How to Bag 30-100% Returns by Hunting for Thrift Conversions. Plus a Real Example for Subscribers.

To paraphrase Peter Lynch, a thrift conversion is like buying a car for $10,000 and finding $10,000 in the glove compartment.

A Thrift Conversion (a.k.a. Mutual Conversion, Demutualization or mutual-to-common conversion), is the process by which a private, mutually/member owned bank transforms into a publicly run and owned company. It is a very unique special situation, with unique incentives to set the initial offering at a low price, and perhaps the only situation where you might want to buy into the IPO.

Thrift conversions typically appreciate 30% on the first day of trading and an additional 50-70% in the following 1-2 years.

For example, consider a hypothetical mutually owned community bank:

That has $70M in loans, $25M in cash, and $5M in real estate ($100M in total asset value).

It also has $85M in customer deposits and $5M in debt ($90M in total liabilities or obligations).

This leaves $10M in equity (similar to the equity a residential home: asset value - liabilities).

Now the bank goes public, and sells 10M shares for $1 each. The bank receives the proceeds, and essentially gains $10M in value overnight, all cash, which is added to the original equity value. So here you have a bank with a $10M market cap and $20M in equity. Or a bank that you can buy for 50% off.

The above hypothetical is what most thrift conversions look like in real life. Notable investors like Peter Lynch and Seth Klarman have both written chapters about this exact situation.

Peter Lynch offers my favorite description:

It’s hard to think of another transaction where the value of the merchandise doubles the minute it changes hands. Imagine it this way. You’ve just paid $10,000 in cash for a new car and driven it home, where you open the glove compartment and discover your $10,000 has been placed there, along with a note from the car dealer: “We don’t need this. You keep it.”

A normal company has founders, early investors, and venture capitalists, all of whom claim a share of the proceeds from a stock sale when the company goes public. But a mutual savings bank has only depositors. There are no sellers to compensate. Officers and directors may get free stock, as we’ve noted, but all the cash that’s raised in the offering, minus the underwriting fee, is returned to the company till.

Is it any wonder then, that the stock price of a mutual savings bank rises quickly as soon as it starts trading on the open market? Indeed, first-day gains average more than 30 percent… The initial price surge is usually followed by a second, more gradual increase. On average, the 384 thrifts that trade on the major exchanges sell for 104 percent of book value in today’s market. Usually, it takes the newer conversions several months or even years to reach this plateau. Investors who miss out on the quick 30 percent profit from the offering can get in on the next 50-70 percent by purchasing shares later.

Long-term there's another reason to be bullish: consolidation. In the past five years, nearly 37 percent of the thrifts and savings banks have been acquired through mergers and buyouts. When this happens, the stock prices are pushed to a third tier, far above book value. Even with the buyouts temporarily put on hold, consolidation is inevitable because we have too many deposit takers in this country. By acquiring smaller banks and thrifts, they can expand their deposit bases and eventually increase their earnings.

• Peter Lynch

Seth Klarman further clarifies:

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.

There is another unique aspect to thrift conversions. 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. Thrift conversions are the only investment in which both the volume and price of insider buying is fully disclosed ahead of time and in which the public has the opportunity to join the insiders on equal terms.

Investors should adjust book value upward, however, to reflect understated assets, such as appreciated investment securities, below-market leases, real estate carried below current worth, and the value of a stable, low-cost deposit base.

• Seth Klarman

Both investors highlight some key risks to be aware of:

• Thrifts that have high non-perfoming loans, or a poor loan book, ideally less than 0.5%.

• Thrifts barely meeting minimal capital requirements, and that are forced into conversion by the government to raise cash to do so.

• Low equity to assets, less than 10%.

• Not cash rich.

• Losing money.

• Return on Assets > 1%.

• High Price to book.

• No owned real estate to provide an asset buffer.

• Many branches with few deposits.

• Things are getting worse and not better.

• Exotic investments, in far-away places, or untested securities like junk bonds.

• Is a mutual holding company selling minority interest while retaining insider control a.k.a. a partial mutualization.

Now a gift for the subscribers who have made it this far.

If you are subscribed and like (or share) this post by Sunday, I will send you an example of a recent thrift conversion I have found that checks almost all the boxes.

✅ Low price to book of 0.66, compared to an industry average of 1, +50% appreciation expected.

✅Good, easy to understand loan book with NPLs below 0.5%.

✅High equity to assets, 31%.

✅Cash rich, 107M in cash on 111M of equity. Great potential for buybacks.

❌ Low ROA 0.25%, but improving.

✅New management team, improving the loan book and improving returns with higher interest commerical loans.

✅Hidden real estate assets.

✅ Full mutualization, not partial.

So if you are subscribed, like (or share) for an early Christmas present. I hear the stock certificates make a good stocking stuffer.

Further Reading:

Peter Lynch’s Articles in Worth Magazine: https://mcusercontent.com/3ac5a512537f3f8059c2cf8fe/files/fab8a2c4-3564-46e3-8703-0c94e1042fde/Peter_Lynch_Worth_Magazine_Articles.pdf