Earlier this year, I had written a number of articles on The Good Investors on investing in thrift conversions (see here, here, and here). An important part of my learning process on thrifts came from investing legend Peter Lynch, who is revered for his track record when managing the Fidelity Magellan Fund. From 1977 to 1990, Lynch generated an annualised return of 29%, nearly double that of the S&P 500 over the same period.
Although his investing book One Up on Wall Street is well-known and highly popular, Lynch actually wrote a few other lesser-known books on investing including Beating The Street. The latter is the source of what I learnt about investing in thrift conversions from Lynch.
Because Beating The Street is not widely known, and because I find studying thrift conversions as potential investments to be a fascinating activity, I thought it would be useful to share my notes from Beating The Street on how Lynch thought about investing in thrift conversions.
What’s shown between the two horizontal lines below, besides the section-headers, are direct quotes from Lynch’s book. Do note that the emphases are mine.
On investing in S&Ls (Savings & Loans institutions)
Prior to the 1980s, Golden West was one of the few S&Ls that was a public company. Then in a rash of stock offerings in meid-defcaded, hundreds of the formerly private thrifts, operating as “mutual savings banks,” went public more or less simultaneously. I acquired many of these for the Magellan Fund. I was so selective in my purchases during this period that anything that had the word “first” or “trust” in it, I bought. Once, I confessed to the Barron’s panel that I’d invested in 135 of the 145 thrifts whose prospectuses had landed on my desk. The response from Abelson was typical: “What happened to the others?”
There are two explanations for my indiscriminate and sometimes fatal attraction for S&Ls. The first is that my fund was so big and they were so small that to get enough nourishment out of them I had to consume large quantities, like the whales who are forced to survive on plankton. The second is the unique way that S&Ls came public, which made them an automatic bargain from the tart. (To learn how you, too, can get something for nothing, turn to page 215.)
On acquisition statistics for S&Ls
The experts at SNL Securities in Charlottesville, Virginia, who keep tabs on all the thrifts in existence, recently provided me with an update on what happened to the 464 S&Ls that came public after 1982. Ninety-nine of these were subsequently taken over by bigger banks and S&Ls, usually at a large profit to the shareholders. (The watershed example is the Morris County [New Jersey] Savings Bank. The initial offering price in 1983 was $10.75 a share, and Morris was bought out three years later for $65.) Sixty-five of the public traded S&Ls have failed, usually at a total loss to the shareholders. (I know this from personal experience because I owned several in this category.) That leaves 300 still in business.
On how to study an S&L
If you decide to pursue the subject of undervalued S&Ls – which to me is much more exciting than any trip to Hawaii – you’d be well advised to seek out the latest copy of The Thrift Digest at the local library or to borrow one from your broker. I borrowed mine from Fidelity.
I spent so much time with my nose in this book before dinner, during dinner, and after dinner that Carolyn began to refer to it as the Old Testament. The Old Testament in hand, I devised my own S&L scorecard, listing 145 of the strongest institutions by state and jotting down the following key details. This, in a nutshell, is everything you need to know about an S&L:
Current price
Self explanatory.
Initial offering price
When an S&L is selling below the price at which it came public, it’s a sign that the stock may be undervalued. Other factors, of course, must be considered.
Equity-to-assets ratio
The most important number of all. Measures financial strength and “survivability.” The higher the E/A, the better. E/As have an incredible range, from as low as 1 or 2 (candidates for the scrap heap) to as high as 20 (four times stronger than J.P. Morgan). An E/A of 5.5 to 6 is average, but below 5, you’re in the danger zone of ailing thrifts.
Before I invest in any S&L, I like to see that its E/A ratio is at least 7.5. This is not only for disaster protection, but also because an S&L with a high E/A ratio makes an attractive takeover candidate. This excess equity gives it excess lending capacity that a larger bank or S&L might want to put to use.
Dividend
Many S&Ls pay better-than-average dividends. When one of them meets all the other criteria and also has a high yield, it’s a plus.
Book Value
Most of the assets of a bank or an S&L are in its loans. Once you assure yourself that an S&L has avoided high-risk lending (see below), you can begin to have confidence that its book value, as reported in the financial statements, is an accurate reflection of the institution’s true worth. A lot of the most profitable Jimmy Stewarts are selling at well below book value today.
Price-Earnings ratio
As with any stock, the lower this number, the better. Some S&Ls with annual growth rates of 15 percent a year have p/e ratios of 7 or 8, based on the prior 12 months’ earnings. This is very promising, especially in the light of the fact that overall p/e of the S&P500 was 23 when I did this research.
High-Risk Real-Estate Assets
These are the common problem areas, especially commercial loans and construction loans, that have been the ruination of so many S&Ls. When high-risk assets exceed 5-10 percent, I begin to get nervous. All else being equal, I prefer to invest in an S&L that has a small percentage of its assets in the high-risk category. Since it’s impossible for the casual investor to analyse a commercial lending portfolio from afar, the safest course is to avoid investing in S&Ls that made such loans.
Even without The Thrift Digest, it’s possible to do your own calculation of high-risk assets. Check the annual report of the dollar value of all construction and commercial real estate lending, listed under “assets.” Then find the dollar value of all outstanding loans. Divide the latter into the former, and you’ll arrive at a good approximation of the high-risk percentage.
90-Day Non-performing assets
These are the loans that have already defaulted. What you want to see here is a very low number, preferably less than 2 percent of the S&L’s total assets. Also you’d like this number to be falling and not rising. An extra couple of percentage points’ worth of bad loans can wipe out an S&L’s entire equity.
Real Estate Owned
This is property on which the S&L has already foreclosed. The REO category, as it’s called, is an index of yesterday’s problems, because whatever shows up here has been written off as a loss on the books.
Since this financial “hit” has already been taken, a high percentage of real estate owned isn’t as worrisome as a high percentage of non-performing assets. But it’s worrisome when REO is on the rise.
S&Ls aren’t in the real-estate business, and the last thing they want is to repossess more condos or office parks that are expensive to maintain and hard to sell. In fact, where there’s a lot of ROE, you have to assume that the S&L is having trouble getting rid of it.
Why larger banks want to acquire S&Ls
An S&L with excess equity, excess lending capacity, and a loyal depositor base is a prize that commercial banks covet. Commercial banks can take in deposits only in their home states (this rule is changing, to some degree), but they can lend money anywhere. This is what makes taking over an S&L a very tempting proposition.
If I were the Bank of Boston, for instance, I’d be sending love notes to Home Port Bancorp of Nantucket, Massachusetts. Home Port has a 20 percent equity-to-assets ratio, making it perhaps the strongest financial institution in the modern world. It also has a captive island market with crusty New England depositors, who aren’t about to change their banking habits and run off to a new-fangled money-market fund.
Maybe the Bank of Boston doesn’t want to make loans on Nantucket, but once it acquires Home Port’s equity and its deposit base, it can use the excess lending capacity to make loans in Boston, or anywhere else around the country.
During 1987-90, a terrible period for S&Ls, more than 100 were acquired by larger institutions that saw the same sort of the potential the Bank of Boston ought to see in Home port. Banks and thrifts will continue to consolidate at a rapid rate, and with good reason. Currently , the U.S. has more than 7,000 banks, thrifts, and other assorted deposit takers – which is about 6,500 too many.
How an S&L’s business model works
An S&L needs loyal depositors to keep money in their savings and checking accounts. It needs to make money on that money by lending it out – but not to borrowers who default. And it needs low operating expenses in order to maximise its profits. Bankers like to live on threes and sixes: borrow money at 3, lend money at 6, play golf at 3.
Examples of S&Ls that Lynch recommended
GLACIER BANCORP
I’d opened my Glacier Bancorp file. The stock was selling for $12 a share, a 60 percent gain over the year before. This was a 12-15 percent grower selling at 10 times earnings – not a spectacular bargain, but there wasn’t much risk in it either.
Glacier Bancorp used to be called the First Federal Savings and Loan of Kalispell, and I wish they’d kept the old name. It sounded antiquated and parochial, which to me is always reassuring. I’d rather have antiquated and parochial than trendy and sophisticated, which usually means a company is desperate to improve its image.
I like companies that stick to business and let the images take care of themselves. There is this unfortunate tendency among financial institutions to take the “bank” out of their names and replace it with “bancorp.” I know what a bank is, but “bancorp” makes me nervous.
Anyway, whoever answered the phone at Glacier Bancorp in Kalispell told me they were having a retirement party for one of the officers, but they’d inform chairman Charles Mercord that I called. They must have dragged him out of the party, because a few minutes later Mercord called me back.
Asking a president or a CEO about a company’s earnings is a ticklish proposition. You’re not going to get anywhere by blurting out, “ What are you going to earn next year?” First you have to establish rapport. We chatted about the mountains. I said that the entire Lynch family had been to all the Western states to see the national parks, and that we loved Montana…
…Then I begin to slip in more serious investment-type questions, such as “What’s the population out there?” and “what’s the elevation of the town?,” leading up to the more substantive “Are you adding any new branches or standing pat with what you’ve got?” I was trying to get a sense of the mood at Glacier.
“Anything unusual in the third quarter?” I continued. “You made thirty-eight cents, I see.” It’s best to pepper these inquiries with bits of information, so that your source thinks you’ve done your homework.
The mood at Glacier Bancorp was upbeat. Non-performing loans were almost nonexistent. In all of 1991, this bancorp had had to write off only $16,000 in bad loans. It had raised its dividend for the 15th year in a row. It had just bought out two other thrifts with wonderful names: the First National Banks of Whitefish and Eureka, respectively
This is how many of the stronger S&Ls are going to speed up growth in the next few years. They are acquiring the valuable deposits of troubled and defunct S&Ls. Glacier can fold the First National of Whitefish into its own system and make more loans with the additional Whitefish deposits. It can also do more administrative cost-cutting, since two S&Ls together can live more cheaply than one.
“You’re building up a nice asset here,” I said, introducing the Whitefish subject. “I’m sure it’s a good move, accountingwise.” My only worry was that Glacier may have overpaid for its acquisition, a topic I approached obliquely. “I assume you had to pay way over book value for this,” I said, inviting Glacier’s president to admit the worst. But no, Glacier hadn’t overpaid.
We talked about Glacier’s 9.2 percent of commercial loans, the sole troubling statistic I’d gleaned from The Thrift Digest. If this had been a New England thrift, that high number would have scared me away, but Montana wasn’t Massachusetts. The Glacier president assured me that his S&L wasn’t loaning money to developers of empty office towers or unsalable vacation condos. Glacier’s commercial loans were mostly in multifamily housing, which was in great demand. Montana’s population was growing. Every year, thousands of escapees from California smog and taxes were taking up residence in the Big Sky, small government state.
SOVEREIGN BANCORP
In the November 25, 1991, issue of Barron’s, I came across an article entitled “Hometown Lender to the Well-Heeled.” It described how Sovereign Bancorp serves a wealthy element in southeastern Pennsylvania from its headquarters in Reading. I liked the part about how a bell goes off in a Sovereign branch every time a mortgage loan is approved.
This was not the only time in my career I was introduced to a stock by a weekly magazine. I checked the annual and the quarterlies. In every important category, Sovereign got good marks. Nonperforming loans were 1 percent of assets. Commercial and construction lending was 4 percent. Sovereign had set aside sufficient reserves to cover 100 percent of its nonperformers.
Sovereign had acquired two New Jersey thrifts from the Resolution Trust Corporation, which boosted its deposits and eventually would boost its earnings. To review some of the details, I called Jay Sidhu, Sovereign’s Indian-born president. We chatted about Bombay and Madras, which I’d visited the year before on a charity trip.
When we got around to serious subjects, Mr. Sidhu said that management was determined to “grow” the business by at least 12 percent a year. Meanwhile, based on the latest analysts’ estimates for 1992, the stock was selling at a p/e ratio of 8.
The only negative detail was that Sovereign had sold an additional 2.5 million shares in 1991. We’ve already discussed how it’s usually a good thing when a company buys back its shares, as long as it can afford to do so. Conversely, it’s a bad thing when a company increases the number of shares. This has the same result as a government printing more money: it cheapens the currency.
At least Sovereign wasn’t squandering the proceeds from its stock sale. It was using the proceeds to buy more troubled thrifts from the Resolution Trust.
Mr. Sidhu’s model for success, I was pleased to discover, was Golden West. Basically, he wanted to copy the penurious Sandlers by increasing loan originations and cutting expenses. With the payroll that Sovereign inherited from its recent acquisitions, the overhead was 2.25 percent, much higher than Golden West’s 1 percent, but Mr. Sidhu seemed devoted to bringing that down. The fact that he owned 4 percent of the stock gave him a considerable incentive to carry out this plan.
Instead of holding on to the mortgages as many thrifts do, Sovereign had decided to specialize in making loans and then selling them to packagers such as Fannie Mae or Freddie Mac. This strategy enabled Sovereign to get its money back quickly and plow it into new mortgages, profiting from the points and other upfront fees. The risk of owning the mortgages was transferred to others.
Even so, Sovereign was being very conservative in the kinds of loans it would approve. It was devoted to residential mortgages. It hadn’t made a single commercial loan since 1989. Its average residential loan didn’t exceed 69 percent of the value of the property on which the loan was made. The few bad loans were thoroughly investigated so that Sovereign could learn who or what went wrong and not repeat its mistakes.
As often happens in my conversations with companies, I learned something new from Sidhu. He described a sneaky method by which unscrupulous banks and S&Ls camouflage their problem loans. If a developer, say, asks to borrow $1 million for a commercial project, the bank offers him $1.2 million on the basis of an inflated appraisal. The extra $200,000 is held in reserve by the bank. If the developer defaults on the loan, the bank can use this extra money to cover the developer’s payments. That way, what has turned into a bad loan can still be carried on the books as a good loan—at least temporarily.
I don’t know how widespread this practice has become, but if Sidhu is right, it’s another reason to avoid investing in banks and S&Ls with large portfolios of commercial real estate
Why thrift conversions are such good bargains
Imagine buying a house and then discovering that the former owners have cashed your check for the down payment and left the money in an envelope in a kitchen drawer, along with a note that reads: “Keep this, it belonged to you in the first place.” You’ve got the house and it hasn’t cost you a thing.
This is the sort of pleasant surprise that awaits investors who buy shares in any S&L that goes public for the first time. And since 1,178 S&Ls have yet to take this step, there will be many more chances for investors to be surprised.
I learned about the hidden cash-in-the-drawer rebate early in my career at Magellan. This explains why I bought shares in almost every S&L and mutual savings bank (another name for the same sort of institution) that appeared on my Quotron.
Traditionally, the local S&L or mutual savings bank has no shareholders. It is owned cooperatively by all the depositors, in the same way that rural electric utilities are organized as co-ops and owned by all the customers. The net worth of a mutual savings bank, which may have been built up over 100 years, belongs to everyone who has a savings account or a checking account in one of the branches.
As long as the mutual form of ownership is maintained, the thousands of depositors get nothing for their stake in the enterprise. That and $1.50 will get them a glass of mineral water
When the mutual savings bank comes to Wall Street and sells stock in a public offering, a fascinating thing happens. First of all, the S&L directors who put the deal together and the buyers of the stock are on the same side of the table. The directors themselves will buy shares. You can find out how many in the offering circular that accompanies the deal.
How do directors price a stock that they themselves are going to buy? Low.
Depositors as well as directors will be given the opportunity to buy shares at the initial offering price. The interesting thing about this is that every dollar that’s raised in the offering, minus the underwriting fees, will end up back in the S&L’s vault.
This is not what happens when other kinds of companies go public. In those cases, a sizable chunk of the money is carted away by the founders and original shareholders, who then become millionaires and buy palazzi in Italy or castles in Spain. But in this case, since the mutual savings bank is owned by the depositors, it would be inconvenient to divvy up the proceeds from a stock sale to thousands of sellers who also happen to be buyers. Instead, the money is returned to the institution, in total, to become part of the S&L’s equity.
Say your local thrift had $10 million in book value before it went public. Then it sold $10 million worth of stock in the offering—1 million shares at $10 apiece. When this $10 million from the stock sale returns to the vault, the book value of this company has just doubled. A company with a $20 book value is now selling for $10 a share.
This doesn’t guarantee that what you’re getting for free will necessarily turn out to be a good thing. You could be getting a Jimmy Stewart S&L, or it could be a lemon S&L with inept management that’s losing money and eventually will lose all its equity and go bankrupt. Even in this can’t-lose situation, you ought to investigate the S&L before you invest in it.
The next time you pass a mutual savings bank or an S&L that’s still cooperatively owned, think about stopping in and establishing an account. That way, you’ll be guaranteed a chance to buy shares at the initial offering price. Of course, you can always wait until after the offering to buy your shares on the open market, and you’ll still be getting a bargain.
But don’t wait too long. Wall Street seems to be catching on to the cash-in-thedrawer trick, and the increase in stock prices of mutual savings banks and savings and loans that have converted to public ownership since 1991 is nothing short of remarkable. It’s been a bonanza almost anywhere you look, from one end of the country to the other.
In 1991, 16 mutual thrifts and savings banks came public. Two were taken over at more than four times the offering price, and of the remaining 14, the worst is up 87 percent in value. All the rest have doubled or better, and there are four triples, one 7-bagger, and one 10-bagger. Imagine making 10 times your money in 32 months by investing in Magna Bancorp, Inc., of Hattiesburg, Mississippi.
In 1992, another 42 mutual thrifts came public. The only loser in this group has been First FS&LA of San Bernardino, and it’s down a modest 7.5 percent. All the rest have advanced—38 of them by 50 percent or more, and 23 by 100 percent or more. These gains have come in 20 months!
Table 13-1. MUTUAL THRIFT AND SAVINGS BANK IPOs COMPLETED IN 1991†
Table 13-2. THE 10 BEST AND 10 WORST RESULTS: MUTUAL THRIFT AND SAVINGS BANK IPOs COMPLETED IN 1992
Table 13-3. THE 10 BEST AND 10 WORST PERFORMING MUTUAL THRIFT AND SAVINGS BANK IPOs COMPLETED IN 1993 THROUGH 9/30/93
There are two quadruples in the group—Mutual Savings Bank of Bay City, Michigan, and United Postal Bancorp in St. Louis. A portfolio of the five top performers taken together has produced a 285 percent return. Even a person who was unlucky enough to have chosen the five worst-performing thrifts that came public in 1992 has made 31 percent on his money through September 1993. Investing in the five worst has beaten the S&P 500 and most of the equity mutual funds.
Through the first nine months of 1993, another 34 mutual thrifts have come public, and in this shorter period the worst is up 5 percent, 26 are up 30 percent or better, 20 are up 40 percent or better, and 9 are up 50 percent or better. (All the above numbers were provided by the skillful crunchers at SNL Securities.)
From Asheboro, North Carolina, to Ipswich, Massachusetts, on the East Coast; from Pasadena, California, to Everett, Washington, on the West; from Stillwater, Oklahoma, to Kankakee, Illinois, to Rosenberg, Texas, in the middle, neighborhood S&Ls have been the best investments that hundreds of thousands of people have ever made. This is the ultimate example of how individual investors can succeed by ignoring companies that are widely held by institutions and by investigating what’s close to home. What could be closer to home than the local thrift where you keep your safety deposit box and your checking account?
An account in any one of these thrifts or savings banks entitles you to participate in the IPO if and when it happens, but you certainly aren’t required to do so. You can go to the meeting where the deal is explained to potential shareholders, see whether the insiders are buying the shares, read the prospectus to find out the book value, the p/e ratio, what the earnings are, the percentage of nonperforming assets, the quality of the loan portfolio, etc., and thus get all the information you need to make an informed decision. It’s an opportunity to take a close look at a local company—and it’s free. If you don’t like the deal, the organization, or the management, you simply don’t invest.
There are still 1,372 mutual savings banks that have not yet come public. Check to see whether any of these are located in your area. By opening a savings account in any of them, you’ll have the right to participate in the IPO when it happens. Sit back and await developments.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.