Welcome, Barbarians! How to profit from the buyout craze
The raiders taking over big companies today are good for stocks - especially ones in the sectors they're targeting.
NEW YORK (Money Magazine) -- First Toys R Us succumbed. Then Neiman Marcus, followed by supermarket chain Albertsons.
In the past two years, those big publicly held companies and dozens like them have been taken private by corporate raiders.
Health-care company HCA's ticker will soon disappear too. A trio of private equity companies, including the famed Kohlberg Kravis Roberts & Co., have bid $33 billion for the hospital chain - a takeover that could eclipse even the legendary 1980s deal for RJR Nabisco that earned corporate raiders their aggressive nickname.
The barbarians are back - and that's likely a good thing for your portfolio.
First, buyouts tend to boost most stocks in the industries where they occur, not just the stock of a firm being acquired.
Second, with more companies going private and few initial public offerings these days, the supply of shares is declining. If demand for stocks remains the same, prices will rise.
What's more, increased interest from private equity firms in public companies indicates that the dealmakers, at least, think stocks are cheap. "These deals happen because valuations of a number of companies in the market are lower than they deserve to be," says Colin Blaydon, director of the private equity center at Dartmouth's Tuck School of Business.
Why they are charging
Private equity funds raise money from wealthy investors and institutions such as pension funds. Some invest their money in start-ups, bankrolling dozens of new ventures in the hopes that one will turn into Google. Others do leveraged buyouts, purchasing established companies by investing a little and borrowing a lot.
In the 1990s, venture capital was all the rage. Now LBOs are hip again.
Buyout math is complicated, but the basic idea is not: Raiders want a return on investment greater than their borrowing costs.
Take the deal for hospital chain HCA. The easiest way to figure out the potential return is to stand the popular price-to-earnings multiple on its head. The earnings-to-price ratio, or earnings yield, is what an owner of a company can expect to make each year as a percentage of what it paid.
Last year HCA produced $4 billion in earnings before taxes, interest payments and depreciation (known as EBITDA, this is a preferred measure of profitability on Wall Street). The hospital chain's buyers are paying $33 billion. That means HCA has an expected earnings yield of 12 percent.
Frank Morgan, an analyst at Jefferies, estimates that on average HCA's new owners will be able to borrow at a rate of about 9.2 percent. They reportedly plan to borrow 80 percent of the cost of the deal, meaning they can expect a 23 percent annual return if all goes well.
Buyout funds also typically charge a healthy management fee to an acquired company, and if they can actually improve its operations, they'll do even better.
Attacking in waves
That math helps explain why buyout funds returned an average of 31 percent in 2005. As a result, investors are piling in. Buyout funds raised $86 billion in 2005, up 70 percent from the year before.
Not everyone witnessing this phenomenon thinks it's a harbinger of good times for stocks. Steven Kaplan, a finance professor at the University of Chicago, says the deals are the result of nothing more than the funds' need for big targets at which to throw their money.
He's got a point. Still, the fact is, all this money creates a huge, newly aggressive buyer for stocks. In total, buyout funds have an estimated $300 billion to invest. If they're putting down 20 percent on a deal, that means their current buying power is around $1.5 trillion.
Where the takeovers are
Where is that money headed? In the 1980s, raiders had their sights on the dying conglomerates of the 1970s. Bought and then sold off in parts, they could provide a nice profit. Few of those types of targets are left.
Instead, private equity funds want businesses that are generating big piles of cash to pay back the debt that finances the deal. "We have always focused on building and improving businesses," says Marc Lipschultz, a partner at KKR. "That is even more true today because businesses are generally more efficient."
And as the $33 billion bid from KKR and others for hospital operator HCA shows, health care is one of the areas private equity firms are looking at. Medical businesses have steady returns and produce a lot of cash - and for the next two decades, they have a large generation of aging baby boomers to fuel growth in demand.
"It's an industry the size of China's GDP and growing just as rapidly," says Jeff Goldsmith, president of consulting firm Health Futures.
Media too has been a growing area of interest for private equity firms. Financier Nelson Peltz, who bought out beverage company Snapple in the mid-1990s, recently purchased 1.2 percent of newspaper company Tribune (Charts).
A $13.6 billion buyout of Spanish-language television station Univision was announced in June.
And private equity firm Elevation Partners recently bought 40 percent of the company that publishes Forbes magazine.
Larry Grimes, president of investment bank W.B. Grimes, which specializes in media, says the perception that the Internet is killing print, TV and radio companies is false. "Traditional media companies generate a lot higher cash flow and profit margins than most other industries," says Grimes. "And at least theoretically, the Internet gives them the potential for growth."
Your plan of attack
The best news about buyouts is that it takes very little to benefit from the trend. As long as you own an index or actively managed fund that invests in a cross section of big companies (and you do have a large-cap stock fund in your portfolio, don't you?), you stand to benefit as private equity firms buy up more and more brand names.
"If the S&P 500 were a public company, someone would be taking it private," says Jason Trennert of Strategas Research Partners.
A more aggressive approach is to buy stocks and mutual funds that specialize in industries where private equity firms are likely to be active.
For health care, T. Rowe Price Health Sciences fund (PRHSX), up 15 percent in the past year, is one the best in its category.
If you prefer lowcost index investing, exchange-traded fund Health Care Select SPDR (XLV) has an expense ratio of just 0.25 percent vs. 0.91 percent for the T. Rowe Price fund.
Greg Peters, chief credit strategist at Morgan Stanley, draws up a list each month of likely buyout candidates. Peters looks for companies with little debt and a stock price that's low relative to the cash the company generates. (Peters doesn't research whether a company's management or owners are interested in a buyout, one of the major hurdles to a deal.)
Two health-care companies make Peters' list.
King Pharmaceuticals (Charts) has increased sales in seven of the past eight years by an average of 70 percent. Its best-selling drug, heart medication Altace, generates nearly $500 million a year and has two years left on its patent.
Watson Pharmaceuticals (Charts) got a boost from the release of a generic substitute for cholesterol drug Pravachol. Its generic business should be a steady cash generator as more name-brand drugs lose patent protection in the next few years.
For media, Powershares Multimedia (PBS) is an ETF that holds all of the largest publicly traded media companies, including recent buyout target Univision.
And the New York Times (Charts) and Playboy (Charts) make Peters' list of potential buyouts. The newspaper and men's magazine publishers each have storied print franchises that are under pressure as advertisers and audience alike gravitate to the Web, but both are responding by making aggressive pushes online. Both companies are long run by family members who would have to sign on to a buyout. Neither of the stocks has done well lately, however. Nor, for that matter, has the ETF.
But then, that's the point. Barbarians, after all, attack the weak.