Peter Lynch on Thrift Conversions
One of the all-time investing greats on thrifts and what he looks for
If I didn’t say it before, happy new year to you and thanks for reading Conversion Confidential!
Peter Lynch is rightfully considered one of the best investors ever. According to Wikipedia, “as the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than double the S&P 500 stock market index and making it the best-performing mutual fund in the world.”
But did you know Peter Lynch was a major advocate for, and personally invested in thrift conversions? He was. He did. In fact, he was one of those depositors that would open savings accounts at thrifts all around the country in the hopes that they would one day convert to publicly owned entities.
If readers any have experience doing this, please leave a comment below. I have yet to personally take this approach and would appreciate hearing from those of you who have. Do you scatter deposits at any institution that will have you? Do you stay within your state? Do you target a list of thrifts you believe have a higher probability of converting, and if so, how do you come to that conclusion pre-conversion?
Throughout the 1990s, Lynch authored a number of articles for Worth Magazine, many of which addressed thrift conversions. In my opinion, these articles are worthwhile reading in their entirety and can be found here for those interested. For the purposes of Conversion Confidential, I’ve gone through the 180+ pages and highlighted my favorite quotes on thrifts which provide guidance from the master himself on how to approach this niche investing space. I think it’s fair to conclude the investment approach to thrift conversions largely remains the same, but that’s for you to decide. Enjoy!
Conversions are the rare exception where the little guy gets to buy shares at the initial offering price. In nearly any other kind of IPO, the Wall Street gorillas (institutions, mutual funds) grab all the shares, while the average person is shut out. I often wonder why we bother to call these events public offerings at all; generally, the public has nothing to do with them. But the offerings of savings banks are truly democratic.
A normal company has founders, early investors, and venture capitalists, all of whom claim a share of the proceeds from a stock sale when the company goes public. But a mutual savings bank has only depositors. There are no sellers to compensate. Officers and directors may get free stock, as we've noted, but all the cash that's raised in the offering, minus the underwriting fee, is returned to the company till.
It's hard to think of another transaction where the value of the merchandise doubles the minute it changes hands. Imagine it this way. You've just paid $10,000 in cash for a new car and driven it home, where you open the glove compartment and discover your $10,000 has been placed there, along with a note from the car dealer: "We don't need this. You keep it."
Is it any wonder then, that the stock price of a mutual savings bank rises quickly as soon as it starts trading on the open market? Indeed, first-day gains average more than 30 percent…The initial price surge is usually followed by a second, more gradual increase. On average, the 384 thrifts that trade on the major exchanges sell for 104 percent of book value in today's market. Usually, it takes the newer conversions several months or even years to reach this plateau. Investors who miss out on the quick 30 percent profit from the offering can get in on the next 50-70 percent by purchasing shares later.
In spite of the built-in advantage of cash in the drawer, it's a mistake to think that one savings bank is as good as another. Some are highly profitable, others less. Some have "clean" loan portfolios; others are plagued with defaults and foreclosures. While most are solvent, a few of the shaky ones are forced into conversion by the government so they can meet minimal capital requirements with the infusion of new money. These so- called supervisory conversions can be hazardous to investors. I wouldn't invest in any thrift without asking some basic questions.
Is there enough equity? You want to see a high equity-to-assets ratio. If a bank lacks sufficient equity, it puts itself in a precarious situation with regulators and becomes a candidate for bailout or liquidation. The S&L; casualties of the 1980s didn't have enough equity to cover the losses from bad loans. Some thrifts, because they've retained a lot of earnings over the years and haven't been aggressive about making loans, have ratios of 10 or even 20 or more.
A couple good things can happen to a bank that's cash rich. The more equity it has, the more loans it can make; the more loans it makes, the more it increases its earnings. Or if it doesn't want to make loans, it can invest the money in Treasury bills and earn a nice living. Better yet, it can buy back its own stock. Fewer shares outstanding means more earnings per share, more book value per share, and a higher stock price.
Is there a high-quality portfolio of loans? Bad loans, a.k.a. nonperforming assets, can break a bank very quickly as it channels more money into its loss reserves and into the management of properties in foreclosure. I look for thrifts that have a low percentage of nonperformers. Less than 0.5 percent is comforting.
Nonperforming assets above 0.5 percent should make you wonder just what this thrift has been up to. Another profitable exception: A very strong equity-to-assets standing gives a thrift a couple of ways to clean up a nonperforming-assets problem. It can write off the bad loans without too much damage to its equity-to-assets ratio. It can even sell the loans at 50 cents on the dollar and put the proceeds to work creating earnings.
Is the thrift making money? The common measure of a bank's profitability is return on assets. I'd be wary of investing in any thrift that is losing money (zero or negative earnings) at the time it goes public.
Healthy thrifts and banks have a return on assets of at least 1 percent. There is, however, a potentially profitable exception. Say a thrift's return on assets is low, maybe even below zero, but is moving up. Take a quick look at the equity-to-assets ratio. If it's high, you may have found a rewarding combination.
What's the book value?
Corporate insiders are not known to be self-destructive. They don't buy company stock unless they expect to make money on it. So when you pay the same price they do, you're in with the right crowd.
I also look for a couple of other things. If a bank owns its own branches, it's a plus. Real estate is carried on the books at cost and can be a valuable hidden asset. Another plus is what bankers call cheap deposits. A bank that has few branches and large concentrations of deposits tends to be more cost effective than one with many branches and smaller deposits.
During 1.5 years out of every 10, on average, we get an inverted yield curve, when short rates are high and long rates are low. This is a calamity for banks. So it may be that the steady upward rise in bank stock prices will be interrupted sooner or later. But long-term there's another reason to be bullish: consolidation. In the past five years, nearly 37 percent of the thrifts and savings banks have been acquired through mergers and buyouts. When this happens, the stock prices are pushed to a third tier, far above book value. Even with the buyouts temporarily put on hold, consolidation is inevitable because we have too many deposit takers in this country. By acquiring smaller banks and thrifts, they can expand their deposit bases and eventually increase their earnings.
I've always found the biggest bargains in the thrift group in regions that are recovering from recession. But you have to be careful to buy the ones where loan delinquencies are in decline, and where the situation--the health of both the bank and the community or region--is getting better and not worse.
A special note about so-called "mutual holding companies." A small number of thrifts have adopted this form of organization because it allows them to sell a minority interest in the business, with the insiders keeping permanent control and preventing a potential takeover. These deals are less attractive for investors. The real earnings power and real book value of the banks are understated, and the stocks don't have much lift.
In the long run, what keeps me interested in the banking and thrift business is the likelihood of future takeovers and mergers. We don't need all these separate buildings, software systems, boardrooms, and highly paid administrators. Every time a thrift is taken over, the acquiring bank can cut costs upstairs and increase productivity downstairs. The acquiring bank can make better use of the thrift's deposits by lending them to a wider range of borrowers over a larger geographical area and by making numerous types of loans where they have a lot of experience and expertise. The entire industry will become more efficient.
On this page is a 1997 research list containing ten new names. Of these, I own Ambanc and Cameron Financial.
There you have it, wise words from Peter Lynch himself. If thrift conversions were good enough to have a place among Lynch’s portfolio, they’re good enough for me (assuming carefully selected of course). That’s it for this week, thanks for reading!
Thanks for sharing Lynch’s take on thrift conversions. I’m one of those people who opened accounts around the U.S. When interest rates were better, I’d collect healthy interest from the CD’s and savings. Taxes were a little annoying, but worth it. The conversions and subsequent takeovers have been a lot of fun and profitable. I’ve never completely sold out and hold 32 publicly traded banks. I was always surprised that more people didn’t put forth effort or have the patience to give this a try.