Get Ready for an Upswing in Thrift Conversions

 | Nov 08, 2012 | 11:48 AM EST  | Comments
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Last night was strangely peaceful. For the first time in months we could turn on the television without a constant barrage of campaign advertising and misinformation. Although I am sure the networks and local stations will miss the revenue, I am glad it's over.

I will be equally glad to see the end of the barrage of "how to invest now" columns and presentations that are flooding the media. It happens every election cycle, and it is equally silly every time. However you pick stocks or investments, keep doing what works. Regardless of whether these predictions will play out, all the information will show up in the financials. If you like growth stocks, buy shares in companies that are growing revenue, earnings and margins. If you are a value type, buy stocks that are worth far less than their intrinsic or asset value. I think you'll make more money and sleep better by reacting to what does happen rather than trying to predict what will happen.

I had a conversation with my friends at FJ Capital the other day -- and, as always, once the niceties were out of the way, the conversation focused on bank stocks. Andrew Jose, one of the partners of the banks-stock hedge fund, was kind enough to forward a copy of the firm's latest presentation and thinking. It was chock full of information about small-bank stocks, but one section really caught my attention. It focused on mutual thrift conversions, an investment strategy that has been successful for more than three decades now, no matter who has resided at 1600 Pennsylvania Avenue. I see no reason it why it won't continue being successful.

Mutual thrifts were formed decades ago to serve local communities. They are owned by depositors, not stockholders. Over time these institutions generated solid earnings, but they were limited by the nature of the institution, and it was difficult to deploy the capital and grow the thrift. Many decided to convert to state-chartered banks and issue stock to the public. It is a tightly regulated process that involves an appraisal and an initial public offering to the public. These are small banks that come public at a steep discount to their asset value, compared with that of larger institutions, and they have been a steady source of profits for astute investors.

Andrew sent over a table that had some useful information about thrift conversions over the past 22 years. It seems that the post-IPO banks trade at a discount to book value, and they have plenty of excess capital and very clean loan portfolios -- and because of this, the stocks have done very well. They also become very attractive takeover candidates. The average life span of a mutual thrift is pretty short. In the past two decades, more than 75% of mutual conversions were taken over within less than five years. In the past few years, I have seen former conversions taken over at a pretty good clip, with banks like Abington and Danvers taken over at large premiums to our purchase price.

Here's where it gets interesting. If you look at conversion deals that have been done since 2006, you'll see the takeover rate has declined sharply. Based on the information Andrew provided, it looks like there have been 80 conversions since 2006 and just five takeovers. The credit crisis hit all segments of the banking industry, and thrift conversions were not exempt. They withstood the storm better than most because of their more conservative approach to lending and high levels of capital, but they still took some hits. In addition, takeover activities slowed down to a near-coma as the focus for many banks became simple survival -- not growth. That's set to change over the next five years.

There are still substantial headwinds for the smaller banks. Regulatory costs and capital requirements will constrain top- and bottom-line growth. Real-estate markets are still struggling in many areas of the U.S. Small business, an important small bank customer, is still reluctant to expand in an uncertain environment. This all is more of a positive than a negative for our thrift-conversion stocks.

Although the group is not back to 2006 levels, there are signs it is stabilizing. As the focus for banking again turns towards growth, the easiest path will be to acquire smaller institutions with excess capital and clean loan portfolios. Given that high regulatory costs make it difficult to operate and profit, many of these former thrifts will find it easier to sell. Since the officers and directors tend to be large shareholders post-conversion, these deals stand to be done at solid premiums to book value and the current stock price.

The opportunity for the last six years' worth of thrift-conversion stocks is a huge subset of the trade of the decade. On Friday I will explore a couple of these banks that are worth exploring for long-term investors.

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