Why
We Own Ocean Shore Holding Company (OSHC)
Ocean Shore Holding Company (OSHC) is
the holding company for Ocean City Home Bank, a relatively new
federal savings bank in Ocean City, New Jersey. The bank has
ten branches, all in southeastern New Jersey, and just under a
billion dollars in assets. It also pays a 2% dividend.
Ocean City Home Bank has been in business since 1887. To be
clear, I'm calling it “relatively new” in
reference to its status as a federal savings bank, in contrast
to its previous corporate structure. More on that in a bit. But
the bank is quite established, to say the least. Grover
Cleveland was president when the mutual was first formed. And
believe it or not, some of the bank's first customers were
alive when the Cubs last won the World Series! Seriously - they
actually won it once! Can you believe it?!?
And just in case you read the words “New
Jersey” and immediately thought of dirty turnpikes or
those reality show buffoons, I suppose I should pause here and
point out that New Jersey is actually one of the wealthiest
states in the country. OSHC serves customers in Atlantic and
Cape May counties, which, as noted here
on Wikipedia, are among some of the richest counties in the
U.S. So it's gotta be true.
Having spent a little time in Ocean City, I can also assure
you that it's the kind of town we want to own a small bank in.
The bank's financials underscore that, too. Specifically:
Asset quality has been exceptional, even throughout the
Great Recession. Bad loans have been extremely rare over the
entire last decade. Turns out OSHC actually required borrowers
to put down 20% on their loans. Who knew?
The vast majority of the loan book is in sound, local
residential loans. OSHC owns no wacky derivatives. It took no
TARP money. The bank's executives have been involved in zero
scandals, nor have they been asked to give any congressional
testimony. So the bank has no dilution risk - or any business
risk, really.
What Ocean Shore does have is a clean, immediately
understandable balance sheet, which is saying something these
days. If there was a knock against the company, it would be
that the bank has almost too much capital.
More to the point, though, this sleepy little bank on the
shore of New Jersey did what thousands of bigger, flashier and
more popular banks failed spectacularly to do the last few
years: it grew - safely, soundly, and without any special
favors. In fact, in 2010, OSHC recorded its best annual
performance since first becoming partially public six years
earlier. And they did it the right way - by focusing on growing
deposits instead of issuing risky loans.
So why is it cheap?
Cuz it's a second-stage mutual holding company conversion!
Er, this is where the special situation investing comes
in.
Why is it Cheap?
The Dodd-Frank financial reform bill passed last year shut
down the Office of Thrift Supervision. For the past two
decades, OTS had regulated savings and loan associations like
Ocean Shore. OTS' regulatory powers were transferred over to
the Office of the Comptroller of the Currency. The OCC is used
to regulating larger banks. And that has caused a great deal of
teeth-gnashing among certain small banks called “mutual
holding companies,” or MHCs.
Yep. If reading about bank regulators doesn't kill ya, the
acronyms will.
In any case, most mutual institutions are long-established
groups that were originally set up by depositors who pooled
their money together to earn some interest and make local
loans. These thrifts resemble community banks, except they have
no shareholders and are controlled by their Boards of
Directors.
Should a Board ever decide to take a mutual public,
ostensibly to grow, there are three ways to do it. For the
purposes of this discussion, though, just know two things, (1)
OSHC finished its conversion to a publicly traded company in
December 2009, and (2) because of those regulatory changes
above, the benefits of being a MHC are going away. That has
prompted a rush of mutual institutions to convert to publicly
traded companies.
And by “rush” I mean a
“last-call-before-the-hurricane-hits” kind of
blitz. Because that conversion window is closing, there are
dozens of thrifts going public at valuations that are not only
historically low, but just silly. It's that kind of temporary
inefficiency in the market that is worth watching as an
investor. Still, though, you've got to be careful what you buy.
Some thrifts are coming public at cheap valuations for good
reason.
OSHC, sensing the writing on the wall, became a traditional
public company in late 2009. For some time, then, it has been
apparent that this was an exceptionally run, conservative bank
in an attractive local economy trading at an obvious discount
to its true value - with more capital than they knew what to do
with, thanks to the money raised after fully converting to a
public company.
Why have shares stayed cheap for so long? Part of that is
due to size. Ocean Shore is a very small public bank, and its
shares seem to trade by appointment only on most days.
Analyzing banks also takes a different set of skills then most
individual investors possess, and a company like OSHC is simply
way too small for a large fund to take a position in. Shoot, it
was hard for me to get us in.
Plus, going public when it did was poor timing in the sense
that there has been a huge number of bank shares issued the
past 18 months. At the risk of oversimplifying, the stock
market is all about supply and demand. The supply of bank
shares has been off-the-charts-high lately due to all the
capital that needed to be raised in the sector. And with demand
further weakened because of all the problems banks have had,
the prices of shares in good banks like OSHC have drifted much
lower than they otherwise would.
Is it Cheap for Temporary Reasons?
It's because I couldn't answer that specific question last
year that OSHC seemed like it might be permanently stuck on the
watch list. Good bank, solid management, the business seemed
cheap…but it could stay cheap for a long time, too. What
I was waiting for was a catalyst - a development that would
help underscore the obvious value in the company.
On February 15th, it arrived. Ocean Shore announced it was
buying a $135 million dollar bank near one of its existing
branches in Egg Harbor, NJ. And that was enough to get me off
the couch.
To understand why requires a quick crash course in Valuation
101. Actually, this is more like a pre-requisite - it's even
more basic.
Here's a simple equation that captures company valuation in
a nutshell:
Value
= what you really know + what you think you know
The ability to accurately determine the true valuation of a
company really rests on two things, ultimately; (1) things you
know you can be confident in, and (2) things you think you can
be confident in. As any good engineer will tell you, to get an
answer you can really rely on, you want both (1) and (2) to be
good data. Adding good data to bad data results in a bad answer
- and we want to avoid those at all costs.
If you were to translate that equation above into something
still pretty simple but tailored to a bank, it might look
something like this:
Value
= (tangible book value and return on equity) + speculative
value
When it comes to analyzing companies, “book
value” is synonymous with what you might think of as
your own net worth. To figure out your own net worth, you'd
first add up the value of all your assets - your home, cars,
antique fly rod collection, IRA accounts, and that $17 you've
got buried in the tin can in the backyard. Then after
subtracting all the debt you owe on those things, you'd have a
number similar to what a bank would call its book value.
(For now you'll have to take my word that book value is more
useful for valuing banks that many other kinds of companies.
Also for our purposes, let's just assume “tangible book
value” means book value without any fluffy stuff
included. It's better data, in other words.)
Now the past few years, the book value of many banks has
been anything but certain, due to all the depressing headlines
you know so well. For instance, it's very easy to find the book
value of JPMorgan Chase, but for a number of reasons, I don't
have much confidence that number reflects good data. There's
just too much fluff.
OSHC is different, though, because it's book value contains
no fluff. We can have a high degree of confidence that it's
good data. And so it might strike you as unusual that the
valuation that the market is currently putting on OSHC shares
means that the company is trading for, quite literally, less
than what we know it is worth. The numbers are right there,
even if nobody else is noticing them, and the acquisition made
the valuation gap even more obvious.
Now typically, if something is trading at less than a very
solid book value, it's for two reasons. The first is because
bad things have happened or are about to happen. A company
might also be trading below book value because the market
believes management is literally destroying value in the
company.
Neither applies to OSHC, though. It's trading below book
value because, well, it's a special situation.
Back to that last equation. If we're confident in the
tangible book value and historical return on equity (which will
actually go up at OSHC due to a favorable acquisition price and
resultant cost cutting), then - and this is the best part - at
a certain share price, we can completely ignore the speculative
elements in our valuation. That's good, because then there will
be no chance that we let any potentially bad data into the
equation. And if the market price is considerably less than a
conservatively-derived intrinsic value, well, we're in
business.
What Are Shares Really Worth?
Let's put aside everything else associated with evaluating
the company as an investment and focus on just this one
point:
If OSHC's post-acquisition tangible book value does nothing
more than compound at its historical rate, then in three years,
basic math indicates that shares that are now trading at $12
will be worth $18.
Sometimes it's just that simple.
There are a few potential scenarios that would make shares
more valuable, too. For instance, one of the reasons investing
in converted thrifts has been so lucrative in the past is that
(as per a study by FJ Capital Research) since 1990, 70% of all
thrifts that convert are acquired within 3.7 years.
Now current regulations prohibit thrifts from selling out
for at least three years after becoming fully public, so in
OSHC's case, that would be in 2013 - if it even happens. But
the odds say it will. And if you presume that Ocean Shore is
acquired at the same multiple of tangible book value that it
just used to buy the Egg Harbor bank, then OSHC shares would be
worth $24 a share. We'll have doubled our money in three
years…while earning a secure little dividend and
sleeping well at night, too.
So, I'm enthused about Ocean Shore and believe we'll be
well-rewarded in this and other recent special situation
investments. I hope the above helps explain why.
Please email me
if you have any questions. Otherwise - until next month!
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Cale's
Notes: 
