It's time to take on more risk. At least, that's what private equity firms are doing right now. Private equity firms are investment companies that raise large amounts of capital from wealthy investors and large institutions. They use this capital to take huge, sometimes controlling stakes in companies. And after six months of fleeing risk, which included buying U.S. Treasurys at record-low yields, these guys are beginning to go shopping. A shopping spree makes sense, given the huge decline in small caps over the past few months. Some companies in the biotech and energy sectors are still down 40%-plus from their highs. One sector that looks particularly attractive is specialty retailers. It includes companies like Chico's and Abercrombie & Fitch – which focus on selling one type of merchandise (clothes, pocket books, jewelry) and cater to a specific clientele. I'm sure these two stocks won't show up on any momentum trading screens following their massive pullbacks. Even value investors may have a tough time buying these struggling retailers. But the "smart money" private equity investors are showing interest in this sector. The chart below includes specialty retailers Talbots (TLB) and Pacific Sun (PSUN). These stocks have exploded higher in the past few days. Talbots recently announced it received a letter from private equity firm Sycamore Partners, proposing to acquire all outstanding shares for $3. Shares jumped more than 60% on the news. Pacific Sun announced it received a $60 million loan from Golden Gate Capital. That will give the private equity firm a 20% stake in the company. Part of the loan will be used to fund lease buyout payments on the 175-plus stores Pac Sun announced it would close. Shares jumped 35% on the news. These aren't the only two... Charming Shoppes, another specialty retailer, is up about 60% in two months. The firm announced it would sell its Fashion Bug label, which has more than 600 stores. Sitting on its board of directors over the past year is Michael Blitzer. He served as a principal of Portsmouth Partners, an advisory firm that provides operational and strategic services to private equity groups that focus on retail companies. Selling its struggling Fashion Bug division will make Charming Shoppes more appealing to private equity firms. And the stock is up huge in anticipation of a possible private equity deal. Retail stocks make for the perfect private equity investment. They can easily sell underperforming stores. Also, once these companies are private, experienced management teams can focus on growth. After restructuring, these companies can easily be taken public again, usually making huge profits for the original acquirer. Just take a look at Dollar General, which was acquired by private equity giant KKR for $7 billion in 2007. After a huge restructuring, the company was then brought public again in 2009. Dollar General has a market cap of $13.5 billion today. KKR still owns a 30% stake. That said, buying a stock solely on the chance it'll get taken over is not one of my favorite strategies. But one thing the two specialty retailers in the chart have in common is they were all trading at a significant discount to book value before their huge moves to the upside. My advice is to screen for specialty retailers down at least 30% from their highs. Also, make sure they trade at a discount to book value. The book value is the theoretic amount a company would receive if it liquidated. You can find it on Yahoo Finance under "Key Statistics." I found several companies that fit this profile, including Coldwater Creek, Christopher & Banks, Office Max, and Brown Shoe. Buying specialty retailers under book value should provide investors with downside protection.
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