Harvard Business School's Erik Stafford recently explained in Replicating Private Equity with Value Investing, Homemade Leverage and Hold-to-Maturity Accounting how investors can meet or beat private-equity returns.
Stafford argued that all you have to do is use private equity's favorite valuation tool -- EV/EBITDA -- coupled with portfolio leverage in a margin account.
He built two samples portfolios using this method. "Strategy 1" closely resembles the private-equity mindset by using low EV/EBITDA stocks and a four-year holding period. "Strategy 2" uses the same guidelines, but changed the selling points to either a 50% gain or a four-year holding period (whichever came first).
Back-testing Strategy 1 found that it earned 21% annualized excess returns between 1980 to 2014, while Strategy 2 garnered an excess 19% per year.
But as wonderful as that sounds, I think there's one flaw in Stafford's work. His hold-to-maturity accounting method measures positions at their purchase price until they're sold, but ignores a day-to-day "mark to market." That is the way that private-equity firms mark many of their positions, but it's highly unlikely that your broker's margin department will extend you the same courtesy.
However, a similar portfolio screen that I recently wrote about only had one severe drawdown between 1999 to 2015, and that was when the market crashed in 2008 and early 2009. And that strategy also held a high cash component for much of the 1999-2015 period, thanks to overly generous valuations.
With that in mind, aggressive investors should be able to use Stafford's EV/EBITDA approach as long as they maintain a healthy dose of common sense. Or, you could even spend a little money and keep a static hedge in place.
You can easily hedge against anything over a 10% portfolio decline for a cost of around 4% a year. Similarly, hedging against 15%-or-higher moves would only cost about 3% annually at current market prices. In that case, a portfolio leveraged 2-to-1 would avoid a dreaded margin call even after a 15% decline.
Now, I'll admit that paying 3% to 4% for a hedge might sound steep. But remember that we're talking about a portfolio that offered 19% to 21% returns in excess of the market's 8.6% yield over the 1980-2014 period. As such, hedging your portfolio would be pretty affordable.
I'm sure there are also more-dynamic ways to hedge the portfolio, but that falls outside my purview. Perhaps option-efficient Real Money columnists like Tim Collins or Bob Lang will chime in later with some other suggestions.
How Things Work
The key to making Stafford's screen work is the same thing that makes private-equity work -- you have to buy companies with solid futures but very low enterprise multiples.
In fact, you'll often be buying stuff that no one else wants and selling companies that everyone loves. That's psychologically difficult even without the added factor of maintaining high leverage, but when done right, you'd have a pretty interesting portfolio of companies.
Running Stafford's screen recently, I came up with several stock that face short-term challenges today, but have pretty strong outlooks over the long term. These include:
Fertilizer giant Mosaic has problems right now because fertilizer prices are so low, but babies being born all over the world today will need food for decades. And while emerging markets have slowed down, they're still creating new middle classes that will want higher-quality crops requiring the phosphates and potash that Mosaic sells.
Argan (AGX) and Fluor (FLR)
Another sector that Stafford's screen favors are infrastructure companies. These firms have seen earnings held down by cutbacks in the energy sector and a lack of government spending at all levels.
But at some point, customers will have to upgrade, replace and repair roads, bridges and water and electrical systems. That's great news for Argan and Fluor, two companies that pass Stafford's screen. Both are dividend-paying stocks that have low enterprise multiples.
Western Digital (WDC) and Brocade (BRCD)
Data storage is another business that's going to see almost-eternally rising demand in the future. The world is becoming more and more data-dependent, and governments, businesses and consumers will have to store all of that information on computers or "The Cloud."
This trend will inevitably benefit Western Digital and Brocade, both of which make the cut on Stafford's screen.
The Bottom Line
While most value investors eschew leverage, I'm reminded that Al Frank used it often in his Prudent Speculator portfolio and averaged about 23% returns over a quarter-century.
Frank shifted his leverage percentages around based on current market conditions, which helped him beat the market by a significant percentage. Using Stafford's screen with prudent margin management or a hedging strategy could likewise help aggressive long-term investors earn higher returns in today's low-return world.