For stock-picking success, think like a PE investor
A certain City metric is taking off with investors as Easyjet is eyed by predators
How do you pick shares for your investment portfolio? If you don’t understand the stock market, you could just chuck everything into a basic tracker fund and leave it be. If you’ve got a computer science PhD under your belt, you could develop your own algorithmic trading system.
You’re more likely to be somewhere in the middle of those two extremes. And so perhaps the simplest thing to do is to find the cheapest stocks, buy them, and hope they appreciate.
Had you done so earlier this year, you might have landed on Easyjet.
The London-listed airline was flying notably low recently, at least in terms of one fashionable City investment metric: EV/EBIT. It has become a popular radar screen to identify takeover candidates. The ratio compares a company’s enterprise value (roughly speaking its debt and outstanding share capital minus its cash) with its earnings before interest and taxes.
Two weeks ago, Easyjet’s stock was trading at less than three times its EV/EBIT multiple after its stock was hammered by the impact of the Iran war (think holidays postponed, flights cancelled and jet fuel shortages).
This narrative has shown up in the ratio, which has established itself as a popular means of assessing how a depressed share price can represent value for potential bidders.
It’s since been reported that US investment firm Castlelake is eyeing Easyjet as a takeover target. The share price rocketed and its EV/EBIT multiple doubled.
Easyjet has described the approach as ‘opportunistic’. But it’s a constant reminder that if you think a stock looks cheap, your view might be shared by private equity firms, who could well be circling, getting ready to swoop.
This has been a familiar tale for London markets for several years now.
At the beginning of April, the Investors Chronicle published a list of the top 30 takeover targets on the London Stock Exchange based on EV/EBIT multiples. Easyjet was 8th on the list. Last year’s edition had also picked out Schroders – and if you’d bought the full list, a year on you’d end up with a total return 12 per cent ahead of the FTSE All-share index.
Of course, many stocks are cheap for good reason.
But many, especially in low-liquidity London, really are cheap for no good reason at all. If you can think like a private equity investor, your portfolio could take off.
According to ONS data out this week, inward M&A activity in the first quarter of this year more than halved compared to the previous quarter, amid wider geopolitical instability and market turbulence.
If things get a little calmer, dealmaking could make a comeback, with EV/EBIT multiples playing an important role in deciding who is in the spotlight. In the meantime, the measure will be one that investors would be well advised to use to screen their own potential investments.