Last year, I shared my notes on investing in thrift conversions from investing legend Peter Lynch’s lesser-known book, Beating The Street. I credited Beating The Street as an important part of my education on thrifts.
There’s actually another book, from another investing legend, that also taught me about thrift conversions: Seth Klarman’s Margin of Safety. Klarman is the founder of Baupost Group, an investment firm that has generated a mid-teens annual return over more than four decades.
Because Margin of Safety is a rare book, and because I’m fascinated with thrift conversions from an investing angle, I thought it would be useful to share my notes from Margin of Safety.
What’s shown between the two horizontal lines below, besides the section-headers, are direct quotes from Klarman’s book.
Thrift IPOs have attractive economics for investors
A thrift institution with a net worth of $10 million might issue one million shares of stock at $10 per share. Again ignoring costs of the offering, the proceeds of $10 million are added to the institution’s preexisting net worth, resulting in pro forma shareholders’ equity of $20 million. Since the one million shares sold on the IPO are the only shares outstanding, pro forma net worth is $20 per share. The preexisting net worth of the institution joins the investors’ own funds, resulting immediately in a net worth per share greater than the investors’ own contribution…
…So long as the thrift has positive business value before the conversion, the arithmetic of a thrift conversion is highly favorable to investors. Unlike any other type of initial public offering, in a thrift conversion there are no prior shareholders; all of the shares in the institution that will be outstanding after the offering are issued and sold on the conversion. The conversion proceeds are added to the preexisting capital of the institution, which is indirectly handed to the new shareholders without cost to them. In a real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free.
Insiders in a thrift participate in the IPO at the exact same terms as public shareholders
Unlike many IPOs, in which insiders who bought at very low prices sell some of their shares at the time of the offering, in a thrift conversion insiders virtually always buy shares alongside the public and at the same price.
Thrifts that stray far from traditional mortgage lending are risky
Thrifts incurring high risks, such as expanding into exotic areas of lending or venturing far from home, should simply be avoided as unanalyzable. Thrifts speculating in newfangled instruments such as junk bonds or complex mortgage securities (those based on interest or principal only, for example) should be shunned for the same reason…
…This does not mean that investors could not profit from investing in risky institutions but rather that the potential return is not usually justified by the risk and uncertainty. Owing to the high degree of financial leverage involved in thrifts, there can be no margin of safety from investing in the shares of thinly capitalized financial institutions that own esoteric or risky assets.
The book value of a thrift is a low estimate of what an acquirer would pay
In evaluating such thrifts, book value is usually a low estimate of private-market value; most thrift takeovers occur at a premium to book value.
An example of a thrift conversion that looked attractive to Klarman
In June 1990 Jamaica Savings Bank converted from mutual to stock ownership through a newly formed holding company, JSB Financial (JSB)…
…At the time of the JSB conversion, the United States had experienced a nationwide real estate downturn. Estimates of the total cost of the thrift industry bailout were reaching as high as $500 billion…
…Organized in 1866 in New York, it had on December 31,1989, total assets of $1.5 billion and retained earnings of $197.1 million, a ratio of tangible capital to total assets of 13.5 percent prior to conversion. This was among the highest ratios in the country. Two-thirds of the assets of JSB were held in U.S. Treasury and other federal agencies’ securities or cash equivalents, while only 30 percent was in loans, virtually all residential mortgages…
…The economics of a thrift conversion are such that even with JSB’s obvious merits, the shares were offered to investors at only 47 percent of book value and a pro forma price/earnings multiple of ten times…
…One interesting way to evaluate the risk of investing in JSB was to consider that half the proceeds from the stock conversion, or $80 million, were to be retained at the holding company. This cash represented excess capital that could be used to repurchase JSB shares subsequent to the public offering. If the cash had been used in its entirety to repurchase JSB shares at two-thirds of book value (a 40 percent premium to the Ira price), the company could have repurchased one-third of the shares of JSB that had just been issued. While most shareholders might have chosen not to sell at that price, the effect of such a program would almost certainly have been to raise the price of JSB shares. In fact, the pro forma book value per share, adjusted to reflect this hypothetical repurchase, would have increased from $21.12 to $25.00, an 18 percent increase. This illustrates the opportunity to investors of owning a thrift that is financially capable of and willing (as JSB indicated it was) to repurchase its shares cheaply.
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