Invest Like a Buyout King

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Invest Like a Buyout King
by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
February 14, 2007

Flush with cash from pension funds, private equity firms like Kohlberg Kravis Roberts, Texas Pacific Group and Blackstone Group generate headlines almost daily for their latest corporate buyout, privatization or restructuring deals. The motivation behind the heavy cash flow into private equity is simple: These firms have historically generated returns for their investors far above stock market averages.

Unfortunately, individual investors have typically not had access to the often dazzling returns of private equity funds. But the astute individual can potentially profit from mimicking the mindset of professional buyout investors. While management changes, cost cutting and financial engineering contribute to their high returns, probably the most critical element driving long-term deal success is transaction price.

Contrast the buyout investor's focus on current price (which is known) with the typical stock analyst's focus on forecasting a company's future earnings growth (which is highly uncertain). Regrettably, most individual investors follow the analyst's uncertain forecast.

How the pros do it
An extremely useful valuation ratio that buyout pros use is something we call "return on capital cost" or RC ratio. Let's start with the denominator of the RC ratio. The total cost of taking a firm private has more elements than just stock market capitalization (i.e., stock price multiplied by shares outstanding) because the buyout investor also assumes the company's debt obligations. But offsetting these costs are the company's cash and short-term investments, which may be a potential source for partially funding the buyout.

The RC ratio's numerator is the earnings of the company available to cover ongoing financing costs. But the best measure of core earnings power is not net income, but operating income, which is often reported as a line item near the top of a company's income statement. (If not reported, operating income can be calculated by starting with net revenues and then subtracting "cost of goods sold" and "selling, general & administrative expenses.")

We use operating income—or earnings before interest, taxes, depreciation and amortization (often referred to as EBITDA)—to gauge earnings power rather than net income because these expenses usually change drastically when a company is recapitalized in a buyout transaction. Therefore, operating income better represents a company's basic earnings capacity. To sum up: RC = operating income / (market capitalization + total debt – cash & investments).

When the price is right
In general, the higher a company's RC value, the more attractive its current valuation is to a buyout investor. Intuitively, higher income is better than lower income for a given transaction cost level, or a lower transaction cost is better for a given operating income level. Schwab research has found that the 20% of stocks with the highest RC ratio have returned about 22% annually vs. 15% for the average stock since 1989. This research suggests that buyout investors' historical success may not be due to sophisticated post-deal maneuverings, but more simply due to their ability to identify attractively valued stocks to take private!

Our valuation shortcut
How can you find RC ratios? Computing them one stock at a time is extremely laborious, so consider the shortcut of using Schwab Equity Ratings, which includes a special version of the RC ratio as one of 18 evaluation metrics. Here's a suggested screening sequence to find stocks with high RC ratios which are also highly rated by Schwab Equity Ratings:

First, log in at Schwab.com and use the Schwab Equity Ratings Stock Screener on the Stocks tab to select only A-rated stocks.
Then, add criteria to further screen for stocks with Sector = All, Return on Equity > 10%, Debt to Equity < 1.0 and P/E (Price-to-Earnings ratio) Last 12 Months < 20. About 30-60 stocks will pass these steps.
Eliminate all stocks in the financial sector—RC ratios cannot be calculated from the financial statements reported by these firms.
For each remaining stock, click on the Quotes & Research tab, enter the ticker symbol, click on the Schwab's Viewpoint tab and look at the Rationale Behind Our Rating panel. Eliminate any stock whose Valuation concept "Operating Income Relative to Market Valuation" is not positive.

The few stocks that pass through this entire process of elimination will tend to have high RC ratios as well as the added bonus of being favored by our comprehensive Schwab Equity Ratings.

Finally, remember that the pros have lots of deals going on at once, so they tend to diversify. One way you can emulate that sound strategy is to consider a mutual fund powered by Schwab Equity Ratings. You can get the benefit of this sophisticated valuation approach—without the hard work.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List®. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services, and other administrative services.

The Schwab Equity Ratings are not personal recommendations for any particular investor; do not take into account the financial, investment or other objectives; and may not be suitable for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Schwab Equity Ratings are based upon a disciplined, systematic approach that evaluates each stock on the basis of a wide variety of investment criteria from four broad categories: Fundamentals, Valuation, Momentum and Risk. This approach attempts to gauge investor expectations since stock prices tend to move in the same direction as changes in investor expectations. Stocks with low and potentially improving investor expectations tend to receive the best Schwab Equity Ratings ("A" or "B" ratings), while stocks with high and potentially falling investor expectations tend to receive the worst Schwab Equity Ratings ("D" or "F" ratings). From time to time, Schwab may update the Schwab Equity Ratings methodology.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment or investment strategy. All expressions of opinion are subject to change without notice. The Schwab Center for Investment Research® is a division of Charles Schwab & Co., Inc. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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