Why PE Replication is so Powerful

When investors approach the market for the first time, they tend to think they’re going to find some magic button that unlocks the secrets of trading and investing success. They spend time studying chart patterns. They dive deep into roundtable TV recommendations. They dream of becoming the next Stevie Cohen or Paul Tudor Jones. 

The print media and Internet doesn’t help much. They’re full of offerings that teach you the “secrets” to investing or the “x-factor” chart indicator putting you on the path to everlasting profits.

My point is that most individuals come to the market with unrealistic expectations…

We all want to find success by trading the short-term market movements or catching the big trends on the way to millions.

But here’s the sad truth.

Want to trade? Enter at Your Own Risk 

When traders enter the market with a short-term or swing trade, they are competing against guys with their Ph.D. in math and statistics who have to install special air-conditioners to cool the computers they’re using to trade.

You think you have a great trade setup because of some chart pattern moving or an oscillator oscillating?

What traders all too often become is lunch money for a bunch of guys who cut their teeth trading in the pits at the Chicago Board Options Exchange (CBOE) or Chicago Mercantile Exchange (CME). These are guys that have an edge in knowledge and application that most traders will never be able to replicate or compete against. 

Wanna Be Like Warren? Good Luck! 

The other mindset that crushes a lot of investors is the “I want to be Warren Buffett,” syndrome. So much has been said and written about Buffett and his investing philosophies that pretty much everyone thinks they can replicate his success.

They can’t.

Although Buffett’s mindset and attitude towards the market should be used by a lot more people, we are never going to see the type of privately offered deals that Buffett and Charlie Munger see at Berkshire Hathaway.

Don’t think that you’ll find success by cloning his portfolio of public companies. Most of his cash flow comes from the private companies he owns and he gets paid to use leverage by his insurance float.

Still no Big Winners? You’re not alone.

When you look at individual investor returns over time as a group, they tend to lag behind not only the indexes, but also actively managed funds and even fall short of the inflation rate over the past 20 years.

Individuals trade entirely too much, tend to chase hot stories and popular stocks, and are too easily influenced by outside forces such as friends and family, advertising, and sales pitches.

Our brains work against us as we cling to loss aversion (it is better to not lose $5 than to find $5) and find comfort by running with the herd. Unfortunately, this makes it almost impossible to earn a satisfactory return in the financial markets. 

Buffett’s teacher Ben Graham once remarked that investing works best when it is most business-like. Investors should approach the stock market like a collection of businesses and adopt the mindset of the most successful business people in the financial markets.

Introducing The Private Equity Mindset

Private equity (PE) funds earn high returns by buying assets that are unpopular, holding them for five to seven years, and selling them to the momentum-minded herd.

Private equity firms are composed of companies, like-minded businessmen, and strategic investment managers. They simply acquire capital from wealthy investors… and then use that capital to invest in existing or new companies. They often purchase controlling interest in companies as well.

While we may not be able to exert the level of control that a big fund can exert over their portfolio, what we can do is adopt the “Private Equity Mindset:” Buying out-of-favor assets and securities, holding them long enough to recover, and selling them for many multiples of the original purchase price.

This is a far more successful practice than trying to place bets on where the indexes will close tomorrow. 

Private-equity firms look at thousands of companies in the course of a year and narrow the list down to those that they think are priced cheaply enough to offer significant returns.

They are the vultures of the market. Whenever there’s an economic or sector downturn, private equity firms become more active. They wait until others are panicking or forced to sell, only to obtain more of an advantageous price.

They hold the assets for several years until conditions normalize and begin to show signs of euphoria and irrational pricing to the upside. This is when they cash in and collect their outsized gains. 

Investors can do quite well when paying attention to what private equity funds are doing at any given point in time. It’s where you’ll find valuable insights into what assets and sectors may be underpriced and set for substantial long-term returns.

I call it private equity replication.

And it will be another backdoor strategy of ours for finding pure deep value investment ideas isolated from the crowd.