Sell in May and go Away

This old market axiom got me out of gold OK, but did'nt keep me from shorting the Dow which was an expensive mistake.

In my "Interesting" post last week (down towards the end, for those of you who didn't get that far) I said the Fed was creating a lot of money to fuel the economy, but that the money wasn't going into productive investments, but into the stock market, thus explaining the markets continued rise in the face of an uncertain economic situattion.

I went about twelve pages deep in Google looking for commentary on this phenomenon, but didn't find it. So let me explain in my own inimicable style.

Private Equity Funds and Leveraged Buy Outs are investment opportunities for the very wealthy (and pension funds). The managers collect money from investors, pick out an investment they like, borrow maybe ten or twenty times as much as the investors ante'd up and buy the investment.

The managers figure they can run the company better than the old managers, make higher profits, and then sell their investment for more than they paid for it.
The borrowing part is important. Thats's where leverage comes in. Say the managers buy a company that makes a profit of 50 million a year for five hundred million.
The investors had contributed 50 million and 450 million was borrowed. The managers try to sell off a couple of divisions of the company for 200 million, paying off part of the loan, but keep the pieces where they think they can increase profits the most. Maybe the sold off divisions contributed 20 million in profits. So they have an operation making 30 million a year. They shut down operations that are only marginally profitable and lay off a lot of people to reduce expenses and concentrate on what they think can be the most profitable operations. So in three years the company is making 50 million a year, and the managers sell it for 500 million. They get a good price for a smaller company because now the company is trimmed down and concentrating on its high growth, most profitable operations. So if the 200 million from selling the spun off divisions paid off part of the loan there is still 250 million to pay off, leaving a profit of 250 million. The managers take 20% of the profit (50 million) leaving 200 million for the investors. In most cases the managers would have paid investment bankers and lawyers 50 million in fees, so that would reduce investors profits to 100 million on the 50 they invested, still a very nice profit. Perhaps too optimistic, but that's how investors hope thing's will work out. It's even conceivable that the officers of the slimmed down company would come up with 50 million and borrow 450 to buy the business themselves. That way they insure they keep their jobs and no doubt believe they can make the company even more profitable. The bank is willing to go alomng because it's been a good deal for them so far. So thats where the Fed's new money is going - to lend to the managers to finance these deals.

Thats what's been going on for a few years. Snags can arise. Maybe the managers can't sell off the divisions they thought they would. Maybe interest rates go up, making the loans more expensive than planned, maybe the competitive circumstances or the economic environment change making it harder to increase profits. In such cases the managers, investment bankers, and lawyers still got their fees, but the investors lose their money. That hasn't been happening lately but it has happened in the past and will again.

A more predictable problem is that good takeover targets get scarcer because the good ones have already been taken, but people keep signing up to contribute their money and become partners, and the managers still have to go out and find (less attractive) companies to buy out. Pretty soon some of the deals are going to go bust and the banks will lose some of their money and the partners will lose their investments.

Remenmber about a year ago I was looking for a good water company to buy and both Hinkley and Schmitt and Culligan had been brought up? So I had to look for other stocks to buy that maybe I didn't like as well. Like I say, all this Fed money going into stock investment is holding the market up and I don't know where it's going to stop. (but it will)