Twenty years ago, super-investor Seth Klarman dedicated a full chapter to thrift conversions in his highly coveted value investing manual, Margin of Safety (priced at $1,200 and up on eBay!). Last year, changes in the regulatory environment spurred an increase in the number of conversions, and that trend looks set to continue this year. Investors who are familiar with these situations have the opportunity to earn rich, low-risk returns.

The investor other top investors lionize
Let me explain why I follow Klarman closely. Odds are you've never heard him -- he keeps a low profile -- but his peers refer to him in reverential terms. Bruce Berkowitz, Morningstar's domestic-stock fund manager of the decade, said of him: "If he isn't Elvis, he's pretty close." Klarman's flagship fund has produced an annualized return of roughly 19% since 1983. Remarkably, he achieved this while maintaining an average cash position of 30%. If he isn't Elvis, that's certainly a rock-star performance.

Klarman on thrift conversions
In a conversion, a thrift goes from being mutually owned (i.e., owned by its depositors) to stock ownership. In Margin of Safety, Klarman explains that the mechanics of the transaction are very favorable to outside investors: Indeed, they're "buying their own money and getting the preexisting capital in the thrift for free."

Even thrifts that have already converted to partial stock ownership can be attractive: The SNL Thrift MHC Index, which contains 30 partially converted thrifts, produced a 188% return over the 10-year period ended Dec. 1, 2010, tripling the return of the small-cap Russell 2000 Index over the same period (to say nothing of the S&P 500, which only managed to eke out a measly 8%).

A minimum 20% discount to book value
Consider Eureka Financial, which is preparing a common stock offering as part of its conversion from mutual holding company to full public stock ownership. If Eureka is able to place the absolute maximum number of shares, the offering price will represent a 20% discount to Eureka's book value. At the midpoint of the offering range, that discount increases to roughly one-third. Why are such discounts on offer?

Last year, Martin Friedman, the CEO of FJ Capital Management, a specialist investor in community banks and thrifts, produced a white paper on the opportunity in small- and mid-cap banks. In it, he remarked: "[Thrift conversions have] produced outsized returns over the last 20 years and, given the current depressed pricing environment, we project superior returns in this sub-space going forward."

Bad pricing for thrifts, good prices for investors
Pricing is depressed because thrifts are coming to market in an inhospitable environment. Demand just isn't there, as traditional bank share investors are tapped out from buying billions of dollars in share offerings from megacap banks including Bank of America (NYSE: BAC), Citigroup (NYSE: C), JPMorgan Chase (NYSE: JPM), and Wells Fargo (NYSE: WFC). I happen to like those four banks as a basket, but they aren't as cheap as some of the thrift conversions out there:

 

Market Capitalization

Price-to-Tangible Book Value

Capitol Federal Financial (Nasdaq: CFFN)

$2.038 billion

1.00

Fox Chase Bancorp

$194 million

0.82

Heritage Financial Corp

$225 million

0.84

Kaiser Federal Financial Group

$127 million

0.83

Oritani Financial (Nasdaq: ORIT)

$717 million

1.10

Viewpoint Financial (Nasdaq: VPFG)

$462 million

1.09

Average (equal-weight)

 

0.95

Source: Capital IQ, a division of Standard & Poor's.

If prior experience is any guide, there are good odds that this basket will outperform. One of the factors behind historical outperformance has been a dependable catalyst for realizing the value in these situations:

M&A as a catalyst for realizing value
Friedman estimates that 70% of the thrifts that converted to full stock ownership between 1990 and 2010 have been acquired, with an average life for post-conversion thrifts of just 3.7 years. These figures highlight the intensity of acquisition activity in this area if one considers that thrifts are usually barred from being acquired for three years after becoming wholly share-owned.

The conditions for a winning investment are in place
In summing up, thrift conversions are currently an area in which every element is in place to earn abnormal returns: Structural and cyclical factors that create an underpricing and a catalyst to realize value. If that's the case, why not simply buy every available thrift conversion? That strategy could outperform, but I think it's worth rolling up your sleeves to focus only on those situations that offer the promise of exceptional returns.

As Klarman reminds us: "Although thrift conversions are attractive, they are not a sure thing. ... Investors, as always, must analyze each potential thrift conversion investment, not as an instance of an often attractive market niche but individually on its merits." That's where having a "jungle guide" like Tom Jacobs comes in handy.

Become a special situations investor 
An expert special situations investor, Jacobs has been tracking thrift conversions for many years, along with other nooks of overlooked value in the stock market. Tom manages a real-money portfolio on behalf of Motley Fool Special Ops. He and his team are continually analyzing spinoffs, recapitalizations, turnarounds, and deep-value situations. If you'd like to find out about capturing these opportunities in your portfolio, simply add your email address in the box below. In return, Tom will send videos with three opportunities he sees today, along with a personal invitation to join the service when it reopens this month.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star Portfolio, the Fool is also short Bank of America. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.