[Newsphopick=Kingsley Lim] According to some observers, markets are currently at overvalued levels. After a 30% correction in April, US markets have lifted to record highs with support from speculative funds from retail investors. Some investors lament that there are no opportunities at today’s market prices.
While that is true to some extent, I have always held the view that the opportunity is in stocks with a small market capitalisation. You can find valuable opportunities in stocks which trade at less than US$100 million. Why? The markets often ignore smaller stocks. Such stocks are usually not covered by analysts and trade at less than the net tangible assets. Sometimes, you can find profitable stocks trading at less than 40% of the net tangible assets, while giving generous dividends.
It is here that I build my argument for investing in businesses instead of stocks. For the intrepid investor, these areas are fertile grounds for exploitation. Since small stocks trade at such low valuations, what about private businesses who do not have a public presence? Quite often, many of these private businesses while profitable, especially in Asia, have had to close down.
There are a number of reasons for this. Firstly, in Asia, there is no market for corporate control. Buyouts are a rarity. Even worse, the leveraged buyout is nearly non-existent in some countries. In Singapore where I live, obtaining financing from the banks to buy a private business is close to impossible. The banks in Singapore are willing to finance real estate development and purchases, but not the purchase of a business. It is the same in many parts of Asia.
So with regards to financing the purchase of a private company in Singapore and many parts of Asia, purchasers have had to look towards family offices and seller financing. While the former is not a usual occurrence, seller financing is the prevalent mode of financing. In a transaction financed by the seller, the seller agrees to take a portion as down payment, and the rest in bond-like instalments until the debt is paid by the buyer. This way, the buyer finances the purchase of the business using the company’s cash flows – similar to a leveraged buyout.
If the target company is large enough, one could look to an investment bank to help with the financing of the company. However, the deal size has to be larger than US$50 million in most cases for the deal to go through. Speaking to an investment banker, besides a large deal size, the banks must see some cross-selling opportunities to be motivated to do the deal. When a deal is executed, the financing will consist of bond-like instruments and a mezzanine layer.
By contrast, buying a business in the US seems to be a less complicated matter. US banks are less conservative and are more willing to finance a deal, if it made sense. If the creditors are willing to finance a purchase, at a low enough valuation, it would be advantageous for buyers to initiate these deals.
Of course, this is easier said than done. Private businesses for sale are a minefield. I recently considered the purchase of a business in Indonesia. It was a packaging company producing packaging for water products. The business owner built the business over a span of 20 years and now wants to retire. The problem is that he has not been able to find a successor. And there is no way that he will consider a public listing, for he does not have a built-in management team to run the business. To add to that, his personal financials have been mixed with the company’s financials. As such, when I requested for the last 10 years of financial statements, he couldn’t produce them.
There are many more problems such as those described above. Sellers typically want the highest valuations for a business. In Singapore, I have seen sellers wanting to sell at a price-to-earnings ratio of ten times. This is pricey for an investment into a private company. But usually, these sellers settle for less. If Singapore’s companies list at between 8 to 12 times, it is unlikely that a private business will get the same valuations of a listing.
Despite all these issues, why buy private companies then? Well, the valuations of these private companies can be very attractive. With enough due diligence, private companies could be purchased at a price-to-earnings ratio of around 3 to 5 times. Simply put, in 3 to 5 years, a buyer would have recovered his entire investment.
The profits of successive years thus become a perpetuity if the company is a going concern. I have even seen and heard of purchases that occurred at a price-to-earnings ratio of 1 to 2 times. At these valuations, acquisitions done right, would likely lead to a good outcome in the future. However, this advice is not for the faint of heart – one would need a strong contrarian streak and be bold enough to make the move.