I noticed while reading first-quarter earnings reports from KKR (KKR), Carlyle Group (CG) and other publicly traded private-equity firms this week that companies attributed their success to buying businesses that combined good growth potential with very low valuations. This is an easy strategy to replicate -- and here are two promising names that I found using a screen based on this system.
Several recent studies have found that individual investors who use a private-equity-like approach can do very well over time. Such strategies are more volatile than the overall market is, but their total returns typically outperform Wall Street's benchmark indices.
Fortunately, looking for companies that offer decent growth is as easy as running a stock screen. You can then simply look at EV/EBIT -- the ratio of enterprise value (EV) to earnings before interest and taxes (EBIT) -- to find firms that also trade at low valuations.
All of the private-equity firms whose quarterly reports I studied this week talked about determining value using EBIT or EBITDA (earnings before interest, taxes, depreciation and amortization). I personally prefer EBIT to EBITDA, as I agree with Warren Buffett and Charlie Munger of Berkshire Hathaway (BRK.A, BRK.B), who say that depreciation and amortization are often very real expenses that you can't ignore.
The screen I set up looked for companies that have managed to grow both EBIT and revenues by at least 10% annually for the past five years. I also limited my search to firms where management reinvested cash flow and grew book value by 10% a year as well. (I used 10 as my upside EV/EBIT measure because that's about two-thirds the S&P 500's current valuation.)
Now, most private-equity firms have record levels of dry powder these days, and it's easy to see why -- there just aren't a lot of bargains to be had. In fact, my screen uncovered just 60 publicly traded U.S. companies that are both growing well and selling for bargain valuations.
Airlines and auto-parts firms are well represented on this list, but both industries have benefited from tailwinds in recent years that might not last going forward. So, I'd recommend a healthy dose of skepticism regarding their future EBIT growth.
Instead, here are two promising companies that the screen uncovered in other sectors:
Smith & Wesson (SWHC)
This legendary gun manufacturer really stood out on my screen.
Regardless of where you fall politically on the idea of gun rights vs. gun control, one thing we can all agree on is that President Obama and his anti-gun rhetoric have been the greatest salesmen ever for firearms.
Gun-control advocate Hillary Clinton also looks like a lock to win the Democratic presidential nomination this year, and the bookies have her as the favorite to win the general election as well. Clinton has made gun control a big issue in her campaign, so fears of stronger restrictions could spark a fresh wave of firearms sales that'd be great for Smith & Wesson.
SWHC has already grown earnings 19% annually for the past five years, but the stock trades at just a 9.7 EV/EBIT ratio. Smith & Wesson's share price has fallen during the past month after the FBI reported a 13% decline in background checks between February and March for gun buyers. However, gun-control rhetoric on the campaign trail could reverse that trend as the general election draws nearer.
HFF Inc. (HF)
HFF is America's largest full-service commercial-real-estate financial intermediary, providing both buyers and lenders with commercial-real-estate and capital-market services. That includes things like debt and equity placement, investment-banking and advisory services and loan servicing.
The company has seen strong growth over the past five years, and as long as commercial real estate holds firm, HFF should continue growing its business. But the stock's current EV/EBIT ratio is just 8.4, making the shares a real bargain.
Management also declared a $1.80-a-share special dividend in January. In fact, the company has paid out $6.95 a share in such dividends since 2012 and remains committed to returning even more capital to shareholders in the future.
The Bottom Line
Investing like a private-equity fund can greatly increase your returns over time. But to make it work, you have to use private-equity timeframes -- owning companies for more than just a few weeks or months.
Lastly, you have to have the discipline to buy only when you can find bargains worth holding for extended periods of time.