Think Like a Private Equity Investor

 | Jan 28, 2013 | 4:00 PM EST
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Over the weekend I spent a lot of time debating the attributes of the Super Bowl teams, spring training baseball and the best way to pick stocks in a tricky market. A lot of good ideas were tossed around, including buying stocks that might benefit from the Obama administration's political agenda, stocks with strong earnings momentum and buying issues with particular technical or statistical patterns. While not dismissive of any of them, my opinion is that in any market, especially a tricky one like we face now, it is best to think like a private equity investor.

Private equity investors do not really spend a lot of time worrying about who is in the White House or what the next quarterly earnings report will be in comparison to the analyst estimates. Private equity investors are looking to buy assets today for a lot less than they can sell them in four to seven years. They look for assets, cash flows and brands that are cheap relative to their value that can be purchased and managed to produce cash flow and be sold for at a much higher price later. Often they are looking in sectors that are unloved by most investors but still viable over the long run. They like to buy ugly and sell pretty. They buy the business and hold it until it is once again popular and highly valued.

With all the attention now on tech stocks and the pretty consumer names like lululemon athletica (LULU) and Amazon (AMZN), the astute PE and distressed investors are looking at the hated sectors. We are seeing the big players in the space putting money into things like steel, coal, energy and even the publishing industry for companies that are cheap enough to provide high returns over the next half decade.

I ran screens this morning looking for stocks that might appeal to a private-equity-type investor. Power-One (PWER) strikes me a great example of such a stock. The stock is certainly cheap enough, trading right at tangible book value and less than 4x free cash flow right now. The enterprise-value-to-EBITDA ratio is less than 3 as well. The stock is cheap because its business is not very popular; it makes power management and conversion products used by alternative energy and communication industries. Eighty percent of its renewable energy revenue comes from Europe, where cash-starved governments are slashing incentives for solar and wind power.

The stock is going to struggle to meet earnings expectation until Europe fully recovers and the U.S. alternative energy marketplace becomes larger. It is going to be at least five years before the global economy recovers enough for tax breaks and subsidies for alternative energy to become prevalent again. Without them, the industry is not viable and new installations will be on hold. If you care about the day-to-day or even quarter-to-quarter stock price, this is not a great stock for you. If, however, you are looking for a business that is unloved and cheap that can be sold for much higher price in five to seven years, Power-One is a strong candidate.

Several Real Money contributors have mentioned Sterling Construction (STRL) as a great long-term buy. It easily fits my definition of a good private equity candidate. The stock is cheap enough trading at tangible book value with an EV/EBITDA ratio of less than 5. Business is stable enough for the company but it is not going to be great again until the economy recovers enough for municipal budgets to heal. Sterling is involved in the construction and repair of highways, bridges, rail and water systems. Infrastructure in the U.S. needs replacing and repair, so someday the money has to be spent. It is not going to happen next quarter or even next year, however. At some point, this sector will become a growth leader, but you are probably going to have to wait five years or more to see Sterling become a market darling. The stock is unloved, cheap and has fantastic profit potential when governments can afford to spend on these projects again.

Private equity investors take a much longer view than most market participants do. They tend to be very patient and hold companies until the business has improved and is once again in vogue on Wall Street. The "buy ugly" and "sell pretty" approach used by successful private equity firms is one that most individual investors would do well to adopt.

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