I first came across a niche corner of the US stock market known as thrift conversions in January 2024. Upon further research over the subsequent months, I realised it could be an interesting hunting ground for potential bargains.
For the purpose of this article, thrifts, which have roots in the USA tracing back to the early 19th century, are small community banks in the country that are mutually owned by their depositors. The mutual ownership structure means that these thrifts have no shareholders. As a result, a thrift’s depositors – despite being owners – have no legal way to access its economics. In the 1970s, regulations were introduced to allow thrifts to convert their ownership structure (hence the term “thrift conversions”) and become public-listed companies with shareholders. Today, there are two main ways for thrifts to convert:
- The first is a standard conversion, where a thrift converts fully into a public-listed entity at one go.
- The second is a two-step conversion. In the first-step, a thrift converts only a minority interest in itself into a public-listed entity and thus still has a partial mutual ownership structure. In the second-step, a thrift that has undergone the first-step conversion process goes on to convert fully into a public-listed entity. As far as we know, there’s no time limit for a thrift that has undergone the first-step conversion to partake in the second-step of the process.
Subsequently in this article, I will be using the word “conversion”, or other forms of the same word, to refer only to the standard conversion, unless otherwise stated.
A thrift conversion can be thought of as a thrift undergoing an initial public offering (IPO). During a conversion, the incentives of a thrift’s management and those of its would-be shareholders are highly aligned. In the process, a thrift offers shares to management and depositors first; if there’s insufficient demand, the thrift will then offer shares to outsiders. Importantly, management would be buying the thrift’s shares during the conversion at the same price as other would-be shareholders (the other would-be shareholders are the depositors and outsiders; as a reminder, prior to a conversion, a thrift has no shareholders1). This means it’s very likely that management wants a thrift’s shares to have as cheap a valuation as possible during the conversion. Moreover, new capital that’s raised from management and would-be shareholders in the conversion goes directly to the thrift’s coffers. This new capital adds to the thrift’s equity (calculated by deducting the thrift’s liabilities from its assets) that it has built from the profits it has accumulated over time from providing banking services. These features mean that a thrift often becomes a full public-listed entity at a low valuation while having a high equity-to-assets ratio. It’s worth noting that a thrift can conduct share buybacks and sell itself to other financial institutions after the one-year and three-year marks, respectively, from its conversion.2
Investor Jim Royal’s comprehensive book on thrift conversions (referring to both standard and two-step conversions), aptly titled The Zen of Thrift Conversions, referenced a 2016 study by investment bank Piper Jaffray. The study showed that since 1982, thrifts that became full public-listed entities did so at an average price-to-tangible book (P/TB) ratio of just 0.75. After becoming public-listed entities, thrifts tend to continue trading at low P/TB ratios. This is because they also tend to have very low returns on equity – a consequence of them having a high equity-to-assets ratio after their conversion – and a bank with a low return on equity deserves to trade at a low P/TB ratio. But the chronically low P/TB ratio is why thrift conversions could be a fertile space for bargains.
Assuming that converted thrifts have low P/TB ratios of less than 1, those that conduct share buybacks increase their tangible book value per share over time even when they have low returns on equity. Moreover, as mentioned earlier, converted thrifts tend to have high equity-to-asset ratios, which means they have overcapitalised balance sheets and thus have plenty of excess capital to buy back shares without harming their financial health. To top it off, the 2016 study from Piper Jaffray also showed that since 1982, 70% of thrifts were acquired after the third anniversary of them becoming full public-listed entities and these thrifts were acquired at an average P/TB ratio of 1.43 (the median time between them becoming fully public and them being acquired was five years).
The growth in a converted thrift’s tangible book value per share from buybacks, and the potential increase in its P/TB ratio when acquired, could result in a strong annualised return for an investor. For example, consider a thrift conversion with the following traits:
- It has a return on equity of 3% in each year;
- It has a P/TB ratio that consistently hovers at 0.7;
- It buys back 5% of its outstanding shares annually for four years after the first anniversary of its conversion, and;
- It gets acquired at a P/TB ratio of 1.4 five years after its conversion
Such a thrift will generate a handsome annualised return of 20% over five years. Investing in the thrift on the third-anniversary of its conversion – when the thrift can legally sell itself to other financial institutions – will result in an even more impressive annualised return of 52% when the thrift’s acquired4. There are also past examples of converted thrifts that go on to produce impressive gains even without being acquired. In his book Beating The Street, Peter Lynch, the famed ex-manager of the Fidelity Magellan Fund, shared many examples. Here’s a sample (emphasis is mine):
“In 1991, 16 mutual thrifts and savings banks came public. Two were taken over at more than four times the offering price, and of the remaining 14, the worst is up 87 percent in value. All the rest have doubled or better, and there are four triples, one 7-bagger, and one 10-bagger. Imagine making 10 times your money in 32 months by investing in Magna Bancorp, Inc., of Hattiesburg, Mississippi.”
But not every thrift conversion leads to a happy ending. Table 1 below shows some pertinent figures of Mid-Southern Bancorp, a thrift which produced a pedestrian return from its second-step conversion in July 2018 to its acquisition by Beacon Credit Union in January 2024.
There are a few important things I look out for in thrift conversions5:
- The equity-to-assets ratio: The higher the better, as it signifies an over-capitalised and strong balance sheet, and would make a thrift look attractive to a would-be acquirer
- The P/TB ratio: The lower the better, as a P/TB ratio that is materially below 1 will (a) make share buybacks a value-enhancing activity for a thrift’s shareholders, and (b) enhance the potential return for us as investors
- Share buybacks: The more buybacks that happen at a P/TB ratio below 1, the better, as it is not only value-enhancing, but also indicates that management has a good understanding of capital allocation
- Non-performing assets as a percentage of total assets: The lower the better, as it signifies a thrift that is conducting its banking business conservatively
- Net income: If the play is for a potential acquisition of a thrift, we want to avoid a chronically loss-making thrift as consistent losses indicate risky lending practices, but the amount of net income earned by the thrift is not important because an acquirer would be improving the thrift’s operations; if the play is for a thrift to generate strong returns for investors from its underlying business growth, then we would want to see a history of growth in net income and at least a decent return on equity (say, 8% or higher)
- Change in control provisions: This relates to payouts that a thrift’s management can receive upon being acquired and such information can typically be found in a thrift’s DEF 14-A filing; if management can receive a nice payout when a thrift is acquired, management is incentivised to sanction a sale
- Management’s compensation: The annual compensation of a thrift’s management should not be high relative to the monetary value of management’s ownership stakes in the thrift
Expanding on the last point of what I look out for, I’ve seen cases of fully-public thrifts with poor long-term business results have management teams with high compensation and relatively low dollar-amounts in ownership stakes. In such cases, I think there’s a low possibility of these thrifts being acquired in a reasonable amount of time to maximise shareholder value because it’s lucrative for the management teams to entrench their positions.
If any of you reading this letter is interested to have deeper conversations about investing in thrifts, please reach out, I would love to engage.
1. Thrifts that undertake the two-step conversion process would have no shareholders prior to the first-step conversion. After the first-step conversion is completed and before the second-step conversion commences, these thrifts would have shareholders who own only a minority economic interest in them.
2. Thrifts that decide to participate in the second-step of the two-step conversion process after completing the first step can begin share buybacks after the first anniversary of the second-step; they can also be acquired on the third anniversary.
3. Why would a converted thrift (referring to both standard conversions and two-step conversions) be an attractive acquisition target and be acquired at a premium to its tangible book value? This is because the acquirer of a converted thrift can easily cut significant costs and make more efficient use of the thrift’s overcapitalised balance sheet; this means an acquirer can pay a premium to book value (i.e. a P/TB ratio of more than 1) for a converted thrift and still end up with a good deal.
4. The potential return of a thrift that has completed the second-step of the two-step conversion process is identical to a thrift that has completed the standard conversion, ceteris paribus. This is because the former has the same important features as the latter, such as the low valuation, the over-capitalised balance sheet, and the possibility of being acquired by other financial institutions at a premium to tangible book value.
5. What I look out for in a thrift that has completed the standard conversion is the same as what I look out for in a thrift that has completed the second-step of the two-step conversion.
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