How I Made 38.2% Gains with “Thrift Conversions”

I’m going to share with you something that I have put a good deal of my own money into. In fact, I have more money invested here than in anything else — about 40% of my personal investment account at the moment.

Last year, I made 38.2% in these low-risk special situations — easily whipping the market’s 13% return.

It was some of the easiest money I’ve made in my investing career. I’ll tell you how you can do the same thing.

I’d like to call these special situations one of the market’s best-kept secrets. Though many people still don’t understand the basic mechanics, or even know these opportunities exist at all, the truth is that these aren’t really secrets.

Investing great Peter Lynch wrote two chapters about them in his best-selling book Beating the Street. Lynch called the idea a “can’t-miss proposition (almost).”

And Seth Klarman, another famous and skilled investor, has a chapter about them in his book Margin of Safety. Even the measured Klarman, a master of understatement, calls this special situation “a compelling investment opportunity.”

Heck, even Barron’s recently called these a “once-in-a-lifetime investment opportunity.” And that may be literally true, as the biggest opportunity in these ideas may disappear forever by the summer of this year.

I first wrote about them in 2005 in my Capital & Crisis newsletter. The timing wasn’t quite right to get in then. Now, finally, the timing is right…

I’m talking about thrift conversions. A thrift, or a savings and loan, is a bank. But it is a special kind of bank. It is a bank owned by its depositors. When a thrift goes public, it’s called a thrift conversion because the thrift is converting from a company owned by depositors to one owned by public shareholders. This process is what creates the investment opportunity.

Let me give you a simplified example.

Say we have a thrift worth $100. For simplicity’s sake, let’s just say that all of its assets are in cash and it has no liabilities. The thrift decides to convert to a public thrift. So it sells 10 shares at $10 each. Now it has $200 in cash and there are 10 shares outstanding.

But look at it from the investor’s point of view. He put $10 in, but he owns a stock backed by $20 of cash — $200 divided by 10 shares outstanding. Put another way, he owns a bank at 50% of book value, or net worth, per share.

In the real world, the values are not usually as extreme, but the idea is very much reality.

It’s pretty simple. You get a bank at a big discount to book value — a book value that includes a whole of bunch of fresh cash.

Most bank stocks over time gravitate toward book value, at least. What often happens to these thrifts is that they get bought out at premiums to book value. According to SNL, a research organization, about 59% of the 488 thrifts that have converted since 1982 have been bought out at a premium to book value. In recent years, the pattern is even stronger. Since 1995, 64% have been acquired.

The multiples paid are pretty good right now. In the last quarter of 2010, there were four pending acquisitions. The average multiple was 111% of book value. There was an additional transaction that closed in that quarter at a value of 148% of book value.

So now you can see the opportunity. If you pay even 80% of book value for a cash-rich thrift and it trades to just book value, you’ve got a 25% gain and you’ve taken very little risk. Of course, you can do much better. But there are a few points you need to understand…

• New thrifts have to follow some rules. One is that they can’t sell for three years. You should look at these investments as three-year holds. Ideally, you want to give the thrift time to ripen and give yourself a shot at maximum gains.

• New thrifts can’t buy back stock for at least one year. This is another important date in the life of a thrift — its one-year anniversary. After that, the thrift could use its ample cash to buy back stock at a discount to book value, thereby enriching the remaining shareholders even further.

Why buy these now? The reason is there are many new deals to choose from. After only a handful of conversions in 2009, things started to pick up in 2010. Last year, there were 23 deals completed and they raised $2.2 billion in capital. This year looks like another rich one for thrifts. There are 17 deals in the pipeline already.

The flurry of activity is due to uncertainty over the new financial overhaul bill, which would take effect this summer. It could mean the end of this long-running investment gold mine: the thrift conversion process. So many thrifts will try to convert before the summer and is something you should keep an eye on this year.

Sincerely,
Chris Mayer
Penny Sleuth

January 19, 2011

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How I Made 38.2% Gains with “Thrift Conversions” was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

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