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  1. Home
  2. / Investing

Trade In Your Trading Mindset, Emulate Private Equity Investors Instead

Most traders fail; they'd be better served by buying undervalued assets and holding them for longer periods of time.
By TIM MELVIN Nov 30, 2016 | 01:00 PM EST
Stocks quotes in this article: KKR, CG, BX

It should come as no secret to anyone that I track the private equity industry very closely. There are several reasons for this, not the least of which is that I own three of the big four private equity firms.

I consider KKR (KKR) , Carlyle Group (CG) and Blackstone Group (BX) to be part of my "never going to sell unless the world gets so insane I can't stand it" portfolio. They all throw off generous distributions, and I don't need the income, so I just reinvest the cash every quarter and will continue to do so as long as I own them. I think that the returns from private equity will be consistently high in the decades ahead, and the best way to participate is to own the shares and collect my share of the incentive and management fees for a few decades. If we get a rough market and they fall, I will dip into my cash hoard and buy more.

The other reason I watch the industry so closely is that most of the private equity managers think a lot like I do when it comes to investing. They buy companies, not electronic dots that can be added and shed over a period of days or weeks. Private equity firms are looking to buy companies at bargain prices and then sell them a few years down the road for several multiples of what they paid. That's pretty much what I am doing, so I keep track of where and what they are buying and selling.

Last week Bloomberg ran an article talking about recent developments in private equity, noting that deal premiums were the highest since 2008 and cash was piling up quickly at private equity firms around the world. According to the article, there is about $860 billion waiting to go to work when the firms can find companies and assets to buy as prices they like. That is also the highest level since 2008, according to Bloomberg.

Too much money bouncing around the world desperately seeking a return has pushed valuations to what appear to be unsustainable levels. I know many folks are of the opinion that because interest rates are so low, then a much higher valuation can be justified. I would be in full agreement with that statement if I were convinced that interest rates would stay lower forever. I think the weak global economy will keep interest rates low for a period, but forever is a much longer time frame than I would be willing to bet on as the likely outcome. I don't think the rules of valuation have changed all that much over the years and the multiples we are seeing do not seem to offer much of a return on investment going forward. The leading private equity managers would appear to agree with me as they are doing more selling than buying and stockpiling cash.

What is the rule of valuation? In its latest shareholder letter, value investing firm Tweedy, Browne summed it up perfectly as it wrote, "We tend to value most businesses using an enterprise value multiple of between 10 and 12 times annual pre-tax operating income (EBIT or EBITA) when calculating intrinsic values, which equates to a pre-tax earnings yield of between 10% and approximately 8% on the debt-free value of the business. This compares more than favorably to low, risk-free interest rates, and we believe reasonable compensation for the equity investor. In making a new investment, we seek a discount of at least one third off of this more conservative estimate of intrinsic value, which implies a purchase multiple between 6x and 8x enterprise value to EBIT or EBITA." The only change I would add to its statement is that for financial and real estate stocks price to tangible book value is probably a better measure of value, and here again I am looking to buy at a significant discount to that number.

There are very few companies that meet either of those criteria of value right now. There are even fewer that are in decent financial shape at the moment. We are probably best served in this environment to adopt the private equity mindset and stockpile cash while waiting for more reasonable valuations.

Over the weekend an associate commented that I seem to write often about private equity firms and the private equity mindset. I do. Indeed, I talk about it even more.

Most traders fail. Pretty much all retail traders who have jobs, family and other interests that keep them from engaging in the type of intense focus and constant testing it takes to trade markets in the short term fail. That's not an opinion; it is a pretty well-researched fact. Most of us would have much better investment results if we quit trading and emulated private equity investors by buying undervalued assets and holding them for an extended period of time of time.

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At the time of publication, Melvin was long KKR, CG and BX.

TAGS: Investing | U.S. Equity | How-to | Stocks

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