I often talk about the need for investors to adopt a private equity mindset to improve their investment returns. Private equity is one of the more successful asset classes and there are solid reasons for that. They tend to buy out of favor companies and assets and hold them for an extended periods of time.
The average holding period right now for private equity firm is over five years, not just weeks or months. They want to find returns over time that are measured in multiples and not just small percentages. This morning we saw a prime example of private equity at work as PE firm Golden Gate just sold the On the Border chain of restaurants for three times what they paid just four years ago. Adopting the same longer-term time frame and investing in sectors and companies that are out of favor and cheaply priced could serve most investors much better than trying to swing trade the earnings report from Amazon (AMZN).
With that in mind, I spend a lot of time these days tracking what the private equity and buyout shops are doing with their money. I watched private equity firms tiptoe into industries like shipping in 2012. That has helped me spot some tremendous opportunities to load up on safe and cheap stocks that lead to huge profits over the next two years.
When private equity money starts showing up in a distressed or out-of-favor sector it's a pretty good indicator that companies in the space are available on the cheap and it is time to start doing some homework.
I sat down this morning and reviewed private equity and M&A activity for the first quarter to see if I could spot some developing trends that could help us become better investors. It seems that the smart and patient money is becoming more selective and have been favoring smaller deals and add on purchases that compliment portfolio companies. Add on deals were 50% of all deals in the quarter which is the highest amount of total deals in a decade.
With easy credit and a robust public equity market the buyout space is very much a sellers' market and buyout transaction declined somewhat in the first quarter of the year. Valuations have gotten somehwat frothy and as a result we only saw seven private equity none add-on buyout deals in the first quarter.
Private equity firms are still pretty aggressive about unloading companies as well. We have seen a bunch of private equity backed initial public offerings this year and PE firms have also been selling to corporate buyers. With multiples of earnings, cash flow and assets fairly high right now it just makes sense for these firms to ring the bell and sell off assets acquired a few years ago at much lower prices. It might make sense for investors to consider following suit and reviewing portfolios for stocks that have reached over valued levels and should be sold at current levels.
Private equity firms are sitting on an enormous amount of dry powder and the number of deal exists is just boosting that amount of cash. The money is going to be slow to be put to work, however, as deal multiples are at a decade high and it is going to be difficult to find deals large enough to deploy the estimated $1 trillion of available cash in PE coffers.
As deep value investors we have been having the same problem as cash has mounted because safe and cheap stocks have been scarce of late. Valuation multiples have to decline for it to make sense for additional capital to be invested in the broader economy and markets.
We are still seeing signs of increased private equity interest in mining and energy related deals. These sectors have been lagging the stock market advance as the global economic weakness has led to increased stockpiles of many commodities. The North American energy sector is one that should see a lot of deal making in 2014 and beyond as assets are cheap because of the tremendous surplus of natural gas.
In a recent survey, 77% of Private Equity executives said they expect to see increased private equity interest in North American oil and gas deals. That should lead to higher valuations for cheap energy stocks like Swift Energy (SFY), WPX Energy (WPX) and Penn West Petroleum (PWE) in the years ahead.
Abandoning the short-term trader attitude and adopting a private equity mindset will help investors use cheap assets and long timeframes to substantially improve their returns.