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  1. Home
  2. / Investing

Living in Your Own Private Equity Portfolio

Six specific selections fill out our Blackstone-inspired stock portfolio.
By TIM MELVIN Jul 22, 2015 | 03:00 PM EDT
Stocks quotes in this article: VISI, KTOS, GIFI, CENX, NAUH, AHC, BX

Now that we have recreated the credit and real estate portions of an alternative asset portfolio it is time to turn to the equity side of things. Blackstone Group (BX) CEO Stephen Schwarzman said on the firm's conference call last week, "When our investors give us a $1, we have generated $2 to $2.50 on average in our private equity and real estate funds across markets and economic cycles for 30 years." I am going to use that as our benchmark and look for stocks that can double or better over the next five to seven years to fill out our equity portfolio.

My first pick for our private equity-like equity portfolio is Volt Information Sciences (VISI). We talked about this company earlier this month and it remains one of my favorite stocks for the next several years. The company has made changes at the board and management levels and its intrinsic value is much higher than the recent stock price. I think owning Volt will easily meet the "$2 to $2.50 hurdle" for equity investment.

As David Neuhauser of Livermore Partners said when we talked to him earlier this month "Volt has made bold and defined moves to both the board and management and the company is now positioned for growth and further equity appreciation. The intrinsic value of Volt remains dramatically higher than the current price as the company steers on a forward path."

Next, I think that Kratos Defense & Security Solutions (KTOS) is another long-term must-own stock. The company is involved in key areas of defense like cyber-warfare and defense as well as critical infrastructure defense, which will be a hallmark of the military's focus in the future. The company also provides avionics systems and ground flight control systems, as well as command, control, and communications systems for various unmanned ground and seaborne platforms and systems, so it should benefit from the shift toward military use of drones.

Another Kratos division is involved in satellite command and control, communications support, signal monitoring and ballistic missile defense. The company is poised to be in the sweet spot of military spending and that should drive the stock a lot higher over a private equity timeframe of five to seven years.

During the Q&A portion of its recent conference call, Blackstone President and COO Hamilton James said that "a lot of the returns we make come from the fact that we can free ourselves from the tyranny of daily liquidity and take advantage of these substantially enhanced returns that come when you can do that without taking more risk."

While I am sure community bank stocks are not what he meant specifically, since a firm with $333 billion in assets under management is highly unlikely to run around scooping up positions in $50 million market cap banks, it doesn't meant we can't use the logic of buying widely across this illiquid sector. Buying a portfolio of small banks that have activist investor shareholders is highly likely to easily meet the 2.5-to-1 payoff factor we are working to obtain.

Like every other private equity firm, Blackstone is looking at energy but it said that these companies tended to be financially stronger than most of the industry.

Finding financially strong energy companies sis a challenge right now. There are 820 energy companies in my database: 216 of those have Piotroski F-scores over 6, indicating improving financials and fundamentals, and 160 have Altman Z-scores, indicating financial safety. Only 56 pass both safety checks, with just four of those trading below book value and just six have an enterprise value/EBIT ratio of less than 6. But only one is cheap on both measures: Gulf Island Fabrication (GIFI).

I already own GIFI and think it's a fantastic long-term buy that will easily exceed the 2.5-to-1 threshold.

Our portfolio should also include a few stocks trading with very low EV/EBIT ratios since that's the metric most private equity and leveraged buyout firms use to shop for bargains. I like Century Aluminum (CENX) with its ratio of 3.4, National American University Holdings (NAUH) with a 3.5 ratio and A.H. Belo (AHC) with a 5.6 reading.

Finally, there's another asset class you need to consider when putting together a private equity-like portfolio: cash. Firms are selling more than they are buying and Blackstone has more than $82 billion in uncalled cash. If you add that to the current assets under management you will come up with a total cash balance that is likely between 20%-25% of its total assets.

There are opportunities out there but it is not what I consider an extraordinary buying time in terms of valuation levels. Right now, a certain amount of "dry powder" to deploy in a selloff is an important part of a long-term portfolio.

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At the time of publication, Melvin was long KTOS, VISI, GIFI and NAUH.

TAGS: Investing | U.S. Equity

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