On Thrift Conversions, OTC Company Drama, and Seeking Info

Seeing small-caps grind downward day after day is a bummer, so here I am, engaging in a little escapism. Rather than self-flagellate over my latest holding to report decent numbers and promptly trade down 11%, I thought it would be more productive to organize my thoughts on market happenings and as always, the quirks of the micro-cap and OTC markets.

First, here is my Q3 letter. I am having a reasonably good year despite the melancholy environment for, well, pretty much everything outside a narrow set of tech stocks. I do wish I could turn back time and tell myself to be more cautious on banks going into 2023, but I continue to think the medium-term outlook for several community banks is very strong. Like many others, I had hoped the return of actual interest rates would cause investors to esteem assets, earnings, and cash flows once again, but so far that remains a dream deferred. I own numerous companies trading at discounts to tangible asset value and at mid-single digits earnings multiples, but today, metrics like these are as inscrutable and irrelevant as the venerated baubles of some ancient and forgotten tribe. Maybe in 2024?

Thrift Conversion Blues

Investing in thrift conversions, mutual banks undergoing partial or full conversion to shareholder-owned banks, has long been a popular niche strategy. The appeal of investing fresh capital into a bank, then getting all the bank’s existing capital for free, is easy to appreciate. Historically, participating in thrift conversions has been good for a healthy first day return of say 15-30%. Many quality banks would go on to reward shareholders with accretive buybacks under tangible book value and eventually, sell to a larger bank at a nice premium. I personally know half a dozen investors who have made millions on thrift conversions. I don’t know Peter Lynch, but the Magellan Fund invested in hundreds of thrift conversions during his tenure.

Thrift conversions are not as common as they once were thanks to the dwindling numbers of mutual banks in existence. But they still happen. However, recent conversions have fallen flat. Instead of trading above the offering price (typically $10) multiple conversions have ended the first day of trading down 10-15%. Bitter medicine for those that expected to flip their shares for a quick gain. The five most recent thrift conversion transactions have produced an average return of -5% to date, with only one trading above the offering price. So what’s to blame? Probably nothing more than the exceedingly gloomy atmosphere that banks and bank investors find themselves in. There is very little appetite for bank stocks, so it’s no surprise that thrifts coming to market are priced accordingly.

But if you are one of those people (like me!) who thinks that the woes facing banks will eventually subside, some of these recently converted thrifts look awfully cheap. I don’t have data in front of me, but my impression is that newly-converted thrifts have tended to trade at 60-70% of tangible book value including newly-raised equity. But because recent conversions have traded down from their offering prices, this most recent crop trading much lower. PFS Bancorp is the worst-performing recent thrift conversion. PFS, parent of Peru Federal Savings Bank in Peru, Illinois, sold 1.725 million shares at $10. Shares change hands at $8.65, giving PFS a market capitalization of $15 million. Post-offering, PFS has tangible equity capital exceeding $31 million and common equity to total assets of 17%. Share repurchases done at these levels would be wildly accretive, so hopefully the company steps up.

I expect the lackluster performance of recent thrift conversions will make it less attractive for the remaining mutual banks to convert to stock ownership. The machine appears (temporarily?) broken. It used to accept $10 bills and spit out $11.50 to $13 or more. Now it leaves you worse off.

One more data point that interests me before we move on to something a little less dry than community banks. Due to the big move in short-term interest rates, the profit uplift that converting thrifts can achieve just by plunking the proceeds from their equity offerings is meaningful. Typically, investors don’t fixate on current profitability when buying into thrift conversions. Mutual banks aren’t managed for the purpose of earning a profit and it takes time for ROE to reach a competitive figure. The trajectory of earnings per share post-conversion matters much more. Aggressive share repurchases are very helpful to this end, as shrinking the capital base is often an easier task than generating sufficient incremental quality loans and deposits to grow into the new, larger equity base. But back to PFS Bancorp. Just by investing its $16 million or so in net proceeds into treasuries at 5%, PFS can earn 60 cents per share, after tax. At a share price of $8.65, that’s not nothing! Obviously, the long-term goal of the offering is to grow the bank’s balance sheet and earnings, not just clip 5% in interest income. But the current interest rate playing field does do a lot to support the earnings stream of these conversions coming to market.

For anyone interested in learning more about thrift conversions, my friend Jim Royal maintains a website and database of recent and upcoming conversions. Check it out.

Chicanery and Skullduggery

I read just about every single report posted by OTC-traded companies at OTCMarkets.com. As >90% of the thousands of OTC companies are and always will be worthless, most of the reports are good for entertainment at most. And let me tell you, sometimes there is no better entertainment! A few years ago I stumbled across Original Sixteen to One Mine, a company in possession of decades-defunct gold mine. Nothing unusual so far, right? OTC markets and junior exchanges are littered with failed exploration companies. The difference with Original 16-1 was management’s absolute faith that the mine would surely be a big producer again with just a little bit of attention and capital. In the mean time, the company eked out an existence offering tours, with management covering the company’s minimal overhead. It all seemed rather harmless, if a bit deluded, but the situation has devolved into accusations of securities fraud, environmental crimes, and now a lawsuit seeking $125 million in damages. Anyone wanting to know the whole story should start with the company website here and then read the complaint.

Stuff like this is why I love the OTC market. Yes, I absolutely think that regulated exchanges should maintain strong listing standards and that investor protection is a serious responsibility. But I also think that if they so desire, investors should have access to a place where they can place their bets on companies looking for Bigfoot (Bigfoot Project Investments, now Lord Global Corporation,) attempting to revive the American Basketball Association (American Basketball Association, Inc.,) seek treasure in sunken Spanish galleons (Treasure & Shipwreck Recovery, Inc..) or even prospect for gold in mines abandoned a century ago. What would America be without its cranks and dreamers?

Seeking Info

I am very deeply interested in non-traditional markets and exchanges. Think company-run bulletin boards, qualified matching services, OTC markets, and the like. I am interested to the degree that I am considering launching a private vehicle just for ideas like this. So here’s my proposal: if you e-mail me and inform me of a trading venue like this that I don’t already know of, I will happily pay you $50 or donate $100 to a qualifying charity of your choice. Let’s say it has to be legally and functionally accessible to an American investor. As fascinating as the Bhutanese Securities Market is, I can’t get there. Thanks in advance!

Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.