My investment philosophy over the years has been influenced by many people and schools of thought. The most obvious is Ben Graham and the offshoots of his Columbia classroom, including Walter Schloss and Irving Kahn. Over the years, I have also stolen liberally from folks such as Martin Whitman and Charles Brandes. The members of the thoroughly disreputable Chicago options crowd have not only been great carousing companions, but they have also added a lot to my approach to the markets over the years. It occurred to me in re-reading my Monday column that the private equity folks I have met along the way have also added a lot to my investment mindset.
I have met a few private equity types along the way and the ones I admire seem to have a certain mindset that fosters success. These are not the ones who buy companies and leverage up to pay special dividends and raise billion-dollar funds. These are small to midsize players who are usually investing either family money or the proceeds from the sale of a successful business that they had founded or owned for a long period of time. They are fairly conservative in their approach to buying and selling companies and only trade when the price is right.
They tend to focus on asset values and EBITDA far more than reported or accounting earnings. They are not huge fans of buying companies with a ton of debt on the books. They do not mind using debt but they do so at a time and place of their own choosing. The real wealth building is in running and growing the business over a period of time and not is using financial tricks to inflate the appearance of value or extract cash at the cost of the future.
One of the most influential pieces of advice I ever got was form a gentleman who invested in a portfolio of companies with the profits from the sale of a high tech company. He told he would never under any circumstances pay more than a 5x enterprise value (EV)/earnings before interest depreciation and amortization (EBITDA) ratio, although he would happily sell higher than that. At the time, deals were routinely being done at 8 and even 10 multiples in a rising market. I asked him how he dealt with such periods and he responded that just because other people were being foolish, didn't mean he had to be.
I spent part of the past two days looking for stocks that might fit the private equity investment profile. With a current EV/EBITDA ratio of just 3, Digital River (DRIV) seems to fit the bill. The e-commerce company provides end to end online store solutions including such things as setting up electronic shopping carts and payment processing. The company has twice as much cash as it does debt on hand and has been cash-flow positive ever year for the past decade. Net of debt cash makes up almost 70% of the company's market capitalization.
E-commerce is a very competitive business and larger competitors could develop software and services that compete with Digital Rivers offerings. However, with the enterprise value at just $157 million, it might be easier to just buy the company outright instead of developing new platforms. The fact that the founder just stepped down as CEO could make the company more attractive to a financial buyer such as a private equity fund or a strategic buyer who wants to add ecommerce to their product line.
Although it is a more basic business, West Marine (WMAR) would make a great fit in a private equity portfolio at its current price. The stock trades with an EV/EBITDA ratio of just 4.5 and a price-to-sales ratio of 4.9. As a bonus, the stock trades for just 90% of tangible book value. The company is the largest in the marine supplies and apparel retail market and most of its competition comes from smaller local stores.
The boating industry has been soft as a result of economic weakness but that is going to change soon. There is going to be an enormous amount of pent up demand in the industry and West marine will see its sales and earnings enter an extended upswing. The company has no long-term debt and almost $70 million of cash on hand. In spite of a difficult operating environment, the company has produced positive operating cash flow every year for the past decade. It strikes me as almost a no-brainer for a private equity firm to buy the company, run it for five years and sell it as growth stock at 3x or 4x the current valuation.
Private equity investing is very similar to deep value investing. The secret to profits is in finding a decent business that is unloved and cheap and holding it for a long time. When business is better and the company is popular, it is time to sell and move on. The focus on five years from now instead of this quarter is the best way to make money.