Sound Mind Investing : Companies "Going Private"

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Companies "Going Private"

Q: Recently, numerous public companies have been bought by "private" groups, which causes them to no longer trade as public stocks. I've read this trend could cause a problem. Is that true? How do these purchases impact me?

A: As you might expect, this isn't a simple question to answer briefly. But as an investor, here's the key information to understand. These private takeovers, often called "leveraged buyouts," aren't new. We've seen cycles like this before when the cost of borrowing money is sufficiently lower than the cost of equities (as measured by their "earnings yield," which is earnings divided by price). When this situation exists, companies have an incentive to borrow money to either (1) buy other companies, or (2) buy up their own stock. They are calculating that the stock they buy, whether their own or another company's, will earn a higher return than the after-tax cost of the money they borrow. This is called arbitrage, and anyone can play, which is what draws in the private groups that have been in the headlines lately. These groups put in some money, borrow a huge amount more, and buy up all the stock of a public company, "taking it private."

When companies are bought, or buy up their own stock, it reduces the total amount of publicly traded stock available in the market. This may sound like a bad thing, but it isn't necessarily, at least not for investors. As more public shares are removed from the market, the remaining dollars are chasing fewer shares. This tends to push stock prices higher. It's a simple supply/demand situation where reduced supply causes prices to rise. Forbes columnist Ken Fisher estimates that the global equity supply will shrink by 5% this year, a staggering amount. It's a key factor why he's tremendously bullish this year.

Plus, the fact that all these buyouts are happening in the first place seems to be an argument that stock prices are fairly cheap. The Fed Model uses the same interest rates vs. stock earnings yield approach to determine if stocks are expensive or cheap (see Stock Market Trends ). For four years it has indicated stock prices are very cheap, so this surge in corporate stock buying is no surprise. You wouldn't expect these financial wizards to buy up all this stock if the shares were overpriced. So the main way this trend is likely to impact you is by continuing to push your stock investments higher.