Buying Stocks With a Private Equity Mindset

 | Nov 01, 2016 | 2:00 PM EDT
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After writing yesterday's article about private equity firms, I spent some time thinking about Apollo Global's Managing Director, Josh Harris, and his remarks on last Friday's conference call. He talked about the fact that although the public equity markets were richly priced -- and private equity markets even more so -- the firm was still finding deals it liked at an enterprise value to EBITDA (EV/EBITDA) ratio of 6 or less. He felt that by buying at this range, the firm should achieve the type of results it hopes to achieve over the preferred timeframe. I had to wonder if we could do the same with public equities to deliver outstanding returns over the next five-to-seven years -- the period usually preferred by private equity investors.

When I sat down and ran a screen of nonfinancial companies that have an EV/EBITDA ratio of 6 or less, I got a list of about 200 names on the first run through. The problem was that there were a lot of companies on the list that are very cheap for good reason. General Motors (GM)  , for example, is coming off a period of strong sales and earnings -- and profits are probably at a multi-year peak. I think it is unlikely that GM grows sales and earnings enough over the next several years to justify owning the stock. First Solar (FSLR) was on the list -- and looks cheap with an EV/EBITDA ratio of just 2.7, but I don't think it will grow enough to help us gain the type of profits we are hoping to achieve.

Apollo has a huge advantage over us when it comes to investing with a private equity mindset. When it buys a company on the cheap, like Outerwall or Apollo Education (APOL) , it buys the whole company. It has been over the operations and policies of the target company and identified areas where substantial improvements and cost reductions can be achieved to help grow cash flows at the rate needed to provide the desired return. You and I are not able to do that, so we have to focus only on those companies that are cheap and have the potential to deliver the needed growth rate. I limited my screen to just those companies that are expected to deliver at least 5% annualized growth over the next three to five years. The new list contains just 24 names.

KBR (KBR)  , the large engineering and construction firm, makes the new list. The company does a lot of business with the oil and gas industry, and while that business has been weak, and might be into 2017, there is a school of thought -- and I am in it -- that thinks we have taken too much capacity offline too fast. And as demand grows, we could see a lot of activity in this space a year or two down the road. KBR also does a lot of construction for the U.S. government -- building military bases around the world, as well as non-government facilities and critical infrastructure support for various government agencies.

KBR currently has EBITDA per share of $3.46. If it achieves the forecasted 9% annual growth rate, that will grow to around $5.3 in five years. If we also see some multiple expansion to around the average deal level of 10 to 11, that would be a stock price of $53 or more, giving you a total return of more than 30%, annualized.

NeuStar (NSR) is in the data analytics business, and that is an industry that should see some decent growth in the years ahead. The firm also provides data security services, and that is one of my 100-to-1 industries for the next several decades. The stock got hammered for missing quarterly estimates last week, but the results were a nice improvement over the year-ago period. After the selloff, the stock is trading with an EV/Ebitda ratio of just 5.4 right now. That strikes me as very cheap for a company that is growing at almost 15% a year -- and is expected to continue to do so.

If we do the math using the expected growth rate, then EBITDA should grow from $4.16 a share today to around $8 in five years. Putting a 10 multiple on the stock gives a possible stock price of $80 a share. That's about 30% a year, on average.

Apollo has one additional advantage over us when it comes to using a private equity mindset. They don't have to take account of the fear and greed cycle that exists in the public markets. If we get a market selloff, then both of these stocks will probably fall right along with everything else. However, if we keep our eye on the long term and use price weakness as a chance to buy more, long-term ownership of these private equity mindset candidates should produce outstanding results.

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