Wednesday, July 1, 2009 0 comments ++[ CLICK TO COMMENT ]++

"Private equity put" dissapears

One of the hardest things for newbies like me is figuring out the "excessive" portion of past valuations. Some of the valuations that prevailed in the last 5 years will never be repeated for a long time (the most obvious are valuations placed on CDOs consisting of mortgages and plain RMBS). But it's hard to say what was "too much".

I think people who started investing an year or two, or those who have been investing for decades, may not be as confused as many of us who started 4 or 5 years ago. One of the problems for people like me is that our perception of what is "normal" is driven by the last 5 years. Sure, we read history books, we look at long-term valuations, and so on, but it is still difficult to overcome the biases from the last few years. This is mainly because most of our lessons were learned during that period. This is doubly so for people like me who rely on multiples, such as P/E or P/BookValue, to value stocks.

MarketWatch has a story that sort of illustrates the problem faced by some value investors. Essentially, the boom in private equity (PE) created a floor whereby PE would snap up any company whose valuation falls lot. This is not the case right now, and I would argue for a long time.

The issue, say managers, is that recent years saw so much cheap money heading to private equity firms that it allowed them to snap up companies if a stock's price fell too low.

The demise of that system has removed a floor in stock prices, say managers, adding a layer of uncertainty.

"I've seen mid- and small-cap valuations fall to staggeringly low levels," said Alex Crooke, London-based value manager of Henderson Global Equity Income.


The distribution arm spin-off of retailer WH Smith PLC /quotes/comstock/23s!e:smwh (UK:SMWH 425.75, +7.50, +1.79%) , Smith News' stock price was 1.57 pounds in May 2007, but fell to 46 pence in early March.

"This company came to market at 10, 11 times earnings, and it dropped to 3.5, 4 times earnings," said Crooke. "It needed no capital expenditure, and at the bottom its yield was 15%."

"If private equity firms had been in full swing, they'd never allow them to fall so far; the floor's been taken out," he added.

"As long as a company was generating decent free cash there was an implicit floor [due to the presence of] private equity," said Phil Davidson, chief investment officer for value stocks at American Century Investments.

"Formerly if you had a high quality, cash generating stock, private equity would be available to buy it," if its price fell, said Sandy Pomeroy, managing director at Neuberger Berman. "Now there are non-cyclical companies with strong cash flows where prices have gotten a little silly," she said.


Arm & Hammer products maker Church & Dwight Co. has a 6.5% free cash flow yield on its common stock and a 30% debt to capital ratio. Its bonds are priced at or about 3.5% above Treasurys, said Pomeroy. In the past, these metrics would have made the company attractive to a private equity buyer, with Pomeroy noting that another company in the same non-cyclical sector but which was more highly levered and had higher priced bonds -- Wrigley -- was taken private last year.

"With 3.5% or more as the cost of debt financing it is hard to make the economics work on a private equity deal," said Pomeroy.

As the article points out, there are two problems. The first one is the declining popularity of PE funds, the blowup of some, and the lack of capital avaiable to many. The other problem is that cost of debt is not as cheap as it was before so even if PE wanted to, they wouldn't pay up. All of these problems means that valuations can fall much lower than in the past. I see many prominent investors who purchased stocks at much higher prices and, even if the involved companies haven't faced permanent impairments in their business, I have a feeling that the shares won't recover for a long time. The difficulty is figuring out how low valuations can really go. After all, one of the biggest mistakes contrarians or value investors can make is to buy too early.

There isn't a simple solution for newbies like me. Even if you somehow discount the "PE put" and look further back, say the last ten years instead of five, the picture isn't necessarily better. Valuations were also high for various reasons in the late 90's and early 2000's. So, one should really look further back, say 15 to 20 years back. Unfortunately, a lot of the free information available on websites only go back 10 years. Without doing a lot of homework and tabulating a lot of data, it's hard to say how the market valued certain companies 15 years ago.


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