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.