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Investor Peter Lynch achieved "legend" status during the 1980s – and it wasn't just because of his best-selling book, "One Up on Wall Street."
It was the fact that he made a lot of mutual fund investors rich.
While helming the Fidelity Magellan fund from 1977 to 1990, Lynch delivered an average annual total return of more than 29% – a performance that would have turned a mere $10,000 investment into $280,000 at the time he decided to leave.
But I'm going to let you in on a stunning secret: Most of the huge gains Lynch made for investors were due to a strategy that almost nobody ever talked about.
And Lynch wasn't alone.
Legendary hedge fund manager and value player Seth Klarman has used this strategy throughout his career. Edward Thorp, one of the best arbitrage and quantitative investors of all time, continues to use it.
And this is why, on Friday, I told you to hang on to your bank stocks. There's still money to be made on banks (a lot of money, in fact). And it's with the same strategy that made these investing legends filthy rich.
The strategy itself is as simple as it is powerful, yet virtually no retail investor uses it.
Heck, most investors don't even know about it.
Here today, we're going to change that.
I'm going to walk you through the strategy.
I'm going to tell you about financial-services play that our system just spotlighted – a tightly run company whose shares trade at less than $15… and that operates in a consolidating industry meaning it could well end up as a buyout…
A Blueprint for Banking Gains
The secret strategy is something called "mutual thrift conversions."
And here's how it works.
When a "mutual" financial institution (a bank or a thrift) converts to a publicly traded bank, there are several ways for investors to grab an enormous profit.
But few investors do so, and I understand why: It's a strategy that demands patience and a certain amount of discipline.
Maybe it's not exciting enough for everyday investors. I mean, there's no big "story" – no tech breakthrough, no "wonder drug" involved. There's no day-trading or digging through Reddit posts.
In fact, there's very little trading at all.
And I'm okay with that – totally okay, in fact – because of all the money I know I'm going to make.
Let's start with a simplified blueprint of the thrift-conversion trade.
When thrift operators decide to convert to stock ownership, they plan an initial public offering (IPO). In an entirely unique situation, every dollar the bank takes in via the IPO process adds value for the buyer.
Let's say that a thrift with $10 million in equity decides to go public. It sells one million shares at $10, raising $10 million.
You've got existing equity of $10 million, you've got IPO proceeds of $10 million, you now have total equity of $20 million, and with 1 million shares outstanding, you have a post-IPO share price of $20.
In other words, the moment the IPO closes, investors are holding shares worth twice what they just paid.
As fantastic as that is, here's the kicker: The bank depositors get "dibs" on the IPO stock, and most of them are way too smart to pass on the opportunity, meaning outside buyers rarely get to invest in a thrift-conversion IPO.
Some smart investors, including Lynch, deposited money in mutual thrifts around the country – and then bought IPO shares when they were finally offered.
That's still a fantastic strategy – provided you have lots of cash and are willing to travel a bunch (as most mutual thrifts only open accounts in-person, to keep institutional "operators" from taking control of the deal).
You'll be building up a lot of frequent flyer miles and can look forward to some severe writer's cramp since there are still 577 mutual thrifts in 44 states. Some geographically fortunate readers could have an easier time using the depositor approach to mutual-thrift investing. According to the Washington, D.C.-based industry advocacy group America's Mutual Banks, the states with the most mutual banks are Massachusetts (111), Illinois (50), Ohio (47), and Pennsylvania (46).
I don't use the deposit strategy. I wait for the IPO to close and then evaluate where I can buy shares after the initial price pop.
And there's always an initial price pop.
Remember, these shares were bought for just $10 and are instantly worth $20. The minute these stocks open on the first day, they're going to go higher by 30% and even 40%. At that level, we'll start to see some selling as investors cash in on their sudden windfall.
Once the IPO is over and the excitement dies down, I can usually buy some shares at 30% to 40% above the IPO price.
While that sounds like I'm chasing the shares, I'm actually not. In fact, I'm still buying at a price below "book value." Remember in our example, the stock went public at $10 and had a book value of $20. If I can buy at $14, I'm still only paying 70% of tangible book value.
Now that I own the shares, I face the "toughest" part of my plan – I sit, I rest, I wait.
I display patience as I watch my investment develop. I act like the bank "owner" that I am. I read the reports every quarter. I sleep well at night (banks like this are among the safest on the planet).
America's Mutual Banks tells us that "the average Tier 1 capital ratio (a barometer of capital strength and safety) for all mutual banks was 12.36% and the average risk-based capital ratio was 25.30%."
The regulatory Federal Deposit Insurance Corp. (FDIC) considers a bank to be "well-capitalized" (the highest ratio for safety and soundness) if a bank's Tier 1 capital ratio is at, or above, 6% and its risk-based capital ratio is at, or above, 10%.
No mutual thrifts received a single dime of TARP bailout money. And of the 350 banks that failed in the 2008-2009 financial crisis and Great Recession that followed, just 12 were mutual banks.
The takeaway: We're talking about very well-run banks with sound loan portfolios, meaning you just don't have to worry very much about them. And if I see a price decline and find that the loan portfolio is still sound, I just buy more shares to increase my stake at favorable prices.
Otherwise, I mostly wait – though I do use two dates as "check-ins."
The first is the one-year IPO anniversary. That's when the newly converted thrifts can begin paying a dividend and start buying back their own shares.
Most of them do so immediately, and some do so aggressively. As an example, one of my favorite thrift conversion banks over the past decade was Charter Financial Corp. It was permitted to start returning capital to shareholders on April 9, 2014. And over the next three years, Charter bought back more than one-third of its outstanding shares. That helped lift the stock price by 70% in just three years – an average annual run of more than 20%.
The bank was taken over in 2018 at nearly three times the thrift-conversion IPO price.
The second "check-in" is on the third anniversary of the conversion IPO.
That's when the change-of-control provisions put in place by federal regulators expire, meaning the bank can be sold or otherwise taken over.
The former mutual thrifts make tempting targets as they tend to have strong loan portfolios and lots of excess capital on hand. They also tend to be smaller, meaning they are navigating a high-cost, high-regulation environment – a reality of the post-financial crisis world, and one that makes a buyout at "the right price" very alluring for management.
That's kind of what we're looking at for now – a purchase in the post-IPO market, several years of nice returns, and a buyout at a big premium to the tangible book value that's been boosted by strong annual financial performance.
And I have one for you here.
My favorite converted thrift right now is Amesbury, Massachusetts-based Provident Bancorp Inc. (NASDAQ: PVBC).
Provident completed its conversion in June 2019 and became a publicly traded bank.
While it looks like a sleepy New England bank servicing the bedroom communities in the Boston-to-Concord high-tech corridor, it's actually a great business helmed by a top management team.
And the guy at the top is CEO Dave Mansfield.
After stints at the Office of the Comptroller of the Currency, where he helped regulate and audit some of the bigger banks, he jumped into the banking business itself, joining Provident as its CFO.
One immediate change was to shift the bank's focus to commercial lending – a move he accelerated after assuming the CEO's chair in 2019.
"Having seen so many community banks, I felt strongly we should focus on serving small and medium-sized businesses, which are the backbone of our communities," he told The Boston Business Journal. "They're owned by people who live locally, usually the ones that are most active in the community. The bank does well, the company can grow more jobs, add to the tax base."
Most converted thrifts have mortgage-heavy loan portfolios – their historical business base. That's not the case with Provident. More than 40% of Provident's lending portfolio is now commercial and industrial loans made to businesses in the region.
Last year, Provident got into warehouse lending, making funds available to mortgage brokers to make loans, which the FDIC recognizes as asset-based commercial lending – that's now 20% of Provident's loan portfolio.
Provident has also been quick to spot emerging opportunities and is finding ways to do business with niche markets like including cryptocurrency, renewable energy, and fintech.
Provident was one of the first banks in the country to offer deposit services to cryptocurrency exchanges and institutional investors and brokers that deal in digital assets. It's still one of a handful of banks providing services to the industry.
This is not exactly what you expect for a bank founded in 1828 (making it the tenth oldest bank in America).
Despite all the positive developments, the bank is trading at less than 1.1 times book value, a discount to the 1.3 average of its in-state peers.
Provident has been very aggressive about buying back stock since passing the one-year anniversary of buyback restrictions. The board has just authorized an additional buyback of 1.4 million shares – or about 7.5% of shares outstanding.
There's good news in Provident's shareholder list as well. Altogether, the officers and directors own over 6% of the bank. They have skin in the game.
And with only $1.5 billion in assets, Provident could easily end up as a buyout play, following so many of the buyouts that have happened before it.
Buy the shares at market, put them away – and wait for your payday.
Now, this isn't the only stock on my radar today.
In fact, Provident is just the start. There are loads of profitable stocks out there right now, with some poised to explode to new highs and others… Well, let's just say they could give your portfolio concrete feet.
And sometimes it can be hard to tell the difference, which I why I put together a full list of the best and worst stocks in America.
And I encourage you to grab a pen and paper – I even made up this sheet to help you keep track of who the winners and losers are because I go over 50+ stocks and I don't want you missing a single one.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.