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Markets: Money to Burn
New York: July 23, 2007
By John R. Stephenson

The subprime mess continues to spiral out of control and the U.S. housing market continues to falter; yet the stock market marches higher. The economy shows signs of stalling and yet the market shrugs off these concerns and moves higher. Company after company disappears from the stock market — taken private for unheard of valuations. All of this has left investors wondering what to do. Should they try and figure out what's next , or exit the stock market altogether?

In the U.S., large-cap funds have languished, while small and mid-cap mutual funds have soared. Just what is driving these stocks higher and what's a savvy investor to do about it?

Look no further than private equity (firms that raise large amounts of money in the private market to buy/restructure private/public firms) and the new titans of Wall Street for answers. An unprecedented wall of money has been raised and is being put to use by these swashbuckling captains of finance as they target small and mid-cap companies with healthy balance sheets and take them private. This has created a bonanza for mutual fund managers lucky enough to be investing in this sweet spot in the market as a perfect storm of opportunity has rained down on private equity players.

Companies such as KKR and Blackstone Group LP once vilified and now revered, have become, along with their principals, the new masters of the universe as deals and pay packages have reached the stratosphere. Stephen Schwarzman, the co-founder of Blackstone Group LP, a private equity firm, reportedly made over $400 million last year as he, along with others, trumpeted in the new era of finance on Wall Street. According to Reuters, "U.S. private equity firms raised $137 billion in 199 funds during the first half of 2007, a 42% increase over the $96 billion raised in 147 funds during the first half of 2006 and on pace to best the record total $261 mllion raised last year."

A near-perfect confluence of events has transpired in the last few years to make private equity the top dog. With interest rates low and treasury yields just as low, bond managers have been scrambling to find investments with decent returns. At the same time, the stock market has stabilized after the sell-off in the Nasdaq while junk bond default rates have shrunk. All of this has allowed private equity firms to post enviable investment track records over the last decade.

Companies with good management, strong cash flows and good growth prospects were the ideal candidates for these private equity players, who, armed with huge checkbooks, could pay exorbitant sums of money to take these companies out of the public markets. And so they did. The vast majority of these companies came from the rank and file of the S&P 400 index as many of these smaller and mid-sized companies were delighted to be removed from the shackles of quarterly reporting and Sarbanes-Oxley compliance.

But in order to make the numbers work, a huge amount of leverage (debt) was appplied to these newly restructured companies. All of this works, of course, on paper — until something goes wrong. But what could go wrong?

Well, for starters, these acquired companies have nothing to show for the buyout other than a mountain of debt. Instead of managing the growth of these businesses, management must focus first on paying down the debt. This means that growth and capital investment by business is largely a thing of the past — at least for now. Not only that, but with a greater piece of the financing pie being contributed by the debt capital markets, the outlook for interest rates has become paramount.

Much of the overall U.S. growth in productivity has come from the small and mid-capitalization sectors of the economy. But with a buyout mania sweeping the globe and private equity and pension funds gobbling up assets, many of these companies won't be able to provide much needed productivity gains in an increasimgly competitive global market. But for now, none of that matters as the stock market has been looking to see who's still standing that could be taken private by private equity.

Private equity itself won't be able to provide much leadership when the going gets tough. Increasingly, they are running hugely disparite, fast-growing portfolios of assets in a wide range of industries around the world. Good luck managing that when interest rates start to really back up and when one or more of these over-leveraged behemoths hickups.

So what's an honest investor to do? For our money, look to capitalize on a trend that is not short-dated in nature, by overweighting your portfolio in the base metals, oil and grain producing stocks whose growth is being driven by a surging middle class in China and India rather than a stagnating U.S. economy.

With capital expenditure in the dumper, technology stocks seem like a poor place to hide and large money center banks where most of the excesses are surely manifested are another area in which savvy investors should lighten up. Stock markets are typically weak in the last quarter of the year and with a lot of pent-up unbridled enthusiasm in the market these days, a cautious approach to new investments might be a wise approach — at least until the dust settles on the excesses of the last few years.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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