Beating the Street (32 page)

Instead of holding on to the mortgages as many thrifts do, Sovereign had decided to specialize in making loans and then selling them to packagers such as Fannie Mae or Freddie Mac. This strategy enabled Sovereign to get its money back quickly and plow it into new mortgages, profiting from the points and other up-front fees. The risk of owning the mortgages was transferred to others.

Even so, Sovereign was being very conservative in the kinds of loans it would approve. It was devoted to residential mortgages. It hadn't made a single commercial loan since 1989. Its average residential loan didn't exceed 69 percent of the value of the property on which the loan was made. The few bad loans were thoroughly investigated so that Sovereign could learn who or what went wrong and not repeat its mistakes.

As often happens in my conversations with companies, I learned
something new from Sidhu. He described a sneaky method by which unscrupulous banks and S&Ls camouflage their problem loans. If a developer, say, asks to borrow $1 million for a commercial project, the bank offers him $1.2 million on the basis of an inflated appraisal. The extra $200,000 is held in reserve by the bank. If the developer defaults on the loan, the bank can use this extra money to cover the developer's payments. That way, what has turned into a bad loan can still be carried on the books as a good loan—at least temporarily.

I don't know how widespread this practice has become, but if Sidhu is right, it's another reason to avoid investing in banks and S&Ls with large portfolios of commercial real estate.

I phoned CFO John G. Medvec at corporate headquarters in New Britain, Connecticut, near Hartford. Mr. Medvec said a lot of weak banks had failed in the area, which strengthened People's position as a safe place to keep money. People's had capitalized on the situation with advertising: the gist was that this was a secure institution with an equity-to-assets ratio of 13. As a result of the advertising, People's deposits of $220 million in 1990 had grown to $242 million in 1991.

People's equity-to-assets ratio would have been even higher if it hadn't used some of its equity to buy back stock. In two phases, this Connecticut S&L had retired 16 percent of its shares and spent $4.4 million in the process. If it continues to buy back shares in this manner, someday they will be very scarce and very valuable. With fewer shares outstanding, the earnings per share will increase even when business is flat. When business is good, the share price can skyrocket.

Corporate managers often pay lip service to “enhancing shareholder value” and then go out and squander the money on fanciful acquisitions, ignoring the simplest and most direct way to reward shareholders—buying back shares. Mundane businesses like International Dairy Queen and Crown Cork & Seal have been spectacular performers in the stock market because their management was committed to buying back shares. That's how Teledyne became a 100-bagger.

When People's Savings Financial first went public in 1986, its
shares sold for $10.25. Here it was five years later, a bigger and more profitable operation with fewer shares outstanding, and selling for $11. What was depressing this stock, I suspected, was that the company had to operate in a depressed state. I don't mean emotionally. I mean Connecticut.

All things considered, I'd rather invest in an S&L that's proven it can survive in a depressed state than in one that thrives in a booming economy and has never been tested in bad times.

From my
Thrift Digest
, I'd noted that nonperforming loans were a relatively modest 2 percent, but I wanted to check into this further. Medvec said that most of this 2 percent problem was caused by a single construction loan, and that People's wasn't making any new loans of this type.

People's had already taken its “hit” against earnings when these nonperformers were written off. The next step was to foreclose on the property. Medvec reiterated what I'd heard elsewhere, that the foreclosure process is drawn-out and expensive. It may take two years to oust a borrower who has defaulted. This isn't like Scrooge firing Bob Cratchit, forcing him and Tiny Tim out onto the street, because most of the defaults at People's Savings have been of the commercial variety, or in fat-cat houses that deadbeats can occupy for months free of charge, until their legal remedies are exhausted.

Eventually, a foreclosed property enters the category called “real estate owned,” and from there the aggrieved lender can attempt to sell it and get something back for its long-lost loan. In some cases, the lender gets back more than was expected, so there's a potential upside here.

Medvec and I also discussed business conditions in the area. You worry about such things when you're talking about Connecticut in 1992. He said that hardware manufacturers used to be the biggest employers in New Britain, but Stanley Works is the only one left. Central Connecticut State University and the New Britain General Hospital have taken up some of the slack, but unemployment is still high.

Before we hung up, I asked the usual parting question: name your most impressive competitor. Medvec mentioned American Savings Bank of New Britain, with a 12 percent equity-to-assets ratio, which hadn't yet gone public. I was tempted to drive down there and open an account so I could get in on the first stage of the eventual public offering. If you turn to page 215 you'll find out why.

This was the first of my two born-agains. Here's a case in which it didn't make sense for the company to buy back its own shares. First Essex came public in 1987, with 8 million shares sold for $8 apiece, and two years later, after the stock had done nothing, the management bought back 2 million of those shares at the same $8 price. If management had only waited until 1991, it could have gotten a 75 percent discount, because by then the stock had fallen to $2.

There were some frightening numbers in my First Essex file—10 percent nonperforming assets, 3.5 percent real estate owned, and 13 percent commercial and construction loans. This tiny S&L in Lawrence, Massachusetts, had lost $11 million in 1989 and another $28 million in 1990, a victim of zealous lending to condo developers and real-estate magnates who perished in the recession. Lawrence is located just across the border from New Hampshire, in one of the most depressed spots in all New England.

“Bottom fishing with a six-hundred-foot line” is the way First Essex CEO Leonard Wilson described his predicament when I got him on the phone. For three terrible years, this S&L had faced a procession of foreclosures, each one requiring a “hit” on earnings, each one causing First Essex to own another piece of real estate, until the S&L was cash poor and rich in unoccupied buildings nobody wanted to buy. It was a top absentee landlord in the region—absent of tenants.

Still, First Essex had a book value of $7⅞ and enough equity remained to give it an equity-to-assets ratio of 9. And this was a $2 stock.

Here's the gamble with S&Ls such as First Essex that have fallen on hard times. If the commercial real estate market stabilizes and the foreclosures stop, the institution will survive, and eventually recoup its losses. This could easily become a $10 stock. The problem is, it's impossible to know when or if the commercial market will stabilize or how deep the recession will be.

I could see from the annual report that First Essex had a total of $46 million in commercial loans at the end of 1991. It also had $46 million in equity. This one-to-one ratio between equity and commercial lending was somewhat reassuring. If 50 percent of the remaining commercial loans went bad, then First Essex would lose 50 percent of its equity, but it would still survive.

Lawrence is another long shot that comes from the same area in the Merrimack valley. It has the same problem as First Essex—a lousy local economy. Their stories are also the same: profitable S&L gets caught up in heady commercial lending, loses millions of dollars, and the stock price collapses.

According to the 1990 annual report, Lawrence still had a 7.8 equity-to-assets ratio, but as I analyzed it, the situation here was riskier than at First Essex. At Lawrence, commercial real-estate loans made up 21 percent of the loan portfolio, whereas at First Essex they made up 13 percent. Lawrence had made more commercial loans ($55 million worth) and had less raw equity ($27 million) than First Essex. This was a much thinner margin for error. If half of Lawrence's remaining commercial loans go bad, it's a goner.

This is the way you look at a long-shot S&L: find out what the equity is and compare that to the commercial loans outstanding. Assume the worst.

Imagine buying a house and then discovering that the former owners have cashed your check for the down payment and left the money in an envelope in a kitchen drawer, along with a note that reads: “Keep this, it belonged to you in the first place.” You've got the house and it hasn't cost you a thing.

This is the sort of pleasant surprise that awaits investors who buy shares in any S&L that goes public for the first time. And since 1,178 S&Ls have yet to take this step, there will be many more chances for investors to be surprised.

I learned about the hidden cash-in-the-drawer rebate early in my career at Magellan. This explains why I bought shares in almost every S&L and mutual savings bank (another name for the same sort of institution) that appeared on my Quotron.

Traditionally, the local S&L or mutual savings bank has no shareholders. It is owned cooperatively by all the depositors, in the same way that rural electric utilities are organized as co-ops and owned by all the customers. The net worth of a mutual savings bank, which may have been built up over 100 years, belongs to everyone who has a savings account or a checking account in one of the branches.

As long as the mutual form of ownership is maintained, the thousands of depositors get nothing for their stake in the enterprise. That and $1.50 will get them a glass of mineral water.

When the mutual savings bank comes to Wall Street and sells stock in a public offering, a fascinating thing happens. First of all, the S&L directors who put the deal together and the buyers of the stock are on the same side of the table. The directors themselves will buy shares. You can find out how many in the offering circular that accompanies the deal.

How do directors price a stock that they themselves are going to buy? Low.

Depositors as well as directors will be given the opportunity to buy shares at the initial offering price. The interesting thing about this is that every dollar that's raised in the offering, minus the underwriting fees, will end up back in the S&L's vault.

This is not what happens when other kinds of companies go public. In those cases, a sizable chunk of the money is carted away by the founders and original shareholders, who then become millionaires
and buy palazzi in Italy or castles in Spain. But in this case, since the mutual savings bank is owned by the depositors, it would be inconvenient to divvy up the proceeds from a stock sale to thousands of sellers who also happen to be buyers. Instead, the money is returned to the institution, in total, to become part of the S&L's equity.

Say your local thrift had $10 million in book value before it went public. Then it sold $10 million worth of stock in the offering—1 million shares at $10 apiece. When this $10 million from the stock sale returns to the vault, the book value of this company has just doubled. A company with a $20 book value is now selling for $10 a share.

This doesn't guarantee that what you're getting for free will necessarily turn out to be a good thing. You could be getting a Jimmy Stewart S&L, or it could be a lemon S&L with inept management that's losing money and eventually will lose all its equity and go bankrupt. Even in this can't-lose situation, you ought to investigate the S&L before you invest in it.

The next time you pass a mutual savings bank or an S&L that's still cooperatively owned, think about stopping in and establishing an account. That way, you'll be guaranteed a chance to buy shares at the initial offering price. Of course, you can always wait until after the offering to buy your shares on the open market, and you'll still be getting a bargain.

But don't wait too long. Wall Street seems to be catching on to the cash-in-the-drawer trick, and the increase in stock prices of mutual savings banks and savings and loans that have converted to public ownership since 1991 is nothing short of remarkable. It's been a bonanza almost anywhere you look, from one end of the country to the other.

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.

In 1992, another 42 mutual thrifts came public. The only loser in this group has been First FS&LA of San Bernardino, and it's down a modest 7.5 percent. All the rest have advanced—38 of them by 50 percent or more, and 23 by 100 percent or more. These gains have come in 20 months!