When High Leverage Can Mean Fat Profits

 | Jan 30, 2013 | 12:00 PM EST
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In practice, incorporating a private-equity approach into your investment strategy isn't very different from long-term value investing, so utilizing it can make a lot of sense. I've been discussing this topic a fair amount over the past few days, and one subject came up several times: the use of more leveraged approaches to PE-like investing. This might particularly work for aggressive investors. If you are looking for the highest returns over time, you could do a lot worse than structuring your portfolio along the lines of a leveraged-buyout fund.

Leveraged buyouts have been around since the 1950s, but they really hit their stride in the 1980s. In short, the LBO fund buys a target company with mostly debt and a sliver of equity financing. The cash flow generated from the business is then used to pay down debt over time and rebuild the equity portion of the capital account. Later on, when the equity in the business has grown to several times the original capital invested, the company is sold, often via an initial public offering.

Granted, you and I may not be able to implement an actual LBO. However, we can find companies that have a post-LBO capital structure and the same potential for long-term asymmetrical payoffs.

I've done a quick and dirty backtest of highly leveraged companies with positive cash flows -- and I've found that, over time, this approach outperforms the market by a wide margin. Even more impressive, during equity investors' very difficult time over the past 12 years, the approach has achieved 5x the annual return of the overall stock market.

One of my favorite companies with an LBO-like capital structure is Coleman Cable (CCIX). This company is not reinventing the wheel -- it is in a very basic business, supplying electrical and electronic cable and wire for a wide variety of uses and industries. Coleman has taken on debt to finance acquisitions and offer everything from basic extension cords to cables for lighting and HVAC systems. It is a highly leveraged company, with $45 million in equity supporting more than $425 million in liabilities, including $328 million worth of long-term debt.

The highly leveraged model is working for Coleman, as the company has seen sales grow from $223 million to more than $867 million in the last decade. During the same period, earnings before interest, taxes, depreciation and amortization have grown from $22.8 million to more than $76 million. Coleman's products are used by a wide range of industries that should enjoy strong growth over the next decade, so the company should be able to continue to growing at a strong pace. The bond market is a believer, as well. In spite of the high leverage, Coleman bonds due in 2018 trade at a premium and yield less than 5%.

Meanwhile, Goodyear Tire (GT) -- with a debt-to-equity ratio of almost 5x -- also has a very LBO-like capital structure. Equity of $1.2 billion supports almost $6 billion worth of long-term debt and an additional $163 million in short-term notes. The company has recently been struggling a bit due to weakness in international markets, which has hit earnings and sales. Management is focusing on increasing profitability even if this reduces sales, and that margin-centric approach should pay off as demand strengthens.

There is pent-up demand in the replacement-tire market, as the average age of vehicles on the road continues to rise, and sales to auto manufacturers are also showing signs of firming. More new cars feature Goodyear tires than they do any other brand, and it's a premium brand in the tire marketplace. So, if analysts are correct about strong auto sales in 2013, Goodyear will be a prime beneficiary. Sometime in the next few years, the stock should challenge the pre-market-crisis highs in the low $30s.

These are two examples of LBO-model investing that could pay off for aggressive long-term investors. Of course, this type of investing comes with some caveats. It is not for everyone, as the leverage necessarily makes it more volatile. Unless you are uber-aggressive, this strategy should only comprise a limited portion of your portfolio. In addition, as with most types of value-based investing, it pays to buy on down days and scale in and out of positions.

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