Contrarian’s “#1 Income Play for 2021”

What's the dividend play being teased by Brett Owens in ads for his Contrarian Income Report newsletter?

By Travis Johnson, Stock Gumshoe, January 11, 2021

We’ve covered some teaser pitches from Brett Owens in the past, he has mostly specialized in targeting closed-end funds that he thinks provide good income, at least when it comes to recent pitches I’ve seen. We’ve covered some past ads where he pitched income-focused investments that have worked out reasonably well and some where those ideas failed (five years ago, for example, he touted three healthcare REITs as a play on “demographic shifts” and an aging population — Medical Properties Trust (MPW) has been a solid winner, but Omega Healthcare (OHI) and Care Capital, now part of Sabra (SBRA), trailed both the market and the REIT index)… so let’s see what he’s pitching this time out.

It’s different, so that’s worth noting up front — he’s pitching a bank, not a REIT or a closed-end fund. So that’s probably good when it comes to shaking things up, I haven’t looked at a boring ol’ bank stock in months and man can not long survive on a diet of tech stocks, bitcoin and LiDAR.

Here’s what Owens promises in his pitch for the Contrarian Income Report ($39 first-year offer, regular price $99):

“… many investors feel stuck between a rock and a hard place…

“Simultaneously scared of a second crash, while worrying about missing a second rally.

“The truth is, the markets could go either way in 2021.

“Which begs the question, what should you do with your money?

“Well, today I want to give you my #1 investment for these uncertain times.

“It’s a little-known investment set to return a safe, secure 14.5% per year — bare minimum — whether the market surges even higher or suffers a second, even greater crash.”

That sounds a like a well-timed balm, at least for those of us who feel like we might be following the path of Icarus and getting that first inkling of a sunburn… frankly, if I was guaranteed 14.5% a year I’d be tempted to sell everything and put all my money in that instrument right now.

Of course, I should note, hinting that this is safe, secure, and will return 14.5% at a “bare minimum” is not the same as a guarantee. Anything with the potential for that kind of sustained return will incur a meaningful risk of loss, just like any other “at risk” investment.

Still, we want to know what it is. So what other clues do we get?

“It’s a way for you to maximize your upside if stocks surge, while protecting your downside if the markets plunge. In short, it’s the best of both worlds… maximum returns with minimum risk, in any environment.”

Again, sounds good… but we want some details, please!

These are the “all weather” criteria he says he’s looking for:

“… when you’re looking for investments that perform in almost any market and protect your income, you really want to see two crucial pillars in place:

“Pillar #1: A high, well-covered dividend of at least 6% – but ideally more. This is so you can keep on collecting a consistent income stream no matter what happens.

“Pillar #2: A resilient and ideally rising share price. Because a 6%+ dividend isn’t much good if the underlying stock collapses 15%, essentially taking the next three years of income with it.”

We can’t control the share price, and it’s also generally a guessing game to predict it, but I personally like to look at dividend growth as the best indicator — a resilient and rising share price tends to come from a steadily rising dividend, all else being equal (if investors decide in two years that the stock should still be valued at a 6% dividend yield, but the dividend has been increased in that time, the stock will have increased at the same pace of the dividend). If the dividend stays flat, then the share price is essentially going to be just a bet on future changes in interest rates (income investments compete with each other for capital), and the risk that investors perceive in the company’s ability to keep paying the dividend.

If you point me to a 6% dividend that’s also growing, I’m immediately tempted. Sustainable dividend growth and a 6% current yield would mean my knee-jerk reaction, not even knowing the name of the company, is “just buy it.”

But investing is not generally a great avocation for those prone to jerky knees, so let’s figure what this stock is, shall we?

Owens does give three more criteria from his “all weather” checklist:

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“A history of outperforming in a crash….

“A bargain valuation….

“Fast (and ideally accelerating) dividend growth.”

OK, if we’ve got all that then you can probably sign me up. Here are the clues for this “all weather” stock that he says is his #1 Income Investment of 2021:

“… my favorite play right now for 2021 and beyond is actually a bank.

“However, this isn’t any regular bank. It is not some corporate behemoth with offices in every country in the world, hundreds of thousands of employees, overpaid CEOs, and trillions of dollars on the books.

“Since 1938 this family owned bank has been the antithesis of Wall Street banks.

“They put their customers first, they have strict moral and ethical codes, and by following this path they’ve built a strong business with over $12 billion in assets on their books.”

That’s enough to get a couple reasonable guesses, but thankfully Owens drops some other hints as well — the Thinkolator will do better with a few more details:

“First, it ‘breaks’ every stock screen due to its special corporate structure and particularly unique shareholder setup (which we’ll get to in just a moment).

“Second, on paper it looks expensive for a bank. Most websites say it trades at a ‘nosebleed’ 2.9-times book value, while its peers trade between 1 to 1.4-times book.”

He says this “broken” book value comes from a “conversion” — which means he must be talking about a mutual savings bank that did a conversion to become a shareholder-owned corporation, and he says this happened back in 2007. Mutual conversions do, on average, tend to be a good deal for folks who participate in the conversion, particularly those account holders who take part in the initial share offering (a “mutual” thrift is owned by accountholders, like a mutual insurance company, so those account holders can often benefit from a “sale” to the public markets), and they often (not always) are misunderstood and undervalued after that.

And some details about that dividend:

“The best part, this bank only pays dividends to its minority shareholders like you and me.

“In the first half of 2020, its earnings per minority share were $1.61, which is MORE THAN ENOUGH to pay out its $1.12 per share dividend.

“And get this… their book value per minority share as I write is north of $30.
This is significant because we individual investors buy these minority shares, which are trading for $17-something today.

“So, this means the stock is trading for just over half its book value and yielding nearly 6.5%.”

That’s a tricky idea to get your head around when dealing with these partial conversions, mutual companies that remain partially owned by their customers, or companies where there’s still a large part of the company which owns a different class of shares that doesn’t trade — does that half of the company which isn’t public and may not get a dividend still count as “ownership?” Should it go into an assessment of the valuation? It’s not so different, really, than the debate over whether we should look at “adjusted earnings” or “GAAP earnings” for a tech stock that issues millions of new shares each year to pay employees — fashions change when it comes to that kind of valuation thinking, there is no single “rule” and investors have to think for themselves in making those judgements.

He does say it’s growing, as well, which is important — apparently the loan book for this bank has been growing at 4.5% a year, and Owens says they are a “very conservative” lender, with just 0.25% of outstanding loans currently “late.”

And he also says “I expect a dividend hike again this summer” — the ad is undated, so I’m not sure which summer he means, but I guess if it’s the #1 stock for 2021 it would have to be Summer, 2021.

That’s also where he gets that projection of 14.5% growth from: The 6% yield, plus his prediction that the dividend will grow and bring the shares up with it (which is usually how these things work, on average)… from Owens:

“Their last raise was 8% and that was on the conservative end.

“Still, when you consider that stock prices move higher with company payouts over time, we should add their dividend growth of 8% to its current yield of 6.5% for a projected total return of 14.5% per year.”

So what’s the stock today? This is, sez the Thinkolator, TFS Financial (TFSL), which has its roots in the Third Federal Savings and Loan in Cleveland. And yes, like most S&L’s, it is primarily a provider of retail banking services, mostly savings and checking accounts, and a mortgage lender. It has indeed been publicly traded since its thrift conversion in 2007, and over those 14 years it has been above-average as a banking stock but trailed the broader market pretty handily.

And yes, a bright spot is that it did much better than the average financial stock during the 2008-9 financial crisis (the main reason it comes in as “above average” since 2007), though it was still a brand new stock at the time, and during the weak market in 2011-12, though it has pretty much tracked along with its sector during this past pandemic year.

How about that dividend? Well, they did pay one right off the bat… though they also paused the dividend for a couple years from 2012-14, too, so that gives some reason for pause. Over the past five years, the dividend has been tripled but the stock has only gained 4% — so that provides a possible catalyst, if investors really do begin to believe in the dividend growth potential, there’s ample room for the stock to jump higher to reflect that confidence.

Right now, the dividend is almost exactly 6%, and the last dividend increase was declared in February of 2020. Before that, they had been on a “raise the dividend every August” pace, so I don’t know what to expect this year, whether they’ve shifted to February for dividend announcements or we’ll have to wait until next August to see if they keep the dividend growth going. Dividend-focused companies don’t like to go more than four quarters without increasing the payout if they can help it, but they are already at the dividend level that was authorized by their mutual holding company shareholders in the waiver vote back in July so it will probably be August before we hear about a new dividend.

TFS is still mostly a mutual company, as of their last quarter 81% of the parent company was owned by the original mutual holding company, and it is still run by the founding family (the bank was founded in 1938, the current Chair and CEO is the founders’ son). And they do make a point of focusing on the minority public shares (about 19% of the company) in their presentations (most recent one is here):

“GAAP Book Value Per Share of $5.91 but Book Value Per Minority Share of $31.22.

“For last 4 quarters, GAAP Earnings Per Share of $0.30 but Earnings Per Minority Share of $1.57.”

And reiterate that this is a typical valuation metric with this footnote:

“In a mutual holding company structure where only the minority shares are publically held, many investors focus on the level of shareholders’ equity and net income per minority shares outstanding, which is a non‐GAAP measure.”

I wouldn’t push back too hard against that assertion, though I will note that in the mutual conversion investments I’ve looked at in the past, the minority shareholders have owned something closer to 50% of the company, not this very small 19% stake. And that shrinking minority stake comes largely from share buybacks — the company has bought back about half of the originally floated minority shares since 2007, which, using their rationale, makes perfect sense. They bought 52 million shares to cut their minority shareholding from 105 million to 53 million, and in so doing dropped were able to claim dramatic growth in earnings and book value per minority share.

The majority shares owned by the mutual company, Third Federal MHC, have not received dividends (though that has to be voted on each year, and could change), so that also juices the potential for dividend growth. That vote has been overwhelmingly in favor of withholding dividends to the mutual majority shareholders in the past, but if that changed it would obviously be a very different investment — TFS reported net income of roughly $83 million over the past year and paid out $55 million in dividends, so that’s a solidly sustainable dividend… but distributing $55 million to the 53 million outstanding minority public shares is a lot more exciting, for shareholders, than would be distributing that money to the full shareholder base, including the majority mutual shareholding company, of 280 million shares.

So that’s why the financials sound a little funny and don’t screen well, GAAP accounting requires them to include the 80% of the shares owned by the mutual company… and the company itself would prefer that investors think about the whole company being owned by the 20% minority shareholders. As long as that’s the consensus of shareholders, and as long as they continue to approve the waiver every year to withhold dividends from the majority shareholders, that might work out well. And the odds are reasonably good that’s how it will turn out, with the dividend continuing to be high and the shares continuing to rise at roughly the same pace as the dividend growth.

As a bank, ignoring the shareholder base, it sounds pretty good — this might change as the shakeout from the pandemic continues to rattle through the economy, and that depends mostly on the level of federal support, but right now they have very low delinquencies, good asset growth, and what sounds like a strong customer base, with borrowers who have very good credit ratings, and while they are primarily an Ohio company they do get more than half of their revenue from mortgages in 25 states, with Florida being the other state that’s big enough to be noted as significant (and the only other state where they have a lot of branches — the loan balances are about 52% Ohio, 17% Florida, the balance “other” states).

They say they’re going to continue to do “strategic buybacks,” though that was suspended due to COVID-19, and that dividends will also continue to be a “capital deployment” focus. The loan balance is substantial and held on their books, so they’re not just a service provider, which means there should be some stability as long as we don’t see a massive wave of delinquencies like 2009, and they do have a pretty strong funding base that’s primarily built on CDs.

The foundation of the company’s profitability is the fact that they have $9 billion in deposits with an average cost of funds of about 1.25% (about 70% of that is CDs), supplemented by $3.5 billion in bonds that cost them 1.75%, and that capital is lent out in a variety of mortgages that provide a yield of about 3.2%. Pretty much like you’d expect from an old fashioned savings bank, it’s a fairly simple business that’s easy to understand — unlike the giant banks, whose balance sheets are an incomprehensible morass.

And while there are a few other smaller things going on, the rest of the business doesn’t matter much — if they can keep borrowing money at 1.5% and lending it at 3.2% and keep the costs of running their corporation and their branch network under control, they’re going to show a decent return, and that return will be further leveraged if you only look at the 20% minority shares.

Things can get challenging for a business like this if interest rates change quickly, since their average term on those CDs is only about 15 months, but that will be sheltered somewhat by the fact that more than half of their mortgages are adjustable rate, so if interest rates rise and that spikes up the competitive rate for CDs, then over time they should also be able to raise the interest rate on the adjustable rate and HELOC mortgages (which comprise 56% of the total loan book). That “over time” part is important, though, if the yield curve flattens it’s generally bad for companies like this that lend out long-term money and finance that lending with short-term deposits.

What will happen here? I don’t know. If it were a typical bank, you’d look at the risks in the lending book and the balance of the funding sources and it would be an obvious buy if those per-share numbers accounted for the whole company — but it’s really a levered stub, a minority stake in a company that the company is trying to convince us to value as if it’s a controlling stake, and that’s a little bit harder to take. You’d have to understand the company well, know how strong and traditional the management team is and who controls the vote in the mutual company and why, and whether this push to reward minority shareholders is likely to persist into the future — if so, it will probably work out well and a 6% yield that can grow is nothing to sneeze at.

I’m not convinced quite yet, partly because this mutual conversion is different than most I’ve looked at in the past, mostly because they don’t seem at all growth-focused, kept the mutual control, and have bought back more than half of their public shares (large partial mutual conversions I’ve noticed in the past have mostly either been taken over, or have converted more and sold more public shares in order to grow — most banks crave scale), but it’s probably worth putting some more time into understanding the potential. There’s an interesting history of the conversion here, from someone advocating investment in TFSL back in 2014, which might help to get some back story.

On the point of those dividends, here’s a quote from that older article:

“A note about mutual holding company dividends. MHC don’t want the dividends. Accepting dividends generates a taxable event. The most cost effective to get more money into the hands of the association’s members isn’t through dividends, but by paying higher interest rates to the depositors who are the members. Of course, the public shareholders do want the dividends, so the traditional MHC answer is to waive their right to the dividends.

“Prior to the Dodd-Frank act, the board of the MHC could waive the dividends issued by a mutual thrift by a board decision. Post Dodd-Frank however, MHC’s are required to have its members vote on the waiver decision. On July 31, the members of the association, voted to approve the board’s recommendation to waive up to 28 cents of dividends for the next year by a 97% approval of those who voted. The request to begin the dividends at seven cents per quarter is now at the Fed awaiting a non-objection notice for up to 45 days. Given the strong capitalization of the thrift, the lifting of the MOU earlier in the year, the previous Fed approval of the earlier buyback, and the dividend coverage from earnings, its approval seems a formality.”

Just keep in mind that the 80% mutual shareholders, that group o