The Private Equity Mindset At Work

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Value investing is a long term proposition. Rather than try to time the short term swings of the stock market, the idea is to find undervalued businesses and hold them until they become fully valued. Often this process takes several years to fully play out. Owning stocks for three, four and even five years is the best path to the type of profits that can fund a retirement, send kids to college and meet other financial goals. One of the secrets of successful investing is adopting the private equity mindset. Successful private equity firms buy companies and assets at favorable prices and hold them for an extended period of time with the intention of selling them at several multiples of the purchase prices.

Amazon has been a growth darling forever and back in 2011 was, as it always seems to be, one of the hot growth stock selection. The market cap was $87 billion and the multiples of earnings and sales were as dramatically high as they are now. Amazon at the time was generating about $1.5 billion of free cash flows on sales of about $37 billion and was a market leading stock as it is today. Amazon's $87 billion market cap was easily capable of purchasing many smaller companies in their entireties.
For $87 billion,  it would have been possible to buy a basket of 12 companies. Naturally I bought some banks as part of my Amazon replacement portfolio. I bought Fox Chase Bancorp (FXCB), Capital Federal Financial (CFFN) Renasant Bancorp (RNST) and First Interstate Bancorp (FITK).

I like what I call the addictive lifestyle stocks as well and at the time they were pretty cheap based on assets and earnings power. The Amazon Replacement portfolio included shares of Callaway Golf (ELY), Cabellas (CAB) and West Marine (WMAR). I have found over the years that regardless of what is going in the world boaters, boat, hunters hunt and golfers golf. They may delay upgrading the newest and brightest accessories and gadgets in a poor economy but when they money returns they rush to buy them. I paid very low multiples of earnings and asset for these stocks at the time.

Grocers were cheap then as they were, as they still do, trying to compete against the massive pricing power of Wal-Mart. I thought the largest of them would figure it out and do okay over time. I also figured that the smaller chains were going to get bought out as the larger chains looked to gain size and volume to improve purchasing power. I added Safeway (SWY), Kroger (KR) and Winn Dixie to the Amazon Replacement Portfolio.

Insurance stocks were ridiculously cheap at the time so I added Transatlantic Holdings to the mix. The reinsurance stock was trading well below book value and earning decent profits at the time so into the portfolio it went. T capture the domestic market I also added Hartford Insurance (HIG) group.

Micron Technology (MU) was trading at stupid prices at the time and since they have wide exposure to several segments of the tech market in it went as well. I figured that internet and cyber security was going to be a big concern going forward so I picked shares of Symantec (SYMC) on the cheap as well. Sprint (S) was my favorite long shot stock at the time as the CEO was buying massive amounts of the stock and I figured it would skyrocket if he pulled off a turnaround so I added the cell phone company to the tech portion of the Amazon Replacement Portfolio.

As I noted at the time “For what it cost me to own Amazon I can buy 15 companies in a diverse range of industries. Remember from yesterday's article that Amazon had about $1.5 billion of free cash flows and sales of about $37 billion. Our empire generates almost $7 billion of free cash on revenues of over $230 billion. If our portfolios cash flow stays static it takes Amazon 7 years of 30% free cash flow growth to generate the same cash flows annually. We own some fast growing companies in our empire so it's unlikely that cash flows stay static. We are only paying 1.25 times tangible book value as opposed to Amazon's 15 times tangible book value.”

The point of the whole exercise was to point out that if you look at buying stocks as buying the business then paying high multiples of earnings, assets and cash flow makes very little sense. You can get a bigger bang for the buck by buying god businesses at great prices. It sounds good in theory but did it work? Let's take a look.

As baseline measure the S&P 500 has returned about 54% since June 1 , 2011. That's a compound rate of return of 15.58%. $15,000 invested in the income fund has grown into $23,160.Amazon has beaten the market as the stock has gone up by 61.24% which is 17.24% annualized. If you put your 15 grand into Amazon shares you now have $24,172.

However if you had placed your 15,000 into $1000 chunks of our Amazon Replacement portfolio of value stocks you now have $25,216 for a total return of $18.82%. You have a $1000 more than if you ever you had placed your bet on one of the greatest growth stocks of our time. You outperformed a stock market that has been in a powerful uptrend over the past three years by adopting the private equity mindset and buying value. The story is even better when you consider that two of the holdings, Transatlantic Holdings and Winn Dixie were taken over early in the story and that money is counted as earning a zero return for two years. Given that the average value stock went up by about 70% during the period it is not much of a stretch to conclude that the reinvestment of these funds into new value sections would have pushed the overall return over 20% annually.

Many of the stocks in the portfolio went down before they ultimately rose in value over the past three years. Investors how worried about day to day or month to month price changes would likely have pancaked out of the stocks at some point. However those who adopted the private equity mindset focused on the value of the stock and not day to day price fluctuations would have enjoyed above average returns and earned more than even those who bought one of the greatest growth stocks of the past 3 years.

Value time and patience are the best combination for profits in the stock markets. Most won't ever use them but those who do should see market beating returns over their investing lifetime.

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