Cash In on the Great Buyout Boom

Last year, private buyout groups raised a staggering $106 billion, the most ever and a 90% increase over 2004. This year stands a good chance of beating that record.

And in 2005, investments in value stocks outperformed investments in growth stocks. I think value will beat out growth again in 2006.

The explanation for the better returns from value stocks is pretty simple: So much money has been raised for hedge funds and buyout funds that corporate management at any underperforming company is really under the gun. Improve your company's performance, the activist investors demand, or we'll improve it for you.

Add in a huge spike in merger-and-acquisition activity, and you have a value investor's dream: No more waiting for years until some catalyst finally forces the stock market to recognize the true worth of an undervalued company. Right now, that catalyst -- in the form of a buyout offer or a demand from a hedge fund -- is likely to arrive in a matter of months.

Getting Management's Attention

Think that's overstated? Look at the drama unfolding at Borders Group ( BGP). Buyout investment groups such as Texas Pacific Group, Bain Capital, Apollo Management and Leonard Green Partners are circling the company like sharks. They've each put together a package of financing for an offer that would value the company somewhere north of $1.8 billion, or $25 a share.

The only thing they had been waiting for is for the company to announce its holiday sales: Weak sales would make the company more vulnerable to a bid -- and at a lower price -- while higher sales might convince management to fight back, or at least hold out for a higher price. Borders announced those numbers after the market close on Jan. 11 and forecast fourth-quarter earnings of $1.70 to $1.80 a share, up from the previous estimate of $1.60 to $1.80 a share. The next day saw the stock jump 10.2%.

You don't think management was, how shall I put it, motivated to do everything it could during the holiday season to pull in every last dollar of sales?

The Borders Group story isn't an isolated one. Last year, Toys "R" Us and Neiman Marcus were purchased by private buyout companies. Last week Burlington Coat Factory Warehouse ( BCF) auctioned itself off to Bain Capital for more than $2 billion. K Capital Partners, a hedge fund, wants management at OfficeMax ( OMX) to forget about its plans to turn the company around and, instead, put it up for sale. Not hard to see why: A recent report from Goldman Sachs estimates that OfficeMax would fetch $39 to $44 a share in a sale. Not bad for a stock now trading near $27.

Catalysts, Flush With Cash

The amount of money raised for private buyout funds is staggering. In March, the Carlyle Group raised $7.85 billion for a U.S. buyout fund, the largest buyout fund ever, at that time. This month, either Kohlberg Kravis Roberts, now raising $10 billion to $12 billion for a new buyout fund, or the Blackstone Group looking for up to $13 billion for a new fund, will take the title.

In 2005, U.S. private-equity groups raised $152 billion, an increase of 65% from 2004, according to Dow Jones Private Equity Analyst. Of that, $106 billion went to buyout funds, the most ever, and 90% more than 2004's total.

And that's not the end of the money available to "incentivize" CEOs to improve their companies' performances. Last year was the most active worldwide since 2000 for mergers and acquisitions, with more than $2.7 trillion in deals, Thomson Financial says, up 38% from 2004.

And it's different this time: Unlike 2000, when companies used their stock to acquire other companies, in 2005 they used cash. Only 11% of the year's deals were all-stock transactions. Some of that cash has come from accumulated earnings on company balance sheets, but more has come from the sale of new debt in the bond market. For example, Oracle ( ORCL) plans to sell $5 billion of debt to fund its purchase of Siebel Systems ( SEBL).

The result of all that money jumping up and down on the managers of underperforming companies until they either performed or were bought out was that in 2005, value investing strategies outpaced growth. And the bigger a stock's market capitalization, the more value outperformed.

At the small-cap end of the stock market, the Russell 2000 Value index outperformed the Russell 2000 Growth index for the year, 4.71% to 4.15%. At the large-cap end, the Russell 1000 Value index beat out the Russell 1000 Growth index, 7.05% to 5.26%. And at the very top of the market-cap pyramid, the Russell Top 200 Value index raced ahead of the Russell Top 200 Growth index, 4.6% to 2.88%.

This year, the Russell 200 Value index was up 3.09% through Jan. 12, and the Russell 200 Growth index was up 2.76%. Value is outperforming growth even as the stock market stages a textbook January rally.

Riding the Backs of the Buyout Artists

So how do individual investors put all this buyout cash to work for them?

Find value stocks where an activist buyout fund has taken a stake.

Take a look at Copart ( CPRT), which puts the sellers of salvaged vehicles, primarily insurance companies, together with the buyers of such cars and trucks, largely vehicle dismantlers, rebuilders, used-vehicle dealers and exporters, through its live and Internet auction services. The company also provides salvage services such as vehicle storage.

The stock is now trading at around $24 a share, with a trailing 12-month price-to-earnings ratio of 22. That strikes me as cheap for a company with projected earnings growth of nearly 10% in fiscal 2006 and 16% in fiscal 2007. The company, which owns about 30% to 35% of the salvage processing market, generated $315 million in operating cash flow in the last four quarters.

The stock is cheap because the company missed October-quarter earnings forecasts due to Hurricane Katrina's effect on the salvaged vehicle market.

But what makes this a value stock rather than a cheap growth stock is the balance sheet and the value of the company's Internet auction system. At the end of the October 2005 quarter, Copart had $255 million in cash and other short-term investments on its balance sheet (and no long or short-term debt). Not too shabby for a company with a market capitalization of just $2.2 billion.

The company is working to secure patents on its new Internet auction platform, VB2, which employs a technology that could be applied to other markets, according to Wall Street analysts. The market has been reluctant to put a value on Copart's VB2 platform, however, because the company has been sued for patent infringement by a competitor.

Looking for a catalyst? It's reassuring to see Jana Partners in the list of Copart's institutional owners. Jana Partners owned 3.1 million shares as of Sept. 30 and had bought 370,000 shares since the end of the previous reporting period, our ownership tool shows. Jana Partners is one of the private equity groups that has piggybacked on Carl Icahn's attempt to force Time Warner ( TWX) to unlock the value of its stock by selling or spinning off its America Online unit. And the company was involved last year in the nasty proxy fights at Six Flags ( PKS) and Sitel ( SWW).

Tilting the Playing Field

Remember what the buyout groups themselves look for in an investment:

  • Cash: They like to see cash on the balance sheet. In these deals, a company's own cash is often used to cover part of the purchase price.

  • Low debt, physical assets: They like to see low levels of debt and solid physical assets, such as property that can be used to back the debt financing that might be used to raise part of the purchase price.

  • Cash flow: And, finally, a buyout group will want to see healthy cash flow that can be used to pay off debt or to reward the buyout group with special dividends: This has been a growing trend in the last year or two.

    There's no guarantee that a stock that meets these criteria will have attracted a buyout group, or that either current management or the buyout group will succeed in realizing the value that you think lies buried in the stock.

    But by aligning yourself with the buyout boom, you've put one more financial market trend to work for you. That always helps. There's no point to investing on a level playing field, after all, unless you absolutely have to.

    At the time of publication, Jubak did not own or control any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.

    Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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