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Peter Lynch (Index)

Saving & Loan Banks
1991-1996
Industry: S&L Banks
Category: Special Situation

Context
Traditionally S&Ls are cooperatively owned by depositors. There are no shareholders.
Depositors do not have voting rights or dividends. Furthermore, the institution cannot raise outside capital.
Therefore, these S&Ls will restructure their operations, known as a "thrift conversion" and go public.
In a thrift conversion, the S&L directors put together an equity offering for depositors.
The directors will price it cheap to their own benefit, because they themselves will participate in the offering.
However, most depositors will ignore the offer and throw it in the trash (only 2% of depositors participate).
This creates a special situation where you can snap up a lot of shares for cheap.
But that's not all, all the money raised will go directly to the equity.
This is the equivalent to buying a new car for cash, taking it home, just to find the money you paid for the car in the glove box.

Why the Company is Mispriced
Since 1988, there was a lot of negative press about S&Ls. There was a $500b S&L bailout by the government. 675 bankrupt financial institutions since 1989.
Many bad actors had taken advantage of thrift conversions to enrich themselves.
For example, they would put $1m in equity into a S&L. That $1m in equity allowed them to raise up to 19m in deposits. They raised deposits by offering high interest Certificate of Deposits.
They took the deposits and made loans to fund dubious projects managed by their friends and family.
They collected enormous front-end fees, effectively putting a part of those deposits into their equity.
Using this newfound equity, they could continue to collect deposits and make more loans. This was basically leaching off the deposits and putting it directly into their pocket.
Other niave banks, seeing these bad actors make all this money, haphazardly followed suit and made loans in these dubious projects.
The problem is, many of these dubious projects were fundamentally unnecessary and may have even caused an oversupply of projects in the commercial real estate space.
This caused a fear of default in the whole S&L basket.

Alternative View
Lynch discovered that there were S&Ls he labelled the Jimmy Stewarts. No-frills, low-cost operators, found in small towns others have overlooked.
He found that these operators were in stronger financial shape than the strongest bank, JP Morgan.
Due to their no-frill cost structure, these S&Ls had very low breakeven on their loan portfolios.
The breakeven spread, the difference between what they pay for deposits and what they receive for loans, is 1.5% on their loan portfolio.
This is compared to Citibank, which has a 2.5-3% breakeven.
This cost structure is so low that means that the business doesn't even need to make loans!
It can just buy treasury bonds on passbook savers and still earn money. Imagine how profitable solid residential mortgages were for the Jimmy Stewarts.
As these Jimmy Stewarts were inheritly conservative, they did not participate in commercial real estate craze.
Furthermore, they could potentially acquire the deposits of troubled/defunct S&Ls, cut costs, and make better loans.

Lynch went through all the public S&Ls and chose 5 Jimmy Stewarts and 2 long shots.
He picked the Jimmy Stewarts based on high equity-to-asset ratios (meaning they could make more loans if they desire), high book value in relation to price, <10% of the portfolio in high risk loans,
low PE, <2% 90-day nonperforming loans, and low/non-rising real estate owned (most S&Ls are not in the real estate business, they do not want to repossess/maintain illiquid units).
Of the 2 long shorts, they had poor earnings, but high enough equity-to-asset ratios and book value to give them room to work out their problems.

Lynch also recommended to put deposits into non-public S&Ls for a chance to participate in their thrift conversions.
In 1991, 14 S&Ls went public. The worst of the 14 is up 87% in 3 years In 1992, 42 S&Ls went public. The only loser is down 7.5%. The rest are up 50% or more in 2 years.

Result
The 5 Jimmy Stewarts in 2 years: Glacier Bankcorp is up 40% in 2 years, Germantown Savings is up 59%, Sovereign Bank is up 65%, and People's Savings Financial is up 26%.
The 2 long shots in 2 years: First Essex is up 70% and Lawrence Savings is up 37%
As a basket, this is about 20% CAGR over 2 years.