This Bank Stock Could Be a Double

TFS Financial is a gem hiding in plain sight. While the market hates the uncertainty surrounding the company, you should love it, because it makes the stock a great bargain. This investment exploits a trick mastered by investing greats Peter Lynch and Seth Klarman.

That's why my Special Situations portfolio is buying shares in the bank on the next market day. Read on to see why this stock could easily double from here with the potential for dividends and buybacks.

The business
From an operational standpoint, there's nothing truly exceptional about TFS Financial. It runs your average bank, taking deposits and lending for mainly residential property. Some 78% of its lending takes place in Ohio, with another 17% in Florida, and the remainder in various states across the U.S. In contrast to seemingly cheap peers such as Bank of America, Citigroup, and JPMorgan Chase -- each with huge exposure to risky derivatives and other financial arcana -- TFS looks much more like your hometown corner bank. You don't have to worry that a London Whale will swallow this one.

TFS's credit metrics have improved greatly since the worst of the financial crisis, though there's still room for gains. For example, delinquent loans have been cut in half since 2009, and non-performing assets have trended down consistently since 2010. These levels are still elevated, meaning profitability should increase as the economy normalizes. The bank has continued to grow book value since 2009.

TFS expects to continue growing book value through its emphasis on adjustable rate financing. The company has moved much of its portfolio -- 48% as of December 31, 2012 -- to adjustable rate. That means that when interest rates rise, as they someday will, TFS is somewhat insulated from the destruction. In addition, recent mortgages have strong credit quality. On first mortgages originated in the 2012 fiscal year, FICO scores came in at 782 with an average loan to value of 63%, so high credit quality with borrowers having plenty of skin in the game. Those figures are similar so far this year.

How much would you expect to pay for a bank like this? At a minimum, I would say a fair price is tangible book value. TFS trades for about half that. It gets better, because TFS has a way to drive book value per share higher even if its banking operations don't improve.

The special situation
If Apple were trading at only the value of cash on its books and had a profitable business besides, would you hesitate to buy? That's exactly the situation here, but it's even better, because TFS plans to actually return that cash to you, unlike Apple. Here's what I mean.

By law, banks have to maintain equity over a minimum level to be considered well-capitalized. For TFS, that means having risk-based capital of at least 10% of assets. TFS vastly exceeds this, with 22.8%. In fact, TFS has so much capital that it could buy every share that trades publicly!

On the most recent conference call, management joked about doing this very thing. Over the last few calls, they've talked about buying a sizable number of shares and how to return cash to shareholders. They are serious about this and have the history to back it up, having purchased nearly $300 million in shares -- more than 25% of the float -- in the two years after going public in 2007. A strong buyback could easily grow book value per share by 35%, which should translate into solid gains for shareholders.

In addition, there's the potential for reinstating a dividend, a move that would bring a whole new class of investors to the company.

Why does the discount exist?
A reasonable question might be how and why such an opportunity exists. There are at least two reasons this bank is trading for half of book value, and the reasons are largely short term or fixable.

First, virtually all the public finance sites, including brokers' sites, report figures on TFS Financial incorrectly. They'll say the market cap is around $3 billion and that the price to tangible book ratio is an average-sounding 1.8, keeping investors away from this cheapie. You simply can't quickly screen for this type of company, keeping a few people in the know and most people out. That's due to the nature of TFS's operations as a thrift and the process of demutualization that it undertook in 2007.

In a mutual bank, a mutual company holds shares on behalf of customer-owners. When a bank decides to demutualize and go public, it typically sells 30%-40% of its shares to the public, with the remaining shares held by a mutual holding company. These latter shares do not trade, but at some later date, a bank can sell those shares to depositors and put the proceeds in its own coffers. This acts as a means to raise capital for banks that need it. But with such a strong capital position, TFS has no need to raise cash.

Because of this partial demutualization, finance sites say that TFS has 309 million shares outstanding, but the actual public float is just 81.9 million. That inflates shares outstanding without giving the company credit for the cash that it could raise from selling the remaining shares. Factor in just publicly floated shares, and TFS is cheap, around 50% of book value. Investing in demutualizations is a trick that legends such as Peter Lynch and Seth Klarman have exploited before for great profit. So incorrect finance sites and the overhang of potentially new public shares keep TFS's price down.

Second, TFS has a pending regulatory action against it, preventing it from buying back stock or issuing dividends. The regulatory action concerns the company's corporate governance, which TFS had been working on before even being contacted by the feds. This concern is correctable. TFS has already cleared other regulatory actions that are more operational in nature (for example, on its interest rate exposure), so I expect its concerted effort to satisfy regulators here as well. That would clear the way for buybacks, which could really drive the stock higher.

How much higher? As my title suggests, it's not hard to foresee the stock at $20 or more this year, if the company is able to repurchase a sizable number of shares. That would still put the price to tangible book value well below one, leaving more room for upside if buybacks continue or a dividend is initiated. For now, though, the market hates the uncertainty. Well, it will pay dearly later for complete certainty.

Foolish bottom line
With so many catalysts and a misunderstood stock, my Special Situations portfolio is buying an initial position of $2,000 -- about 5% of my capital -- of TFS Financial on the next market day.

Interested in TFS Financial or have another stock to share? Join me onmy discussion boardand follow me on Twitter (@TMFRoyal).

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Jim Royal owns shares of TFS Financial. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple, Bank of America, Citigroup, JPMorgan Chase, and TFS Financial. Try any of our Foolish newsletter services free for 30 days. 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.

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