Thrifty Opportunity

I have another homework assignment for the few of you that will take me up on it.

As I said yesterday, I can pretty much give away the keys to the bank stock kingdom without too much fear of a mass movement into bank stocks screwing up the opportunity. Most people simply are not going to do the work and many others are so addicted to the action of trading that their idea of buying something and sitting on it for a few years is just not emotionally comfortable, no matter how much money they might make.

The short-term fixation and need to run with the crowd that infects most individual investors makes my illiquid, inefficient sector of the market safe from invaders no matter how often I hang out the welcome sign and draw the map.

Today, I want to reintroduce the subject of thrift conversions. Investing in thrift conversions has been one of the most profitable endeavors of my career and the vast majority of my current holdings once went through the conversion process. Mutual thrifts tend to be conservative, overcapitalized institutions and they do not change their stripes that much once they go public. The vast majority are just well-run little banks and post-offering can usually still be bought at a discount to tangible book value, presenting fantastic long term opportunities.

The idea of investing in thrift conversions has been touted by some pretty smart investors over the decades. Peter Lynch wrote about the idea in “One Up on Wall Street,” which was published back in 1990. Seth Klarman suggested that this approach to investing made a lot of sense for long-term investors in his book “Margin of Safety,” which was published back in 1991. It is not a huge secret, but it takes time to play out and requires some homework and digging to put into practice.

There will be a few thrifts that go through a conversion offering every year. It looks like there are seven in some stage of the registration process right now and five deals have been completed so far in 2015. If you can get shares in a thrift conversion IPO, do it. Every time. Always.

Odds are if you are not a depositor, you won’t be able to do it. But it still makes sense to buy after the initial pop when the stock settles down as the newly-converted thrifts are usually still trading between 80-90% of book value. The recent IPO of First Nowthwest Bancorp (FNWB) is a great example of this. Even after the move up from the IPO price, we still paid just 85% of book value in the aftermarket.

One of my favorite ways to invest in thrifts is to buy those banks that have done a partial conversion and the mutual holding company still owns the majority of the shares. This creates a situation where the public company is tremendously undervalued and, when the second-step conversion is eventually completed, the existing shareholders profit tremendously. As Klarman tells us in “Margin of Safety,” the math of conversions is compelling and that is especially so in banks that may undergo a second-step conversion in the future.

I am going to use a simplified version of the equation to walk you through how this works.

We have ABC Bancorp, which is 60% owned by the mutual holding company. The bank has $100 million in assets and 10 million shares. If the stock is trading at 80% of book value, then the stock is trading at $8. It files for a second-step IPO and the mutual holding company sell its 6 million shares at 80% of book value to the public, raising $48 million. Subtract 15% for related expenses and they add $40.8 million to the asset base. The investor who owned the $8 stock in a bank with a $10 book value now owns shares in a bank with a book value of $14.80. If the price-to-book value ratio remains stable at 80%, his or her shares will pop up to about $11.84 after the offering and he or she still owns a quality institution at a bargain price that is likely to appreciate further in the years ahead.

Right now there are 29 banks on my list of second-step conversion candidates. All of them trade at sizable discount to their fully-converted value. Ten have at least one known activist investor involved in the stock who is no doubt gently encouraging the board to move forward with an offering sooner rather than later. The majority of them are very small and you will require some time and effort to uncover the numbers. You will become very familiar with the SEC and FDIC websites as you go about the research process for these small thrifts. But if you do the work, you will find a lot of opportunities to become a lot wealthier over the next few years.

I have seen the weather map for this weekend. It is going to be hot with lots of thunderstorms all across the country. It’s a great weekend to find a cool spot and spend some time looking for the little bank stock that makes you very big money over time.

The Best Trade You Will Ever See

While everyone is debating the hot topics of the day, I have been digging through an enormous stack of spreadsheets, SEC and FDIC filings and other documents. While I am absolutely fascinated by the implications of the Trump candidacy and the drama and humor that adds to the campaign, disgusted by the news that one of baseball’s most storied franchises is accused of having cheated in a big way, and even marginally interested in the Fed statement, there is bigger game afoot. On May 15, new banking regulations went into effect that add a turbo charge to the community bank stock trade of the decade, and I want to make sure I uncover every possible opportunity.

On that day there were changes to the Small Bank Holding Company regulation that extended the size limit for these regulations. Now banks up to $1 billion of assets can qualify as small bank holding companies, up from the former limit of $500 million. Banks with total assets between $500 million and $1 billion will no longer be subject to BASEL III capital rules and reporting requirements. While that’s a welcome reduction in regulations, that’s not the real benefit in the status change.

The criteria are simple. In addition to asset size, in order to qualify bank holding companies must not be engaged in significant non-bank activities, have no significant off-balance sheet activities conducted through a non-bank subsidiary, and have no material amount of SEC-registered debt or equity securities outstanding. Determinations of the materiality of SEC-registered debt and equity securities are made on a case-by-case basis by the Board of the Federal Reserve, based on a number of factors to assess the complexity of a firm, and smaller banks easily pass the materiality test.

The real benefit of qualifying for small bank holding company status is that qualifying banks may use senior debt to finance up to 75% of the purchase price of an acquisition. According to the legislation policy statement, “The principal ongoing requirements are that a qualifying small bank holding company: (i) reduce its parent company debt in such a manner that all debt is retired within 25 years of being incurred; (ii) reduce its debt-to equity ratio to .30:1 or less within 12 years of the debt being incurred; (iii) ensure that each of its subsidiary insured depository institutions is well capitalized; and (iv) refrain from paying dividends until such time as it reduces its debt-to-equity ratio to 1.0:1 or less.”

This is gas on the M&A fire. Banks of $500-$600 million asset size want to grow in order to spread regulatory and technology costs over a greater asset base, and now they have a new tool to finance an acquisition. They do not want to surpass the $1 billion mark and lose the small bank holding company status, so they are going to looking at banks of around $350 million or less in assets. Reasonably priced banks of that size or lower are now on an M&A countdown. The odds of someone making an offer for these smaller institutions were high anyway. They are a lot higher now.

I have been digging through the record and databases looking for banks that fit into this size and valuation levels. Since they are small and have tiny capitalization, the search can be more difficult than normal, as very few conventional stock screens have databases that include these microscopic companies. I had to revert to my earlier, pre-screener days to do some digging and checking.

Here is what I have so far. There are 194 publicly traded banks with $350 million or less of assets. Publicly traded is optimistic, and some of them trade pretty much by appointment, but if you are patient you can usually buy a little of most of them. Of these, 142 trade for less than tangible book value right now; 129 of them have nonperforming assets that are 2% or less of total assets; 132 of them of them have equity to asset ratios over 10; 24 of them are well overcapitalized, with equity to asset ratios over 15. This is important, since we know from FJ Capital’s recent white paper that the more capital you have, the more potential acquirers are attracted. The sub-$350 million bank space is a fertile field of opportunity right now.

Of these little banks, 55 have an activist or known bank specialist as significant investor in their shares; 34 of these trade for less than book value. This is like being dealt aces in every hand during a poker tournament. You might not win every hand, due to a few bad breaks here and there, but you are going to win most of them and pile up a ton of money.

A friend asked why I would publish this and give away valuable information. All of these stocks are too small to mention publicly, so what I have really done is given you a massive homework assignment. Once you have the list, it will take weeks and maybe even months to buy shares of the target banks. It will take years for this strategy to play all the way out. The vast majority of people who read this will think about it for a minute and upon realizing just how much work it will take to reap the fantastic long-term profits I expect this to earn, will go back to parsing the punctuation of the Fed report and to drawing lines of charts of the leading stocks of the day.

For those who get it and are willing to do the work, the changes to the small bank holding company regulations represent one of the biggest investment opportunities of your lifetime.