the buyers pay $10 for the $10 book value, but after closing they not just own the $10 of equity but also their additional $10 of cash is in the drawer (on the bank’s balance sheet to be used to grow earnings or often just returned back to you through buybacks and dividends).
Lynch wasn’t the only one who invested in these “thrift conversions”. Seth Klarman, Joel Greenblatt, Walter Schloss and many other value investors made recurring profits buying these discounted small banks.
Klarman even devoted an entire chapter to thrift conversions in his famous book Margin of Safety. And Greenblatt had a case study on one (highlighted here by my friend, Dirt Cheap Stocks).
These thrift conversions produced great results in the 1980’s and 1990’s. Again from Lynch in Beating the Street:
“In 1991, 16 mutual thrifts and savings banks came public. Two were taken over at more than 4 times the offering price, and of the remaining 14, the worst is up 87%. All the rest have doubled or better, and there are four triples, one 7-bagger, and one 10-bagger. Imagine making 10 times your money in 32 months by investing in Magna Bancorp, Inc., of Hattiesburg, Mississippi.”
I kind of prefer something like Bound Brook Building and Loan, which has been around since 1887, but I can’t argue with a 10-bagger.
Thrift conversions also performed very well between 2000-2010. The S&P 500 went nowhere during this 10-year period, which included the worst banking crisis since the Great Depression, but the SNL Thrift MHC Index (a basket of thrift conversions) returned 188% (source: The Zen of Thrift Conversions).
Excess returns in these stocks often are a result of their low starting valuation (often 70% of book value or cheaper) and their ultimate takeover price, which has averaged 140% of book value over the past 4 decades (source: Piper Jaffray 2016 paper on thrifts; Zen of Thrift Conversions).
Like most big market anomaly, thrifts began trading more efficiently in the last decade. But in 2023, bank stocks got hit hard when the Silicon Valley Bank effectively failed (and was taken over for literally 5 cents on the dollar by FCNCA, more here on the deal; FCNCA is interesting in its own right at 8 P/E with a quality management team and growth potential).
The bank run of 2023 hit stocks of small banks hard — especially those that tied up too much of their deposits in long-term, low interest mortgages. Many thrifts now trade below their $10 IPO price. To be clear, most of these banks should be avoided because of this duration mismatch, poor credit quality, too much leverage, or a combination of all three. Many of these banks are still too subscale to ever make decent returns on assets.
But there are a few bargains, and the small banks with stable deposit bases have real value to other banks that want to grow. There are true cost synergies when two small banks merge together, which improves a bank’s efficiency ratio — a bank’s non-interest expense as a percent of net revenue, or a measure of profit margins from the viewpoint of costs (lower efficiency ratio means higher profit margins, and this can often be achieved through combining, for example, two $1 billion banks and eliminating duplicate operating costs such as branch locations, technology costs, loan departments or even key executives — the combined bank doesn’t need two CEO’s, two CFO’s, two chief risk officers, etc…)
Ben Graham Basket
I wrote about Saber’s three categories of investments in this post. One of these categories is what I like to call our Ben Graham basket — stocks that sell at big discount to liquidation value or to what the assets are worth to an acquirer. I think of this basket as one investment in a collection of safe and cheap assets, and I let these stocks sit in the coffee can until either I determine I made an error or until we receive fair value, which might come through a takeover bid, a catalyst involving a merger, special dividend or buyback, or occasionally through random appreciation back toward fair value (I’ve often noticed cheapness is its own catalyst). Like Graham’s net net strategy, not all of these investments will work out, but as a group they offer nice safety and good risk/reward.
In this basket are a few small banks that I believe are worth twice the current market price to another bank. Mergers for banks with stable deposits and good assets typically take place at 120%-150% of book value. If you can find banks at 50-70% of book value (we have a few of these), there often is a great margin of safety.
It’s interesting how the market sometimes places no value on this call option that the bank will sell itself: one tiny bank last year called Midland Federal Savings & Loan traded around $5 and got a takeover bid at $31; MCPH is extreme (and unfortunately we did not own it at $5) but there are numerous deals each year where a bank takes over another bank at 50-100% premiums to where the stock traded the day before. We’ve invested in a few of these as merger arbitrage deals, including MCPH and MSVB, which closes this week at 1.5x tangible book value. Both offered IRR’s in the 20’s even after the deal was announced and approved by shareholders. Due to their small size, these small bank mergers can occasionally offer nice returns, but the big returns come from buying these banks for 50 cents on the dollar and waiting patiently to receive the dollar, which sometimes might grow to $1.50 or $2 over time.
My strategy here is to locate banks with a long history (I like looking for banks that have been around for 75 or even 100 years or more), a track record of quality loan making, stable deposits, insider ownership, and excess capital (which is very important for safety but can be used to grow earnings, buyback shares, or both). There are many other factors I look at (spending time poring over call reports on bankregdata.com is a favorite pastime of mine), but these are five musts.
I believe the stock we’ll discuss today is one such example. It has:
138 years old
Trades at 65% of tangible book value
Lots of excess capital (17% equity to assets with half the market cap in excess cash)
Is actively buying back shares (announced a 10% buyback with plans to continue as long as the discount persists)
Pristine credit quality with virtually no charge offs over the last decade
Management is conservative, long-term oriented, and is actively buying shares in the open market
I think the stock is worth twice what it currently trades for…