OSB Group Stock: Appealing Stock Trading At A Discounted Price (OTCMKTS:OSBGF)

The following segment was excerpted from this fund letter.

We bought OSB Group. Shares of the British OSB Group constitute a new addition to Vltava Fund’s portfolio. This is a smaller and very specialised bank that provides mortgages to professional lessors of predominantly residential (buy-to-let) properties. It has a long tradition and a strong position in this market segment.

Tax changes in the UK since 2016 have made it easier to own residential property through an Ltd company, and especially if the owner holds multiple properties. Traditional large banks have more or less pulled back from lending to professional “buy-to-let” (or BTL) entrepreneurs, leaving the market opportunity to smaller and specialist institutions such as OSB. The opinions occasionally expressed suggesting that the BTL business is risky are, in our opinion, not grounded in reality. We think BTL is less risky than lending against properties that are occupied by their owners. OSB’s long-term results demonstrate this.

Allowances for bad loans are typically in the lower tenths of 1 per cent (ca 0.25%). This is a very low number and indicates low-risk lending. In addition, loans are pledged against properties with an average LTV (loan-to-value) ratio of 64%. OSB is a bank whose loans are fully funded by deposits on the liabilities side and is not dependent on the availability of bond financing or the interbank market. OSB is remarkably efficient, having a cost/income ratio of around 30% that almost any other bank would envy. Long-term ROTE (return on tangible equity) is above 15% and ROE (return on equity) is more or less the same. The bank regularly pays a large dividend and at the same time buys back its own shares.

For such an established and quality business, we would not expect it to trade at a price below book value and with a P/E near 5. The dividend yield is 7%. This is perhaps due to the fact that last year’s profits dropped because of specific accounting rules requiring that earnings reflect negative expectations for client behaviour caused by the rapid rise in interest rates. This does not, however, change the long-term attractiveness of the business and so this year should mark a return to normal.

How is it possible that such an appealing stock is trading in the market at such a discounted price?

Because it is almost completely ignored by most investors. The investments of passive investors (i.e. most of the money in the markets) are placed elsewhere. OSB is a smaller bank, a so-called small cap. Passive money tends to avoid these. It also mostly avoids banking as a sector and, finally, it has shunned UK equities in recent years. British markets have been among the least sought after markets for some time. Taken together, this is almost a perfect storm. But for us, it’s absolutely ideal and we can’t help but reiterate that we hope the prevalence of passively invested money in the markets continues as long as possible.

Banks are relatively straightforward to value, and a well-performing bank can also be a very good long-term investment. In fact, capital accumulation occurs relatively quickly in banks and compounding of interest can run similarly briskly there. In looking at a bank’s balance sheet, one sees that it consists almost entirely of financial items. A bank has no factories, no production lines, no large inventories, no big capital expenditures, no large research and development expenditures, and so on. A bank’s profits are almost purely credited to its equity. This, then, means they can grow rapidly at high ROEs.

The long-term return to an investor in bank shares (when reinvesting dividends) is approximately equal to the bank’s long-term average ROE while holding constant the price-to-book (P/B) multiple. OSB’s long-term ROE can be expected to be around 17% and, as the bank is now trading at 0.8 times book value, the stock’s long-term return will most probably exceed the long-term ROE.

With its ROE of 17%, we see a reasonable P/B value for the bank somewhere above 1.25 (given that it is a smaller bank). Book value growth per share should also be supported by share buybacks, which are now being made below that price level. OSB’s shares are very cheap, and the expected long-term return from holding them (inclusive of reinvested dividends) could be around 20% p.a. Much more that can be expected from the stock market and that is why the shares find themselves in our portfolio.