Thrift Investing

Good morning to all new subscribers. Every week I write about off the beaten path investing ideas. I like to invest in bombed out industries. Stocks no one else is talking about. And companies Wall Street hedge funds can’t touch. My favorite stocks are the ones trading at multi-decade lows with one last puff.

Today I am writing about investing in mutual banks or thrifts. A sub-sector of community banks that are so tiny and obscure that many investors don’t even know they exist. But before we get into thrift investing, first a word from today’s sponsor…

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Thrift Investing

Ten years ago on I was a flight across the country. Headed to the West Coast of America for the first time in my life. I built a small reputation on stock message boards as a value investor and met someone ten years my senior on these boards. Over the course of a few months we would exchange investing ideas and have weekly chats about stocks on the phone. He was a successful investor who managed his own money. I was a fresh college kid trying to break into the buyside with $5,000 to my name.

One afternoon he ended up calling me and asked if I was going to some big time investing conference on the West Coast. I told him I wasn’t and he asked if I wanted to go. He then bought me a plane ticket and put me up in a hotel with all of my expenses paid for that week. All he said was, “when you become successful like me pay it forward to a hungry kid with ambition to learn”. While we don’t talk much anymore he was a key mentor for me in my early days of learning how to invest and finding my style.

Going to that conference was instrumental in developing my style as an investor. I met with dozens of management teams and sat in various presentations. It was a great learning experience that I recommend to any newbie investor. But the greatest learning experience was the after conference networking event.

This is the scene: a bunch of old white portfolio managers drinking wine, liquor and craft beers while women in cocktail dresses walk around with hors d'oeuvres. If your hand is empty they immediately place another glass of the best wine in it while the sun sets over the coast.

I naturally ended up finding my way into a circle of younger guys and a couple of girls. We got to talking about the industry and a few stocks. I was way out of my league. They were all top MBA students and working through the CFA. Investment banking backgrounds and well connected. I came from an untraditional finance background and had a small reputation on stock message boards under a pseudonym.

We got to talking about stocks we like. They talked about Facebook, Apple, Tesla and all of the big named companies. When it came to me I told them I invest in net-nets and mutual thrift conversions. Their faces glossed over as they had no idea what I was talking about. Second-step conversion and buying assets under their net current asset value? They don't teach you that stuff in the CFA or any MBA course that I know about.

That is when I knew I could have an edge. If I focused on the smallest most undervalued companies out there I could standout from guys coming from the more traditional finance background. The goal was to focus on a niche area in the investing scene where I could put capital to work, while taking less risk than my peers, and generating attractive returns.

Which brings me to mutual thrift investing. A small niche in the community bank investing world where outsized returns are generated while taking minimal risk. And it is actually quite simple once you have a basic understanding of the opportunity.

I’ll try to explain it as simple as possible:

• Mutual banks are owned by the depositors and not investors. Overtime some mutual banks end up converting into a publicly traded corporation. This is done for one reason: to get cash on the balance sheet. Cash is then used to grow the bank by making more loans, investing in securities, buying other banks, upgrading the banks technology system or providing the management team with a nice cash bonus at retirement.

• The banks that go through a mutual conversion are typically in small towns in the United States and have market caps under $100 million. This prices out almost every institutional investor based on pure size alone. In addition, most retail investors don’t touch them because they are very boring.

• When the banks convert they are over capitalized with an excess amount of cash on their balance sheet. This makes the return on equity look poor. Despite the poor return on equity, they typically trade under tangible book value. The cash rich balance sheet combined with an asset trading under tangible book value provides a strong margin of safety, limiting downside for the investor.

• After a conversion the banks typically have too much cash and can’t put it all to work. Due to arcane rules, banks must wait one year after a full conversion to start buying back stock and doing dividends. After this year passes most banks begin to buy back large blocks of stock while paying quarterly dividends as it is almost impossible to allocate the IPO proceeds to more loans in a town of 10,000.

• Three years after a conversion the bank is allowed to sell themselves. 70% of mutual banks that have converted ended up selling themselves. Strong franchises usually go for 140% of tangible book value. Less attractive mutual banks sell for at least 100% of tangible book value, or liquidation value.

• Selling a mutual bank is usually a way for a small town banker to get a nice payout. Executives typically own stock in the converted bank and have a change of control agreement where their options are exercised and a bonus is paid if the company is sold. It isn't atypical for a CEO to receive over $5 million from the sale in the form of bonuses. This is a great retirement package in small town America.

• Mutual banks have outperformed the market through all cycles. Even during the 2008 financial crises very few of them had issues with their loan book or went bankrupt and/or bailed out by TARP funding. Their balance sheet is conservative and most of their loans are to single family houses. It is the bread and butter of community banking, a niche and conservative business that generates predicable returns.

I’ll be spending a lot more time on mutual banks going forward. It is an interesting niche market for value investors who want to outperform while also preserving their own capital and taking minimal risks. There are also a handful of activists making noise in the community banking space that we can coattail.

I’ve written up one name so far and plan to expand the coverage over the course of the next few months. If you are a paying subscriber and want to chat about tiny little banks head to the Telegram channel and post about some names you like. We recently started a channel dedicated to discussing community banks with goals to dive into the industry together.

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