Today, I will be covering another interesting area of investing for the deep value investor - mutual thrift conversions.
Mutual thrift conversions are a unique investment opportunity that is still widely under the radar. For those wanting more information on how Mutual Thrift Conversions work, I highly recommend reading: The Zen of Thrift Conversions: How to Turn Hidden Bank Stocks into Big Gains by James Royal. The book highlights the fact that 70% of mutual thrifts eventually get bought out. From 2000 - 2009 during the “lost decade” for stocks, when the S&P 500 was flat, a portfolio of mutual thrift conversions—specifically the SNL Thrift MHC Index returned 188%.
A return of 188% over 10 years is equal to about 11% annually.
From 2000 - 2009, the S&P 500 returned about -1% per year including dividends.
How Mutual Thrift Conversions Work
Mutual thrift conversions occur when a mutually owned savings and loan bank converts into a publicly traded stock corporation.
In the mutual structure, the bank is owned by its depositors rather than shareholders.
During a mutual thrift conversion, the bank creates a new holding company and sells shares to the public—often giving depositors and local community members priority to purchase stock.
The proceeds from the offering go directly onto the bank’s balance sheet as new equity capital, substantially increasing book value and strengthening the bank’s financial position.
Because the newly converted bank suddenly holds a large amount of excess capital relative to its size, these institutions often trade well below book value for years and become attractive acquisition targets for larger banks seeking deposits, loan portfolios, and cost synergies.
Suppose a small regional bank has $100 million in assets and $10 million in equity capital. The bank offers depositors 1,000,000 shares at $10 per share and raises $10 million. The bank’s book value (net worth) doubles from $10 million ($10 per share) before the conversion to $20 million ($20 per share) after the conversion. Sometimes, recent thrift conversions can be bought at 50% of book value or less.
In Beating the Street, Peter Lynch likened a mutual thrift conversion to buying a house and then discovering a check for your entire down payment hidden in a kitchen drawer.
Why Thrift Conversions are a Great Hunting Ground for a Value Investor
There are a few reasons I really like mutual thrift conversions. Here’s why:
The bank’s net worth (book value), often doubles after the IPO
These small banks often have much less correlation to the overall market - if the Dow is down 1,000 points, these little bank stocks are not likely to move much
Insiders typically participate and there are no selling shareholders. Which is opposite of a typical IPO where the insiders typically dump huge amounts of overvalued stock on the market
Banks all have very similar business models, and the framework for valuing them tends to be consistent. Once you understand how to analyze one bank’s balance sheet, loan book, and deposit franchise, you can apply that same framework to thousands of banks across the country.
Most of these small regional banks (roughly 70% of mutual thrift conversions) eventually get acquired by a larger bank or credit union - often at a premium to book value
Due Diligence Checklist for a Bank
There are several important metrics and factors to consider when analyzing a bank.
Before getting into valuation, it’s helpful to briefly understand how the business of banking actually works.
Interest Rates - Borrowing Short, Lending Long
Perhaps the most important factor when evaluating a bank is its sensitivity to interest rates.
Banks generally “borrow short and lend long,” meaning they take in short-term deposits and then extend longer-term loans such as residential mortgages, HELOCs, multifamily loans, construction loans, commercial loans, and auto loans.
At its core, a bank earns money through the interest rate spread—the difference between the interest it earns on loans and securities and the lower rate it pays on deposits and other funding sources. This spread, often referred to as net interest margin, is the primary engine of profitability for most banks.
When rates rise, banks can earn more on their loans, but they are also susceptible to risks of being locked into long-term loans at lower rates. This is why many banks sell their loans to decrease their interest rate risk.
Banks are also at risk of seeing the value of their securities portfolio decline in a rising rate environment. When interest rates rise, bond prices fall and it is important for bank investors to check the health of a bank’s securities portfolio and assess the impact of interest rate risk.
Deposits
Lower-cost deposit bases are obviously better for banks since they cost less and are stickier than time-based deposits such as CDs. Lower cost demand deposit accounts include checking and savings accounts. It’s important to make sure the bank you’re looking at doesn’t have too much of the deposit base in time-based deposits. Time-based deposits such as CD’s are short-term accounts that are not as “sticky” as non-time-based deposit accounts. If rates rise and a large percentage of deposits are time-based accounts, the bank will be more susceptible to rising cost of deposits.
Ideally, a bank will have 70% or more in non-time-based deposits and 15% or more in non-interest-bearing deposits. There’s no hard and fast rule on this but the lower the deposit costs and the less a bank has in time-based deposits the better.
Credit Quality
While the interest rate spread is the primary driver of profitability, investors typically focus on three key areas when evaluating a bank: credit quality, capital strength, and operating efficiency.
First, credit quality is critical because a bank’s assets are largely composed of loans. Investors should examine metrics such as nonperforming loans, charge-offs, and the allowance for loan losses to determine whether the loan portfolio is healthy. Even a small percentage of bad loans can significantly impact earnings and capital.
Some key metrics to watch for:
Non-Performing Assets/Total Assets (NPA/TA)
This is the total amount of non-performing assets divided by the total assets for a bank. Ideally this should be less than 1%. Less than 0.5% is even better. Investors should take a closer look if NPA/TA is over 1%.
Loan loss reserves (LLR)/Non-Performing Assets (LLR/NPA)
A bank should have more than enough loan loss reserves to cover non-performing assets. LLR/NPA should be at least 100%
Texas Ratio - developed in the late 1980s during the Texas banking crisis, the Texas ratio provides investors with insights into potential solvency issues for a bank. The Texas ratio assess whether or not a bank has adequate reserves and tangible equity to absorb losses. This ratio should be less than 50% and the lower the better. The Texas Ratio = NPA/ (LLR + tangible common equity)
Capital Levels
Capital levels provide a cushion against potential losses. Banks are highly regulated institutions and must maintain minimum capital ratios to ensure stability. Investors often look at metrics such as the tangible common equity ratio, Tier 1 capital ratio, and book value per share to evaluate how well-capitalized a bank is. Many recently converted thrift banks will have equity to asset ratios in the 12 - 20%+ range, which is higher than most larger banks.
Most larger banks have equity to asset ratios below 10%. High equity/asset ratios can be both good and bad for banks.
Banks with higher equity to asset ratios have lower risks compared to other banks since they have a ton of equity. The downside to having a high equity to assets ratio is that a bank is overcapitalized and their returns and operating efficiency will suffer until they can make more loans.
Efficiency Ratios
Finally, operating efficiency measures how effectively a bank converts revenue into profits. This is commonly evaluated using the efficiency ratio, which compares non-interest expenses to total revenue. Lower efficiency ratios generally indicate a more profitable and well-run bank, while higher ratios can signal excess costs or a lack of scale. A larger bank with economies of scale might have efficiency ratios in the 50 - 70% range, while smaller recently converted thrift banks will often have efficiency ratios of 90 - 100% or more. That’s not necessarily a bad thing. Ironically, these very inefficiencies are what make them attractive acquisition targets, since a larger acquirer can often eliminate redundant costs and significantly improve the bank’s profitability.
Larger banks have more economies of scale, are usually profitable and the best run banks might have returns on equity (ROE) in the 12 - 15%+ range. Smaller regional banks will typically have ROEs in the low to mid-single digit range.
A Recently Converted Thrift Priced at Less than 50% of Book Value
One small bank I’ve been studying recently illustrates many of the dynamics discussed above. It’s a recently converted thrift with roughly $150 million in assets, a clean loan book, and a stable community deposit base. Yet despite having a book value of more than $23 per share, the stock currently trades for roughly half of that in the public markets.
The bank’s weak profitability today largely reflects its subscale size and elevated operating costs, not balance sheet problems. In fact, many of these inefficiencies could potentially be eliminated by a larger regional bank.
Interestingly, three recently converted thrifts in the same geographic region were acquired in the past few years at valuations ranging from roughly 94% to 122% of book value. While there is no guarantee a similar outcome occurs here, these transactions highlight how consolidation can unlock value in small community banks.
Below I walk through the numbers and explain why this particular bank caught my attention.
