Thrift conversions pay off for David Chilton

Author of The Wealthy Barber shares a little-known investment secret: thrift conversions.

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From the February/March 2013 issue of the magazine.

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Chilton2013_322In 1993, when I was a young man, I flew several times a week. That was “back in the day” when passengers didn’t have individual TVs and all had to watch the same movie. Can you believe the indignity? What’s more, the airlines didn’t rotate in new titles very often. The irony of watching Groundhog Day over and over again wasn’t lost on me. Fortunately, I love reading and devoured many a book, most on the world of finance. One of them, Beating the Street, ended up providing me with an incredibly good rate of return. I invested only $23 yet the knowledge it imparted is still paying huge dividends 20 years later.

The book was a follow-up to the mega-hit One Up On Wall Street by Fidelity’s superstar manager, Peter Lynch. It covered off a wide variety of investment concepts in an entertaining and understandable fashion. However, one particular idea really caught my attention. I’m normally skeptical when someone, even a very smart someone, claims an approach has provided and will continue to provide better-than-market returns. But there was something about this one that intuitively appealed to me. Its simplicity and strong logic drew me in.

In a chapter titled “It’s a Wonderful Buy,” Lynch explained the merits of investing in thrift conversions. Most people have no idea what a thrift conversion is and those who do tend not to get overly excited by them. I’m grateful for their lack of interest as my investments in these little gems have collectively provided me with returns that have, indeed, easily beaten the market averages—a very difficult thing to do (as many of my other investments have proven!).

Thrifts, found in the U.S., are essentially neighbourhood financial institutions. Their operations tend to be much less complicated than those of the big banks we’re all familiar with. They gather deposits, make loans primarily to home purchasers and provide some basic services…pretty boring stuff really.

Thrifts begin as mutual companies—that is, they are owned by their depositors. Some thrifts, though, eventually opt to go public—they “convert” their form of ownership. Essentially this process is similar to a conventional IPO (Initial Public Offering). However, there is one major difference and therein lies the opportunity. All the cash raised by the conversion stays with the thrift; none escapes with selling insiders. Therefore, the investors are buying their own capital (dollar for dollar) and getting the thrift’s existing net worth (its book value) for free! Say what?

Well, let’s say a thrift has a net worth of $50 million, then goes public by issuing 10 million shares at $10 per share. With all the money staying with the thrift, its new net worth is $15 per share (cash of $100 million plus the pre-existing net worth of $50 million divided by the 10 million shares). Basic math but I thought it was pretty cool that I could pay $10 a share for something that had a net worth of $15 a share moments later. Of course, there are no guarantees that the converted thrift’s shares will immediately (or even soon) trade at its net worth but over time the share price usually moves toward that mark, if not past it.

Can making money really be this easy? Sadly, no—there are always things that can go wrong. First, it’s quite tricky to acquire shares in the initial offering. They’re reserved for the thrift’s depositors and management. So, I’ve been forced to buy shares in the after-market and often had to pay a premium to the issue price. I’ve never bought shares, though, unless they were still trading at a significant discount to the thrift’s book value. And, remember, despite having to “pay up” a bit, my returns have been excellent.

Other risks, obviously, include a major market pullback, as thrifts are unlikely to buck the downturn. But, hey, that’s true of any industry. Of course, the financial sector itself is exposed to its own set of risks (as we now know all too well). So proper diversification is, as always, important. And, naturally, some thrifts will inevitably run into issues caused by careless lending and/or deteriorating local economies. To mitigate that risk I purchase thrifts in baskets of five to seven. To further limit downside, I also pay attention to selection criteria identified by Lynch that take very little effort to calculate. My success investing in thrifts has not been the result of keen insights or back-breaking research.

Caveats aside, I have a gut feeling that this straightforward investing approach will continue to post relatively good returns. Most institutions—pensions, mutual funds, etc.—pay no attention to thrift conversions, as they’re not big enough to register on their radar screens. Retail investors don’t like the fact a converted thrift can’t buy back stock or pay a dividend in its first year of trading. Everybody now thirsts for yield. The thrift also can’t be acquired for three years after a conversion. A takeover is the ultimate payoff and happens frequently but in this fast-paced world of day trading and little patience, three years seems like an eternity to most. These factors tend to keep the post-conversion price suppressed for a while and provide me with a good entry price. Once the share buyback begins, a dividend is instated and some time goes by…well, I’m usually smiling!

I’m a big believer in index funds, but for a little adventure…

David Chilton is the iconic Canadian author of The Wealthy Barber and The Wealthy Barber Returns. He currently stars on the hit show Dragons’ Den.

One comment on “Thrift conversions pay off for David Chilton

  1. First the hook — "All the cash raised by the conversion stays with the thrift; none escapes with selling insiders. Therefore, the investors are buying their own capital (dollar for dollar) and getting the thrift’s existing net worth (its book value) for free! "

    Then the truth gets eased in "They’re reserved for the thrift’s depositors and management. "

    So what the author is talking about is the conversion process for those people already owing and 'equity interest'. The price of the issue is essentially arbitrary and not onerous, so that pre-existing 'owners' now have a marketable asset. This is essentially a 'rights' issue. (Like a short-term warrant)

    As soon as the old owners start trading their new shares in the secondary market, they should be asking a price for their new shares equal to full book value. Witness the author's fessing-up " I’ve never bought shares, though, unless they were still trading at a significant discount to the thrift’s book value."

    If the author has made a profit on buying these shares it is probably because so many of the original 'owners' want to sell right away – driving the market price below its true value. His profit has not derived from the conversion pricing (cost of the right) for the existing owners. It comes from the excessive selling by those old owners at the start, driving the market price down.

    Reply

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