Most weekends are devoted to reading, with a healthy dose of sports thrown in. This weekend was no different as we had the Orioles in a pennant race and Navy football to keep me company while I reviewed the stack of material that accumulated during the week. There was a lot of private-equity material, with one piece from Deloitte Touche Tohmatsu, in particular, standing out. The piece, titled "Growth in Private Equity," examined all the challenges facing private-equity firms as they seek to compete in a low-return world.
Deloitte partner Frank Fumai looked at all the challenges facing private equity right now. In addition to the semi-permanent state of low interest rates, the global tax and regulatory climate is changing in a manner that is making it more difficult to earn high returns. Geopolitical risks are widespread and seem to be increasing on a pretty regular basis. Most of the gains from recapitalizing companies have already been reaped.
The answer to finding higher returns, according to Fumai, is surprisingly simple. Gains will have to be driven by growing EBITDA that is generated by portfolio companies. Private-equity firms need to focus on companies that can generate organic growth in a weak economy and hold them long enough to generate the multiples of capital invested that their investors are looking to attain.
We can combine that simple nugget of wisdom with the idea that Leon Black of Apollo (APO) expressed on his quarterly earnings call last month. He said one of the biggest reasons for Apollo's success was that in a world where private-equity firms are doing deals at EBITDA multiples of over 10, Apollo's purchases all had a six handle on the EBITDA multiple. If we put the two together then we want to look for companies that are growing EBITDA and then pay as low as possible a multiple to buy the entire company.
That's an easy screen to set up and search for ideas that fit the private-equity growth on the cheap model. I looked for companies that have grown EBITDA by at least 15% annually over the past five years and had also accomplished that level of growth over the past 12 months to make sure they were still growing. Although it is a fairly short list of stocks, there are some interesting stocks on the list worth investigating.
Guns made the list. Strum Ruger (RGR) is growing at 17% a year, but the shares can be purchased with an enterprise-value-to-EBITDA multiple of just 6.5. Smith & Wesson (SWHC) has grown EBITDA by 43% a year on average but trades with a multiple of only 6.8. I know many private-equity firms have stayed away from the firearms industry because of some people's negative views on the industry, but if I ran a PE firm, I would have a fund focused on ammunition, firearms and weapons because I just don't see demand going away. The current president has been the greatest gun salesman in history, and I suspect Hillary Clinton will challenge for the title should she win the White House in November.
Neff Rental (NEFF) makes the list of cheap candidates for private-equity-mindset investors. The Miami-based company rents heavy equipment, including earth-moving and material-handling equipment in the Sun Belt states. Given the amount of construction going on here on the west side of Orlando, I am pretty sure much of their equipment is within a few miles of me right now. Business is booming across much of the South at the moment, and the company has been able to grow EBITDA at a very rapid pace the last five years. The stock is cheap right now with an enterprise-value-to-EBITDA multiple of just 5.1. If they are able to meet analysts' projections of a 16% annual growth rate for the next five years, investors willing to adopt a private equity timeframe should do very well with this stock.
Combining EBITDA growth rates and EBITDA multiples to search for stocks is a recipe for finding long-term winning stocks. I have two caveats about this approach right now. First, the list produced by the screen is very short as the market does appear to be extended and a bit pricey right now at 25x trailing earnings as reported in the latest issue of Barron's. Second, if you are going to use private equity metrics to pick stocks, you must have a private equity mindset and be willing to own the stock for the five- to seven-year timeframe used by private-equity buyout funds.