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Wednesday, August 21, 2013

The Right Minded Investor

With all the traveling and distraction this week I didn’t get around to reading Barron’s all the way through until last night. The highlight was the interview with David Rubenstein the co-CEO of Carlysle Group (CG) the giant private equity firm. He made several interesting points in the article including the fact that one of the best opportunities is in the energy space. He told the magazine that carbon based fuels are the most efficient and inexpensive energy source we have and as long as that’s true we will burn the stuff. He doesn’t expect renewables to be a viable source in his lifetime and neither do I. Companies that explore for, produce, transport and store oil and natural gas have not really participated in the market rally of the past few years and are very cheap. Long term investors should be focusing on the group.

He also talked about opening private equity up to the general public by creating vehicles for investors along the lines of limited liquidity closed end funds with monthly or quarterly redemptions. He correctly points out that private equity usually has higher returns than public markets over time for a variety of reason. I have to say I think this is a horrid idea. Investors have proven that they will earn less than they should because they trade too much and are too vulnerable to news, emotion and price action. Private equity vehicle may return more than equity mutual funds but investors will probably enter at the wrong time and exit at an even worse time as they have done with other investments and strategies.

Investor’s do not need a private equity investment vehicle as much as they do a private equity mindset. Private equity earns higher returns because they investor for an average 6 year holding period. They buy companies no one else wants and focus on industries that are out of favor. They buy companies rather than trading electronic betting slips day in and day out. They also sell when the markets are moving up and investors are looking for merchandise to buy. The private equity mind knows that they get more than the company is worth by selling into a happy stock market.

I pay a lot of attention to what’s going on in the private equity world because we tend to be looking at the same types of stocks most of the time. Their activities also usually set a benchmark for buyout prices and that is part of our intrinsic value calculation. If you have a private equity mindset and are paying attention right no you will see that most private equity firms are selling with both hands. In fact Leon Black of industry leader Apollo (APO) recently said that his funds were “selling everything that is not nailed down.” Mr. Rubenstein’s co-CEO at Carlisle recently told the Wall Street Journal “With the world awash in liquidity, interest rates at rock bottom levels and asset prices being bid up, it has become increasingly difficult for us to compete when underwriting our investments, particularly in the U.S., to a 20% to 25% internal rate of return."

A look at recent and pending IPO activity shows that a lot of the deals are private equity cash outs. We have Hilton Hotels coming public soon as Blackstone sells back part of one of the 10 largest PE buyout deals in history. TPG and Warburg Pincus are preparing to unload some of their stake in Neiman Marcus in an initial offering. Blackstone has already unloaded part of Sea World (SEAS) and Pinnacle Foods (PF) in earlier offerings. So far this year there have been 18 private equity backed deals and the IPO calendar is crowded with PE exit offerings. The ZIRP fueled market wants to buy and the PE mindset is happy to oblige.

Individual investors should consider adopting a private equity mindset. Take a look at the market objectively and sell the stocks and sectors that have been strong the past several years and now carry premium valuations. Dividend paying blue chip stocks have been pushed beyond the boundaries of reasonable valuations and are not worth chasing here. Homebuilders have rebounded nicely and now trade above any reasonable calculation of corporate worth. Barring an economic miracle in the next six months many retailers are selling premium valuation in spite of non-premium prospects. High multiple hot story stocks have a had a good run but the time to take the money and run is before momentum shifts not after large selling wipes out your gains in a short period of time.

A private equity mindset is looking where no one else wants to go right now and considering the 5 to 7 return potential for industries like oil and gas, coal, mining and small banks. They are not chasing hot deals or market indexes and are doing far more selling than buying. There are reasons PE returns more than public equity and patience and discipline are a big part of that equation.

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