Well, what the hell have I been up to..? Yes, I know I’ve owed a couple more posts on catalysts for some time now. But that’s the luxury of being a blogger, I’m master of my domain! Oh, er…I mean I can write about whatever I fancy each day/week. But damnit, Carstairs, a gentleman always finishes what he starts..! OK, OK, here we go: btw While I believe my final two catalysts are genuine catalysts, note they’re harder to spot/evaluate, riskier and may require a longer time frame to crystallize. [You may have noticed I've broadly laid out this series in terms of increasing risk & timelines].
v) A major sale (or purchase…in v rare instances!) is the next catalyst I want to talk about. Yes, of course, companies buy & sell divisions/businesses constantly – in most cases, it’s not a catalyst, it’s just part of their ‘story‘. Let’s get acquisitions out of the way first: Despite the hoopla from management surrounding corporate purchases (it’s ‘transformative‘, it offers ‘synergies, and scale‘, it’s an ‘exciting new market entrance‘, etc.), they’re almost never a catalyst (at least one that’s identifiable in advance). Acquisitions are just another growth strategy, there’s plenty of excitable suckers who’ll bid up the shares on such news, and the impact of acquisitions is generally vastly over-rated anyway.
Then you’ve got the accompanying debt or share dilution – at least you can depend on that..! Oh, and there’s plenty of studies out there that show (serial) acquirers ultimately under-perform their less acquisitive peers. Truth is, most acquisitions boil down to empire-building – another unsavoury aspect of the principal-agent problem. Next time you talk to management, or even their underlings, and they’re wildly enthused about some new acquisition, just simply (and slowly!) remind them:
Usually 2 + 2 = 3, occasionally 2 + 2 = 4, and very rarely 2 + 2 = 5.
So, I think we can file acquisitions away… We can probably dispense with most divestments also. They’re less trumpeted (usually because they represent management’s disasters…), but are mostly just another feature of corporate life. Sale proceeds are probably earmarked for existing business expansion or new acquisitions (despite the fact many sold businesses were once bright & shiny new acquisitions too..!). Proceeds often just equate to the existing valuation embedded in the share price, or are just not that significant in terms of current market cap.
However, I tend to think the (potential) impact of sales is less appreciated, or priced in, by investors (perhaps reflecting management’s silence?!). They also can, occasionally, offer a true catalyst in terms of value (realization). So, how exactly do I separate the exceptional from the pedestrian? Well, let me remind you I’m offering a (more or less specific, depending) catalyst framework here. Every investor approaches investing in different ways, no matter how specific or prescriptive a strategy might be. And, of course, every situation/set of circumstances is unique, and may demand a new or different response. Broadly speaking, though, my rule of thumb is:
A sale amounting to at least 50% of the current market cap and/or causing a P&L increase of at least 50% (or a flip into profitability!) may offer a significant catalyst.
I’m not saying this type of sale necessarily increases underlying intrinsic valuation (though the magnitude/impact of the sale might imply that). But:
- It can transform financial structure. As every good value investor knows, the share price of an over-leveraged company can horrify you by plumbing unimagined depths. And then, just to celebrate & reward you, it collapses another 75%… The elimination of debt, or a reduction to non-risky levels, is often the only viable course of action to reverse this price spiral.
- If assets are mostly intangible or have an underlying/more permanent intrinsic value, but current profitability’s weak, the market can be a v poor judge of valuation. Think of brand/luxury companies, resource stocks, forestry, media, technology/patents etc., or even a company which ploughs its (potential) profits into an accelerated growth rate. Sometimes a sale’s the only way to highlight & capture this underlying intrinsic value.
- Even if value’s mainly reflected in property, plant & equipment, inventory, receivables, etc. we all know the market can studiously ignore that for a v long time. But that’s a lot harder to do when the majority of a balance sheet is composed of cold hard cash… And, if management’s smart, their resulting follow-up actions (like special/increased dividends, buybacks & tender offers) will reinforce/increase this inherent value.
- Even simpler, the sale of a loss-making division can radically revise the P&L. This is particularly true of small(er) companies with proportionately higher fixed costs, which really leverages their profitability. First, I’m occasionally amazed at the top-notch prices companies manage to obtain (again, a problem with acquisitions). Second, it’s usually easy to assess the P&L impact of a sale, but I’m often perplexed to see investors ignore this! Seems like they prefer to wait around 6 to 12 months, and then be surprised by a nice pop in the P&L and share price..?!
Remember: A catalyst is any kind of transaction/fact/event/etc., actual or potential, that offers the opportunity for a full/partial realization of value in a stock, within a (reasonably) accelerated timescale.
So, the real benefit of a catalyst’s not necessarily about a change in valuation, it’s in recognizing & taking advantage of a fact/event that offers potential for realizing that valuation in a (reasonably) accelerated fashion. Think about what that ‘acceleration’ can mean, in terms of a vastly improved Internal Rate of Return (IRR) on your investment… Or in terms of a lower risk and/or higher confidence investment.
Of course, a catalyst becomes much less valuable the more it’s priced into a stock. Then risk increases, upside decreases, and it simply becomes another part of that particular stock’s price and ‘story’. But the beauty of a catalyst is that they’re often ignored – investors simply don’t pick up on it, or its potential impact, in the first place. Or they’re forgotten – excitable investors cause a brief pop in the stock, which then drifts right back down once they get bored and move on…
OK, next post in the series, we’ll take a closer look at a few examples – obviously the best way to understand a major sale catalyst in action!
To be Continued…