Beating the Street (30 page)

By sticking to its simple function, a Jimmy Stewart S&L can avoid hiring the high-priced loan analysts and other expensive mucka-mucks employed by big banks. Likewise, it can avoid spending money on a Greek temple for the main office, Queen Anne furniture for the lobby, blimps, billboards, celebrity sponsors, and original artwork for the walls. Travel posters will suffice.

A money-center bank such as Citicorp routinely spends the equivalent of 2½ to 3 percentage points of its entire loan portfolio just to cover its overhead and related expenses. Therefore, it must make a “spread” of at least 2½ percent between what it pays for deposits and what it receives from its loans in order to break even.

A Jimmy Stewart S&L can survive on a much narrower spread. Its break-even point is 1½ percent. Theoretically, it could make a profit without making any mortgage loans at all. If it pays 4 percent in interest to passbook savers, it could invest the proceeds in 6 percent Treasury bonds and still earn money. When it writes 8 or 9 percent mortgages, it becomes highly profitable for the shareholders.

For years, the inspiration for all the Jimmy Stewart S&Ls has been Golden West, based in Oakland, California. Golden West owns and operates three S&L subsidiaries, all of them run by a delightful couple, Herb and Marion Sandler. They have the equanimity of Ozzie and Harriet and the smarts of Warren Buffett, which is the perfect combination to run a successful business. Like Ozzie and Harriet, they've managed to avoid a lot of unnecessary excitement. They avoided the excitement of investing in junk bonds that defaulted and commercial real-estate ventures that defaulted, both of which enabled them to avoid the excitement of getting taken over by the Resolution Trust Corporation.

The Sandlers have always been reluctant to waste money on foolishness. Their distrust for the newfangled caused them never to install automated teller machines. They never lured depositors with toaster ovens or ice buckets. They missed the great boom in misguided construction loans. They stuck to residential mortgages, which still make up 96 percent of Golden West's portfolio.

When it comes to economizing in the front office, the Sandlers are champions. I visited their headquarters, not in San Francisco where most of the fancier banks are located, but in a lower-rent district in Oakland. Visitors to the corporate suite announced themselves by picking up a black telephone in the reception area.

The Sandlers don't mind spending money in the branches, where the goal is to make customers as happy and as comfortable as possible. Teams of covert “shoppers,” as the Sandlers call them, are sent out periodically to investigate the service.

In a famous incident in the mid-1980s, Marion Sandler was addressing her peers at an S&L conference in West Virginia on one of her favorite topics, “productivity and expense control.” The subject was so captivating to the other S&L directors in the audience that a third of them walked out. They'd packed the house to hear about exciting new computer systems and counting machines, but not to hear Ms. Sandler talk about cutting costs. Perhaps if they'd stayed for her lecture and taken good notes, more of them would still be in business today.

Prior to the 1980s, Golden West was one of the few S&Ls that was a public company. Then in a rash of stock offerings in mid-decade, hundreds of the formerly private thrifts, operating as “mutual savings banks,” went public more or less simultaneously. I acquired many of these for the Magellan Fund. I was so selective in my purchases during this period that anything that had the word “first” or “trust” in it, I bought. Once, I confessed to the
Barron's
panel that I'd invested in 135 of the 145 thrifts whose prospectuses had landed on my desk. The response from Abelson was typical: “What happened to the others?”

There are two explanations for my indiscriminate and sometimes fatal attraction for S&Ls. The first is that my fund was so big and they were so small that to get enough nourishment out of them I had to consume large quantities, like the whales who are forced to survive on plankton. The second is the unique way that S&Ls came public, which made them an automatic bargain from the start. (To learn how you, too, can get something for nothing, turn to page 215.)

The experts at SNL Securities in Charlottesville, Virginia, who keep tabs on all the thrifts in existence, recently provided me with an update on what happened to the 464 S&Ls that came public after 1982. Ninety-nine of these were subsequently taken over by bigger
banks and S&Ls, usually at a large profit to the shareholders. (The watershed example is the Morris County [New Jersey] Savings Bank. The initial offering price in 1983 was $10.75 a share, and Morris was bought out three years later for $65.) Sixty-five of the publicly traded S&Ls have failed, usually at a total loss to the shareholders. (I know this from personal experience because I owned several in this category.) That leaves 300 still in business.

Whenever I get the urge to invest in an S&L, I always think of Golden West, but after it doubled in price in 1991 I decided to search for better prospects. As I went down the S&L list in preparation for
Barron's
1992, I found several. You couldn't have invented a better atmosphere for creating bargains.

The S&L-fraud story had drifted off the front pages, only to be replaced by the collapse-of-the-housing-market story. This had been a popular scare for two years running: the housing market was going to crash and take the banking system down with it. People remembered that when the housing market collapsed in Texas in the early 1980s, several banks and S&Ls collapsed in sympathy, and they expected that the same fate would befall S&Ls in the Northeast and California, where fat-cat houses were already suffering a correction.

The latest quiet facts put out by the National Association of Home Builders, that the median price of a home had increased in 1990 and again in 1991, convinced me that the collapse of the housing market was largely a figment of the fat-cat imagination. I knew that the best of the Jimmy Stewart S&Ls had a limited involvement in expensive houses, commercial real estate, or construction loans. For the most part, their portfolios were concentrated in $100,000 residential mortgages. They had good earnings growth, a solid base of loyal depositors, and more equity than J. P. Morgan.

Yet the virtues of the Jimmy Stewart S&Ls were lost in the funk. Wall Street was down on these stocks, and so was the average investor. Fidelity's own Select S&L Fund had dwindled in size from $66 million in February 1987 to a low of only $3 million in October 1990. Brokerage houses had reduced their coverage of the thrift industry, and some had stopped covering it at all.

There used to be two full-time analysts at Fidelity assigned to
S&Ls: Dave Ellison for the larger thrifts and Alec Murray for the smaller ones. Murray left for Dartmouth graduate school and wasn't replaced. Ellison was given other large companies to follow, including Fannie Mae, General Electric, and Westinghouse, so for him the S&Ls had become a part-time job.

There are nearly 50 analysts in the country who track Wal-Mart and another 46 analysts who track Philip Morris, but only a few devote themselves to keeping up with the publicly traded S&Ls. This leads to Peter's Principle #18:

When even the analysts are bored, it's time to start buying.

Intrigued by the cheap prices at which many S&L stocks were selling, I immersed myself in a copy of
The Thrift Digest
—my idea of the perfect bedside thriller. It's published by SNL Securities, a company I mentioned above, and it's edited by Reid Nagle, who does an outstanding job.
The Thrift Digest
is as thick as the Boston metropolitan telephone directory, and it costs $700 a year to get the monthly updates. I mention the price so you won't run out and order the thing, only to discover you could have bought two round-trip tickets to Hawaii instead.

If you decide to pursue the subject of undervalued S&Ls—which to me is much more exciting than any trip to Hawaii—you'd be well advised to seek out the latest copy of
The Thrift Digest
at the local library or to borrow one from your broker. I borrowed mine from Fidelity.

I spent so much time with my nose in this book before dinner, during dinner, and after dinner that Carolyn began to refer to it as the Old Testament. The Old Testament in hand, I devised my own S&L scorecard, listing 145 of the strongest institutions by state and jotting down the following key details. This, in a nutshell, is everything you need to know about an S&L:

Self-explanatory.

When an S&L is selling below the price at which it came public, it's a sign that the stock may be undervalued. Other factors, of course, must be considered.

The most important number of all. Measures financial strength and “survivability.” The higher the E/A, the better. E/As have an incredible range, from as low as 1 or 2 (candidates for the scrap heap) to as high as 20 (four times stronger than J. P. Morgan). An E/A of 5.5 to 6 is average, but below 5, you're in the danger zone of ailing thrifts.

Before I invest in any S&L, I like to see that its E/A ratio is at least 7.5. This is not only for disaster protection, but also because an S&L with a high E/A ratio makes an attractive takeover candidate. This excess equity gives it excess lending capacity that a larger bank or S&L might want to put to use.

Many S&Ls pay better-than-average dividends. When one of them meets all the other criteria and also has a high yield, it's a plus.

Most of the assets of a bank or an S&L are in its loans. Once you assure yourself that an S&L has avoided high-risk lending (see below), you can begin to have confidence that its book value, as reported in the financial statements, is an accurate reflection of the institution's real worth. A lot of the most profitable Jimmy Stewarts are selling at well below book value today.

As with any stock, the lower this number, the better. Some S&Ls with annual growth rates of 15 percent a year have p/e ratios of 7 or 8, based on the prior 12 months' earnings. This is very promising,
especially in light of the fact that the overall p/e of the S&P 500 was 23 when I did this research.

These are the common problem areas, especially commercial loans and construction loans, that have been the ruination of so many S&Ls. When high-risk assets exceed 5–10 percent, I begin to get nervous. All else being equal, I prefer to invest in an S&L that has a small percentage of its assets in the high-risk category. Since it's impossible for the casual investor to analyze a commercial lending portfolio from afar, the safest course is to avoid investing in S&Ls that make such loans.

Even without
The Thrift Digest
, it's possible to do your own calculation of high-risk assets. Check the annual report for the dollar value of all construction and commercial real estate lending, listed under “Assets.” Then find the dollar value of all outstanding loans. Divide the latter into the former, and you'll arrive at a good approximation of the high-risk percentage.

These are the loans that have already defaulted. What you want to see here is a very low number, preferably less than 2 percent of the S&L's total assets. Also, you'd like this number to be falling and not rising. An extra couple of percentage points' worth of bad loans can wipe out an S&L's entire equity.

This is property on which the S&L has already foreclosed. The REO category, as it's called, is an index of yesterday's problems, because whatever shows up here has been written off as a loss on the books.

Since this financial “hit” has already been taken, a high percentage of real estate owned isn't as worrisome as a high percentage of nonperforming assets. But it's worrisome when REO is on the rise. S&Ls aren't in the real-estate business, and the last thing they want is to repossess more condos or office parks that are expensive to maintain and hard to sell. In fact, where there's a lot of REO, you have to assume that the S&L is having trouble getting rid of it.

 

I ended up choosing seven S&Ls to recommend in
Barron's
, which tells you how much I liked the group. Five of these were strong Jimmy Stewart-type thrifts, and two were long shots—I call these the born-agains—which have come back from the edge of
Chapter 11
. Two of the five strong thrifts, Germantown Savings and Glacier Bancorp, were repeat recommendations from 1991.

The five Jimmy Stewarts got excellent marks in several categories: book value (four sold at a discount), equity-to-assets ratio (all 6.0 or better), high-risk loans (under 10 percent), 90-day delinquencies (2 percent or less), real estate owned (less than 1 percent), and p/e ratio (below 11). That two of them had been buying back their own shares in recent months was another positive. For Glacier and Germantown, the percentage of commercial lending was a bit high, but this was less bothersome after I heard the bankers' explanations.

With the two born-agains, many of the numbers are quite dismal—everything a conservative investor should try to avoid. I picked them as long shots because they still maintained high equity-to-assets ratios in spite of their problems. Having this equity cushion gave them a little leeway to work out of their troubles. The region in which these two S&Ls do business, near the Massachusetts-New Hampshire border, was beginning to show signs of stability.

I couldn't guarantee that these born-agains would survive, but their stock prices had fallen so low (in the case of Lawrence Savings, from $13 to 75 cents) that I knew the bottom fishers would make a lot of money if they did.

Dozens of S&Ls around the country are as strong as or stronger than my top five. You might find one or more of them in your own neighborhood. A lot of investors are going to be very pleased that they've concentrated on this group. The Jimmy Stewarts will either continue to prosper on their own or be taken over by larger institutions at prices far above the current levels.