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Private Equity: Why Momentum Strategies Don't Work

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Approach makes no sense unless every best-case scenario pans out.

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Sometimes you get so used to backwards herd mentality -- "I want to do whatever the other guy is doing" thinking -- that you can't believe it when a professional money manager says something reasonable.

Take private equity, known once upon a time as leveraged buyouts.

The logic behind private equity has always been that public markets, for a variety of reasons, don't always accurately price the future cash flows of a business. In that case -- and that case only -- it makes sense for a financial buyer to come in and buy those claims at a large discount to their real value, using borrowed money to help buy out the stockholders. It's a mean-reversion approach, an anti-momentum philosophy.

Ah, momentum. If it's going up, I want to buy it. If it's going down, since other people are selling, I should sell as well. For certain financial strategies, momentum works. Indeed, most technical analysis is based largely on identifying and following trends deemed likely to persist.

But momentum has absolutely no place in the world of private equity.

Unfortunately, momentum has every place in the mindset of looking good in the perceived public eye. Thus, after a stretch in which private equity has succeeded -- showing big returns from buying low and then harvesting by selling much higher -- we often see a rush of money into the strategy. Prices become too high for the approach to make sense unless, by some miracle, all the best-case scenarios play out.

This is what we were seeing a few years ago, with deals happening at unheard-of sizes and multiples as stocks were making all-time highs. You know the names that were actual or possible candidates: Clear Channel (CCO), TXU Energy, Affiliated Computer Services (ACS), and so on.

More recently, of course, many buyout participants have been looking to get out at prices their own strategy's logic dictates the opposite.

This is all preamble to CALPERS' announcement that it seeks to add to its private-equity investments. While this would have been even more compelling had we heard it a few months ago, it still makes sense.

A big player actually going against the trend.

Hard to believe -- but let's hope we see more of it.
No positions in stocks mentioned.

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