My Largest Personal Investment

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 bestselling book Beating the Street. (This is one of the best books about investing out there, by the way, along with One Up on Wall Street. My well-thumbed hardcovers have made me a lot of money over the years.) 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. (More on why below…)

I’ve been an enthusiast of these things for years. I first wrote about them in 2005 in my Capital & Crisis newsletter.

You would think such opportunities would close with all this coverage. Yet nearly every year, new deals crop up and the opportunities persist. I have a few hunches why more people still don’t buy these. Part of it is that they seem boring. Part of it is the payoff doesn’t often come right away. I earned 38% over the course of a full year. Sometimes it might take a little longer. Ideally, you should look at these as three-year holds. And part of it is simply that people have prejudices that prevent them from buying.

So what am I talking about? I’m going to tell you, but I want you to keep reading even if, initially, the idea has no appeal to you. It’s important you understand the full story before you pass judgment.

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. As Klarman writes:

“The preexisting net worth of the institution joins the investors’ own funds, resulting immediately in a net worth per share greater than the investor’s own contribution… In a very real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free.”

Peter Lynch called it the “hidden-cash-in-the-drawer rebate.”

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.

It’s pretty simple. You get a bank at a big discount to book value – a book value that includes a whole 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…

First, new thrifts have to follow some rules. One is that they can’t sell for three years. This is why I said 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. (Lynch tells the story of Morris County Savings Bank. It went public at $10.75 per share and sold three years later for $65.)

Of course, you don’t have to wait three years. I made my 38% in one year and I could sell if I wanted, but I’m content to let the investment story play out. My thrift still trades for less than book value. And more good things can happen after that first year – and this gets us to our second point.

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.

So after one year, if the thrift trades for less than book value, a stock buyback is likely the best use of cash. And many thrifts do implement buybacks. In the last quarter of 2010 alone, five different thrifts announced buybacks of 5-10% of their shares.

The third point is 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.

Finally, one last point before we look at specific opportunities: There are no free lunches. Even here. That is to say you have to be careful which thrifts you buy. Some thrifts come with problems and risks you probably don’t want to take. Remember the 1980s? Charles Keating in handcuffs? The S&L crisis? Lots of thrifts got in trouble doing all kinds of stupid things. Greedy guys always manage to ruin a good thing. You can easily avoid the problems with a little attention upfront to some key details.

Peter Lynch goes through some of his favorites in his book, and I’ve relied on his guidance when investing in these things over the years. There is a certain kind of thrift we want to own to increase our odds of success. Lynch calls them the “Jimmy Stewarts.”

Surely, you’ve seen the classic It’s a Wonderful Life, in which Jimmy Stewart plays the part of a humble banker at an old savings and loan. Lynch wants to find the Jimmy Stewarts. The no-frills, low-cost neighborhood thrifts that make old-fashioned mortgage loans. They don’t have splashy advertising. They don’t pay to have their names on stadiums. Their branches don’t look like Greek temples.

So the first thing we want to pay attention to is the loan portfolio. We want low-risk loans, like simple old-fashioned mortgages. We don’t want a lot of construction loans or anything that smacks of high finance. We also want to look at nonperforming loans (stuff that’s gone bad) as a percent of assets. Ideally, we want low numbers, like 2%.

Second, we want to look at financial strength. We want lots of equity. This is usually not hard to find with recently converted thrifts because they just went public and have lots of cash. It’s pretty common to find ones with equity to assets of 13% or 17%, or even 20%. For perspective, the nation’s biggest banks – the JP Morgans and Citis – have ratios of 5% or 6%. (And that’s surely overstated, given all the off-balance sheet stuff. More likely, they have ratios of 1% or 2%.) This is why they are always getting in trouble. They operate with huge leverage. Thrifts are financially strong.

We also want to look at book value. Ideally, we want to buy for less than book value for all the reasons I went through above.

As Lynch advises, “Pick five S&Ls that fit the Jimmy Stewart profile, invest an equal amount in each of them and await the favorable returns. One S&L would do better than expected, three OK and one worse and the overall result would be superior to having invested in an overpriced Coca-Cola or a Merck.”

This is the plan I am implementing for the subscribers of Mayer’s Special Situations. I don’t expect this opportunity to be around forever, but it is around for the moment.


Chris Mayer
for The Daily Reckoning

The Daily Reckoning