With all the traveling and distractions this week, I didn't get around to reading Barron's all the way through until last night. The highlight was an interview with David Rubenstein, co-CEO of Carlyle Group (CG), the giant private equity firm. He made several interesting points, including the fact that one of the best opportunities is in the energy space. He told Barron's that carbon-based fuels are the most efficient and inexpensive energy source we have and as long as that's true, we will burn the stuff. He doesn't expect renewables to be a viable source in his lifetime. Neither do I. Companies that explore for, produce, transport and store oil and natural gas have not really participated in the market rally of the past few years and are very cheap. Long-term investors should be focusing on the group.
Rubenstein also talked about opening private equity to the public by creating vehicles for investors along the lines of limited liquidity closed-end funds, with monthly or quarterly redemptions. He correctly points out that private equity usually has higher returns than public markets over time for a variety of reason. I believe this is a horrid idea. Investors have proven that they will earn less than they should because they trade too much and are too vulnerable to news, emotion and price action. Private equity vehicles may return more than equity mutual funds, but investors will probably enter at the wrong time and exit at an even worse time, as they have done with other investments and strategies.
Investors don't need a private equity investment vehicle as much as they do a private equity mindset. Private equity earns higher returns because they invest for an average six-year holding period. They buy companies no one else wants and focus on industries that are out of favor. They buy companies rather than trading electronic betting slips day in and day out. They also sell when markets are moving up and investors are looking for merchandise to buy. The private equity mind knows that they get more than the company is worth by selling into a happy stock market.
I pay a lot of attention to what's going on in the private equity world because we tend to be looking at the same types of stocks most of the time. Their activities also usually set a benchmark for buyout prices and that is part of our intrinsic value calculation. If you have a private equity mindset and you are paying attention, you will see that most private equity firms are selling with both hands. In fact Leon Black of industry leader Apollo (APO) recently said that his funds were "selling everything that is not nailed down." Rubenstein's co-CEO at Carlisle, William Conway, recently told the Wall Street Journal that "With the world awash in liquidity, interest rates at rock bottom levels and asset prices being bid up, it has become increasingly difficult for us to compete when underwriting our investments, particularly in the U.S., to a 20% to 25% internal rate of return."
A look at recent and pending initial public offerings shows that many of the deals are private equity cash-outs. Hilton Hotels is coming public soon as Blackstone (BX) sells back part of one of the 10 largest PE buyout deals in history. TGP and Warburg Pincus are preparing to unload part of their stakes in Neiman Marcus in an initial offering. Blackstone has already unloaded part of SeaWorld (SEAS) and Pinnacle Foods (PF) in earlier offerings. So far this year there have been 18 private equity-backed deals and the IPO calendar is crowded with PE exit offerings. The zero-interest-rate-policy--fueled market wants to buy and the PE mindset is happy to oblige.
Individual investors should consider adopting a private equity mindset. Look at the market objectively and sell stocks and sectors that have been strong the past several years and now carry premium valuations. Dividend-paying blue-chip stocks have been pushed beyond the boundaries of reasonable valuations and are not worth chasing. Homebuilders have rebounded nicely and trade above any reasonable calculation of corporate worth. Barring an economic miracle in the next six months, many retailers are selling premium valuation in spite of non-premium prospects. High multiple hot-story stocks have a had a good run, but the time to take the money and run is before momentum shifts, not after selling wipes out gains in a short period.
A private equity mindset is looking where no one else wants to go and considering the five- to seven-year return potential for industries like oil, gas, coal, mining and small banks. They are not chasing hot deals or market indices and doing far more selling than buying. There are reasons private equity returns more than public equity, and patience and discipline are a big part of the equation.
