This article was selected to be shared with PRO subscribers, who also got 7 days’ exclusive access to Ian Bezek’s original Top Idea on TFS Financial (NASDAQ:TFSL). Ian Bezek worked on the buyside for several years before moving to Latin America to pursue entrepreneurial opportunities. Find out more about PRO here.
Seeking Alpha: Can you briefly summarize your bullish thesis for readers who may not have seen it yet?
Ian Bezek: TFS Financial is a regional bank, operating primarily in Ohio, that offers both a 7% dividend yield and solid stock price upside. Shares are much cheaper than you’d expect because of the company’s unique holding structure. At this time, you can find plenty of quality regional banks trading for around 0.7-0.8x book value and paying a 4-5% dividend. TFSL stock, however scores much better on both counts. It’s at 0.5x book and a 7% dividend. What explains the difference?
A mutual holding company controls 81% of TFS, but this control is largely illusory. At some point in the future, when the bank makes its second-stage conversion, that stake will be IPOed out to the public at close to book value, which will be a huge premium to the current stock price.
Yet, financial screeners count those shares — which do not yet exist in any meaningful sense — as already outstanding stock. Thus TFSL stock screens as if it trades at almost 3x book value and 50x earnings. What the screener misses, however, is that only 19% of the reported shares outstanding matter to the bank’s current valuation. Correcting to the proper share count, TFS trades for just 0.5x book value and 9x earnings. As the economy recovers, I’m looking for TFSL stock to trade up to 0.7-0.75x book which gets a share price in the low-to-mid $20s along with the 7% dividend.
SA: There are a number of short and long-term catalysts (which should reduce the risk of this being a value trap) – can you walk readers through them?
Ian Bezek: Prior to Covid-19, TFS voraciously repurchased its own stock, as is logical when shares are trading for half of book value. It’s hard to make any investment better than repurchasing one dollar’s worth of your own assets for fifty cents, after all. Since 2014, the bank’s true share count is down from 76 million to 53 million as TFS has bought back nearly a third of its outstanding stock.
With the pandemic, most banks, including TFS, have currently suspended their share buybacks. However, at some point in the future — and hopefully as early as 2021 — the bank will be able to reinstate its buyback. When purchasing stock at that level of discount to book, you achieve incredible compounding of shareholder capital.
Additionally, 99% of TFS’ lending is for single-family residential housing, with the vast majority being vanilla first mortgages on homes. This is a low risk business which protects the bank’s capital during an economic downturn. Usually this lending, while safe, is not particularly compelling. However, thanks to the current housing boom, TFS has reached a record level of loan originations, thus offering it earnings upside. Around 20% of TFS’ lending is in the Florida market, which is doing particularly well at this time.
Finally, you have the second-step conversion at some point in the future. At this point, the 81% of the bank held by the trust will be sold to the public. I expect this will happen at somewhere around 0.8-0.9x book value (mid-to-high $20s if it happened at the current price levels), thus being hugely accretive to the existing shares which now trade for $16. After a second-step conversion, banks are typically way overcapitalized and either pay special dividends or sell themselves thus fetching an M&A premium. TFS’ CEO has suggested that he will leave the second-step conversion decision to the next generation of his family, however he’s in his mid-sixties so something could potentially happen within the next few years.
SA: Is the mutual holding company (“MHC”) structure the gift that keeps on giving in terms of creating mispricings? If so, why does this persist, whereas other mispricings have been corrected or competed away?
Ian Bezek: Yes, there have been opportunities within this space for several decades now. Both Seth Klarman in his book Margin of Safety and also Peter Lynch in his books described ways that investors could benefit from the thrift conversion process. However, Margin of Safety famously went out of print for many years, while Lynch’s ideas started to fade from the popular view after his retirement from Magellan.
Then throw in the financial crisis, and a lot of people that had had favorable experiences investing in banks suddenly realized large losses and swore off the sector forever. It was hard for bank-focused mutual funds to attract capital either in the wake of the crisis. This naturally deprived the community banks of investors that actively wished to buy their shares.
And now the biggest investing trend, passive ETFs, largely misses smaller banks together. For example, the sector specific fund, First Trust Nasdaq ABA Community Bank ETF (QABA), only has $63 million in assets under management. Meanwhile broader factor funds such as small-cap value may miss TFS and other MHCs because their stocks don’t screen properly and thus end up excluded from indexes.
SA: To follow up, is part of the reason for the mispricing because it’s so underfollowed and misunderstood as you note the valuation appears to reflect perceived concerns rather than actual (positive) results so far?
Ian Bezek: Yes, it’s not only that TFS Financial is off-the-radar, even if you look at it briefly, it doesn’t seem attractive. You have to understand the MHC math to see the appeal, and a lot of people simply aren’t going to do the work for a sleepy regional bank.
That said, professional managers should be wiling to kick the tires at TFS. There though, another issue springs up. Generally active managers want some near-term catalyst to justify holding a position. If your clients are asking if you beat the market every month or whatnot, it’s hard to focus on something that will likely take several years to play out. TFS has a conservative management team and doesn’t take many risks as an institution. Thus, there’s not much to drive a narrative on a quarterly basis, so fund managers needing short-term performance are probably going to look elsewhere.
And the individual investors that do have the longest time horizons often simply don’t know about MHCs or how to look at the real numbers here. When I bring up TFSL stock with many people, it’s dismissed out of hand because it seems like the P/E or Price/Book ratio is too high, or the dividend doesn’t seem to be covered out of earnings. Hopefully this article and interview help people discover the true numbers and opportunity in TFSL stock.
Thanks to Ian for the interview.
Disclosure: I am/we are long TFSL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.