Equity markets offer attractive return potential in an environment of persistent low bond yields. Yet the macroeconomic background is complex.
For investors seeking to tap equities, it may seem hard to develop conviction in the fundamental qualities of companies that should drive stock returns over the long term.
But there is a way to stay focused on sustainable sources of potential return. It involves approaching public equity markets with the same frame of mind as strategic business owners or private equity investors.
They think and operate very differently from most investors in public markets – and their time horizons tend to be longer.
So, which private equity investing techniques can deliver particularly valuable long-term perspectives?
Focus on business strategy, operations and management
Investors in equity markets often focus on financial-market metrics such as a stock’s beta or its volatility. But these types of indicators don’t tell an investor anything about whether a business will be successful or not.
Private equity investors seek to buy companies – not stocks. They focus on business strategy, operations, market dynamics and management.
These are the factors that drive value creation for a company, and ultimately deliver returns to investors.
Business owners always scrutinise companies’ balance sheets, aiming to ensure, for example, that they aren’t artificially amplifying their returns on equity by taking on excessive debt.
And the quality of a management team is also the key to improving the chances of successful execution of business and financial plans.
Emphasise cash flows
Cash flows are perhaps the most important indicator of a company’s business health.
While many investors in stocks put earnings at the centre of their analysis, private equity investors tend to focus more on cash flows, which can’t be manipulated as easily as reported earnings figures.
They provide transparency on how much cash is flowing in or out of the company in the form of working capital and capital expenditure – which don’t show up in reported earnings.
Cash-rich companies are clearly getting a lot of things right, suggesting they could prove to be well placed to invest in their businesses in ways likely to enhance their earnings potential.
Private equity investors typically measure the return potential from a company’s cash flows by calculating their internal rates of return (IRRs).
This involves looking at dividends and expected proceeds if the company is sold back to the market after five years at a conservative exit multiple, either equivalent to – or lower than – the current multiple.
In other words, calculating proprietary IRRs can show the return potential from investing in a company based on cash-flow forecasts, without the benefit of any expansion of its stock-market multiple, or market re-rating of the stock.
Maintain a longer-term outlook
When bad news hits a stock, a few days or weeks of volatility can undermine confidence in a long-term investment thesis. Many long-only investors focus on a one- to three-year time frame, while hedge funds tend to think little more than a quarter or year ahead.
We think a clear emphasis on the longer term – for example, three to five years – makes it much easier to maintain conviction through shorter periods of uncertainty.
Shift away from benchmarks
Private equity investors aren’t tethered to the benchmarks that dominate many public equity strategies.
In our view, benchmark-hugging doesn’t provide investors with the return potential of portfolios based on research convictions. Moving away from benchmarks can allow investors to build highly concentrated portfolios with a relatively small number of stocks.
These guidelines are the key to creating differentiated portfolios that can withstand external pressures to deliver long-term performance.
Business owners don’t stop searching for persistent sources of growth and profits just because economic or political conditions have become tricky.
By adopting a similar mindset, we believe that equity investors, too, can discover global opportunities with real staying power.
Tawhid Ali is a portfolio manager, global research insights at AllianceBernstein.
