Portfolio Insights by Brett Arends

Nov. 15, 2011, 12:01 a.m. EST

The stock market’s big lie revealed

Commentary: Private-equity companies outperform the market

By Brett Arends, MarketWatch

BOSTON (MarketWatch) — Millions of people still put their faith in the stock market.

Even after the events of the past dozen years people still hold trillions of dollars in equities and equity mutual funds in their personal accounts and 401(k) plans.

They believe, as they’ve repeatedly been told, that “free” and public markets offer the best long-term deal for themselves and for the economy as a whole. They are told that the stock market is “efficient,” always setting the “right” prices for securities and always squeezing the best performance out of the economy. Our country, including our government, relies to a remarkable degree on the idea that if you let stocks trade publicly they will “find their level” and we will all gain. Even the Supreme Court has cited the verdict of the stock market in support of decisions.

But is that right? Or is it all a big lie? 

Into my hands last week fell a confidential document that makes me wonder, once again.

It is the latest analysis of the private-equity industry by Cambridge Associates, a highly regarded investment advisory firm. Private-equity firms jealously guard their performance figures from the public and, to a lesser extent, from competitors. The person who gave me the document begged me not to disclose him as a source.

Why is the document so explosive?

Because it shows what a terrible deal the public stock markets have really been for ordinary investors. And it does that by showing how much better investors have done in the hands of small groups of private-equity managers.

The numbers, reported as of June 30, are simply staggering.

Over any decent stretch, private equity has trounced the Standard & Poor’s 500 index (SNC:SPX) .

If you’d invested $100,000 in the Standard & Poor’s 500 index 25 years ago, and stuck it out through all the turmoil that followed, you would have made about $800,000 in profits in return for all your trouble.

Sound good? Try this. If you’d invested in a typical basket of private-equity funds you’d have made $2.1 million. No kidding.

The gap in recent years has been even more startling.

Over the past, grim decade, that same investment in the S&P would have earned you $30,000 in profits. Meanwhile, private-equity investors have earned $180,000. Six times as much.

Even over the last five years, a disaster for the U.S. economy and for investors in the U.S. stock market, private equity has posted returns of 10% a year.

This is no mere detail.

If public markets were really “efficient,” then you would expect them to capture most, if not all, of this potential performance themselves. After all, if Amalgamated Widgets is currently trading on the New York Stock Exchange at $50 a share, but under the right management, and with the right strategy, it should really be worth $100 a share, you would expect the public markets to get it there. You would expect stockholders would get the upside at least into the $90 to $100 range. You would not expect, in an “efficient” market, for AW to drift around at $50 or so, maybe for years, before being taken over by a private-equity firm for $60 … and then sold back to the stock market five years later at $120.

But, as the research from Cambridge Associates shows, this happens all the time. Over and over again.

Remember, too, that these private-equity funds are achieving this outperformance even after hefty fees.

If this were the case of a few private-equity funds beating the stock market, or a few stocks being mispriced, it wouldn’t matter so much. And if the outperformance were restricted merely to funds that invest in small companies and start-ups, maybe that would be OK, too. After all, maybe the stock market isn’t that efficient at pricing tiny companies.

But when the entire stock market systematically underperforms private equity, and does so by a country mile, it stands condemned as shockingly inefficient.

Most egregiously of all, it seems that private-equity investors are making some of their best returns by taking big public companies private and running them better.

If public markets were efficient, that would be either incredibly difficult or impossible. Big companies should be efficiently priced and efficiently run. Yet the actual numbers prove otherwise. Over the past 20 years, public investors in large-company stocks, through the S&P 500, have reaped a total profit on their initial investment of about 400%. But over the same period of time large-company stocks that have been bought out by private-equity firms have produced returns for their investors, net of fees, of 1,700%.

There are three take-aways.

First, the next time someone cites the verdict of the stock market have a good laugh. Federal Reserve Chairman Ben Bernanke is fond of arguing that his latest money-printing endeavor is a success because the Dow or the Russell 2000 is up. Maybe we should ask him: Is it improving returns for private equity?

Second, the next time someone tells you stock-market index funds must always outperform, because “you can’t beat the market over time,” laugh at them as well. Index funds beat most actively managed funds, but that is largely an indictment of most actively managed funds. Private-equity firms have handsomely beat the market over time for decades.

And, third, be wary of dealing with a private-equity manager. As a general rule, don’t sell him anything he is willing to buy, and don’t buy anything he is willing to sell. Private-equity managers make their money at the expense of the suckers… excuse me, ordinary investors. They only buy stocks for a lot less than they are worth, and they only sell them for a lot more than they are worth. It’s not complicated.

No wonder Chairman Stephen Schwarzman, and the other honchos at private-equity group Blackstone (NYSE:BX) were so eager to sell stock in their company to the public in 2007. The IPO was $31 a share. Today that stock is $15. Their gain, your loss. It’s something to bear in mind during the next IPO.