Rational Investing: LBOs can be used as indicator of market bottom

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Year before last we witnessed a level of new issues (initial public offerings) being brought to market. It was not just the number of issues, but also their questionable quality that added evidence that the markets, especially NASDAQ, were, as the saying goes, "priced to perfection." IPOs are brought to market in highest volume when investor psychology is at its most optimistic, historically a reliable indicator that a top is close at hand.|ret||ret||tab|

We may soon be seeing the opposite early signs that a bottom is at hand should leveraged buyouts, or LBOs, grow in number. With many financially sound, frequently cash-rich and often high-cash-flow-generating companies carrying low market valuations, a rash of "going private" should not surprise investors. All that is missing is low interest rates for below-investment-grade bonds (euphemistically referred to by Wall Street as "high yield bonds" and pejoratively by investors as "junk bonds"). Whether leveraged buy-out firms, company executives, or other shareholder cabals and their corporate bankers are the acquirers matters little. |ret||ret||tab|

What does matter, as it relates to market bottoms, is the fact that LBOs are not done by inexperienced investors. These are not stock traders who follow every tick in stock prices nor are their decisions made on the basis of emotions. They are knowledgeable individuals who buy entire companies that they recognize as having more value than is reflected in the market price.|ret||ret||tab|

When that kind of value recognition activity occurs at a growing pace, a market bottom is at hand. Keep an eye on LBOs and acquisitions if market bottoms and tops are important to your strategy. (For us, market tops and bottoms are relevant in a macro sense, but our focus remains on patiently and consistently owning those undervalued companies that are potential candidates for being acquired or taken private.)|ret||ret||tab|

You had better be what you say you are that's the gist of a ruling from the Securities and Exchange Commission. If you are a mutual fund with a style claimed in your fund name, you must hold investments consistent with that style. If you call yourself an income fund, you had better not be loaded with growth issues; a growth fund better not be holding large corporate bond positions, etc. You get the picture.|ret||ret||tab|

One of my pet peeves has been professional money management firms, whether independents (as we are) or mutual funds, that promote themselves as employing a particular style, but deviate wildly from that style if it is out of favor and under-performing the market. |ret||ret||tab|

Early last year, I had lunch with a broker from a major Wall Street firm who told of the company's in-house value fund manager and his outstanding performance. He mentioned several issues the value manager held in the portfolio, stressing Motorola in particular. I asked why the portfolio manager would continue holding Motorola when it was outside even the loosest parameters for a value stock. He said, "When I asked him about that, he said it was because he bought it at lower prices when it was a value issue."|ret||ret||tab|

Duh! There are two sides of value investing the buy side and the sell side. When issues appreciate to the point that they exceed value parameters, they should be sold. In this case the manager was evidently holding on because the stock was moving up, not because it was a value holding. He was (and may still be) chasing momentum to get short-term performance, and doing so at the expense of a consistent value discipline. (I wonder what he thinks of that issue now that it is under $20?)|ret||ret||tab|

If you employ mutual funds (large cap growth, large cap value, small cap growth, small cap value, etc.) in an asset allocation construction of your portfolio, be certain that the managers of those assets remain consistent with that style description. If they don't, they are altering the performance and risk tolerance for which your portfolio is designed. If you are uncertain about style consistency among your holdings, have your broker do an evaluation based on at least the top 10 holdings of each fund. While you're at it, have him also check the funds for duplications in holdings. |ret||ret||tab|

Stay disciplined; stay focused. It makes for better investing and better sleep.|ret||ret||tab|

|bold_on|(Clark Davis is a 30-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money management company. Questions or comments can be directed to him by mail via The Springfield Business Journal, 313 Park Central West, 65806 or by e-mail at sbj@sbj.net.)[[In-content Ad]]