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The Curse of Overcapitalization Pervades the Stock Market Today

NEW YORK (TheStreet) -- At Smead Capital Management, we are conscious of the few but significant pitfalls we believe exist for the long-duration, common stock investor.

One of the main pitfalls we want to avoid is the overcapitalization curse. This is a situation where investor enthusiasm gets very high, prices get historically high and investors drown the company, industry or sector with capital. In our experience, it pays to avoid the overcapitalized areas for as long as five to 10 years as they work their way back to being hated and contentious.

We were recently reminded of this pitfall by Wall Street Journal writer, Andrew Blackman, who wrote a piece called, Private Equity Has More Than It Can Spend. Here is how he explains the overcapitalization of the private equity sector:

It [the private equity industry] has been so successful in raising money from investors recently that it can't spend it fast enough. The amount of money raised by private-equity firms but not yet invested -- known as dry powder -- hit a record high of $1.073 trillion globally at the end of 2013, according to data provider Preqin, an increase of $130 billion from 2012. The total has continued to grow this year, reaching $1.141 trillion globally as of the start of June.

Some background might be necessary. Thirty years ago there was a small segment of money managers called leveraged buyout, or LBO, firms. This was a group of people who looked to buy publicly traded companies with borrowed money. In the 1980s, much of that borrowed money came from junk-bond financing by my original firm, Drexel Burnham Lambert.

A market for the trading and issuance of junk-bonds was created and run by the junk bond king Michael Milken. Public companies that were targets of the buyouts had to be very depressed in price to justify the double-digit interest rates paid by LBO firms in the 1980s and 1990s. I remember in those days large institutional investors and white-shoe investment firms did not want to be affiliated with what was considered unsavory borrowing and speculation.

When the largest investors in the world, U.S. institutional investors, go from not being involved in an arena to having as much as 20% of their portfolios invested in a 25-year stretch, the possibility of overcapitalization exists. In explaining Harvard's commitment to private equity investments equal to 16% of its endowment and 5% more than in U.S. long-only equities, former CIO Jane Mendillo said the following in Barrons on Feb. 8:

You've talked about some of the challenges now in the private-equity industry.

Private equity is a much more crowded place than it was 10 or 20 years ago. So you need to be choosy and pick the right managers and opportunities. It has been estimated there is a trillion dollars of dry powder in the private-equity industry today.

So that's money committed by investors, waiting to be deployed?

That's right. That is going to create a competitive environment for private-equity managers who are putting money to work. It will drive up deal prices and drive down returns to more modest levels.

Let us say what we think nobody in the private equity arena wants said: We believe that overcapitalized market returns won't just moderate, they will become miserable.

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