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Monday, November 19, 2012

Convert and Prosper

The last few weeks have been strangely peaceful.  For the first time in months we could turn on the television without a constant barrage of campaign ads and misinformation. Although I am sure the networks and local stations will miss the revenue I am glad to see it end. 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. All these predictions will or will not play out but all the information will show up in the financials. If you like growth stocks buy the stocks that are growing revenue, earnings and margins. If you are a value type buy those stocks that are worth far less than their intrinsic or asset value. I think you make more money and sleep better by reacting to what does happen rather than trying to predict what will happen.

I had a before conversation with my friends at FJ Capital the other day. 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 their latest presentation and thinking. It was chock full of information about small banks stocks but one section really caught my attention. It focused on mutual thrift conversions, an investment strategy that has been successful no matter who resides at 1600 Pennsylvania Avenue for more than three decades now. I see no reason it will not continue to be 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 grown 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 IPO offering to the public. These are small banks that come public at a steep discount to their asset value compared to larger institutions and they have been a steady source of profits for astute investors.

Andrew sent a table along that had some useful information about thrift conversions over the past 22 years. It seems that because the post IPO banks are trading at a discount to book value, have plenty of excess capital and have very clean loan portfolios 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 5 years. In the past few years I have had former conversion taken over at a pretty good clip with banks like Abington and Danvers taken over at large premiums to our purchase price.

Here where it gets interesting. If you look at conversion deals that have been done since 2006 the takeover rate declines sharply. Looking at the information Andrew provided it looks like there have been 80 conversions since 2006 and just 5 take overs. 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 was to simply survive not grow. That will 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 country. Small business, an important small bank customer, is still reluctant o expand in an uncertain environment.  This all is more of a positive than a negative for our thrift conversion stocks. Although the world is not back to 2006 levels there are signs it is stabilizing. As banking’s focus is again turned 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 will be done at solid premiums to book value and the current stock price.

The opportunity for the last 6 years’ worth of thrift conversion stocks is a huge subset of the trade of the decade. This is an investment strategy that has worked regardless of who was in the White House, which party controlled the congress or what condition the economy was in at the time. The inevitable market dips and declines were merely inventory creation events that allowed investors to buy at sale prices. The conversion process itself creates bargain issues adding capital to an already strong balance sheet. Most of these are smaller local institutions that are extremely well run in the first place and would be attractive without the extra capital. As the good folks at FJ Capital pointed out most of them get taken over in a few years.
The banking crisis has bought mergers to a standstill in all sectors of the banking industry including conversion. We now have an excess inventory of converted thrifts that are still public and trading at attractive prices. Most of them fit comfortably with my trade of the decade strategy of buying banks with high levels of capital, low loan losses and trade below tangible book value.

One such institution is Home Bancorp of Lafayette Louisiana (HBCP). The bank entered the conversion process in late 2008 just as the credit criis began to boil over. In spite of this they have done a great job since that time. They have seen deposit growth for 13 consecutive quarters as consumers favor a relationship with a strong small bank with strong local ties. The bank has been able to acquire other banks in the area with FDIC assistance. The organic nonperforming assets ratio is below 2. The total NPL ratio is over 3 but much of that is acquired loans that have FDIC assistance and guarantees. The stock trades at just 90% of tangible book value and the equity to assets ratio is over 14. Home Bancorp has been buying back shares and intends to continue doing so. During the third quarter they bought back 162,629 shares and more than 220,969 shares remain under the current buyback authorization.

The 2007 crop of 2007 has already given us several cheap stocks. I currently own shares of ESSA Bancorp (ESSA), First Financial Northwest (FFNW) and Westfield Financial (WFD) all of which engaged in conversion transaction just before the crisis struck. They are all still cheap and have decent fundamentals. First financial Northwest has had some difficulties with troubled loans and real estate owned but conditions are improving and they have plenty of excess capital. Very few of the 2007 crop have been taken over so far and I expect this to change over the next few years.

 The 2010 crop has given us some solid portfolio holdings as well. I wrote recently about Fox Chase Bancorp (FXCB). I own the shares and have a nice gain in the position. The shares now trade right at tangible book value and I would wait for a sell off to add or initiate a position in the stock. I also own Capital Federal Financial (CFFN) and am up slightly on the position.  The bank is in the Midwest and has one of the healthiest loan portfolios in the industry. The equity to assets ratio is a little over 20 and they have been using the capital to buy back shares and pay dividends. Neither of them is exciting or sexy but I expect to make enormous profits over the next decade as these banks grow or are taken over at large premiums.

The 2011 conversions included one of my favorite little bank stocks. BSB Bancorp (BLMT) is a four branch bank in Massachusetts that has incredibly attractive numbers. The stock trades at just 84% of tangible book value and the equity to assets ratio is over 16. Nonperforming loans are just .34% of total assets. Unlike many banks the past few years BSB is growing. They have seen solid growth in both deposits and loans over the past year. The bank has seen asset growth of more than 22% so far in 2012. Insiders like what they see in the future as they have been steady buyers of the stock so far this year.

The thrifts that converted to stock ownership since 2007 have not seen anywhere near the level of takeover and merger activity experienced in the past. I expect that to change and conversions will be a source of large profits for those that invest in these safe and cheap financial institutions. Most of them are way too small to write about on Real Money but it will be worth the time and effort to uncover these gems for your portfolio.

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