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catalyst, difficult girls, Expecting Value, hedge funds, Interactive Investor, IRR, Margin of Safety, value investing
Lewis (at Expecting Value) and I started a convo here about stock catalysts. I thought it best in the end to tackle this (a little better?) in a blog post, as it’s something I’ve tried to focus on/prioritize in the past year. And he challenged me to give some real examples!
First, let’s highlight two particular problems with value investing/stocks. How do I describe them..?
Seduction: How many times have you been itching to buy something, and been seduced by the siren call of 20 different cheap stocks? Umm, how to choose..? Or you’re feeling your value investor oats, and begin to fall in love with a particularly unique, difficult and undoubtedly complex stock. Jesus, ever date girls like that? Yes, yes, you’re such a wonderful guy – the only one who recognizes how misunderstood she is, the only one who sees the heart of gold beneath the vodka, smeared lipstick and hysteria. Yeah, I’ve known a few, including one where my mother finally posed the question ‘God, why couldn’t you just sleep with her, why’d you have to bloody date her?!’ I won’t forget that day in a hurry… So, how do you avoid this type of tragedy?**
Neglect: You buy a marvelously undervalued stock, and then…and then nothing happens, for years! Why the hell doesn’t the market close the valuation discount? In fact, why does the price keep sinking? Hmm, maybe somebody will swoop in with a takeover offer. Perhaps you are forgetting that unsolicited bids are usually flushed out by unprecedented declines in the target stock price. So, that momentary surge of joy at a 30-40% bid premium may well be very fleeting when you remember it just gets you back to breakeven. How come the best hedge funds don’t seem to have this problem?
I’m sure, like me, you’ve suffered from the above on more than a few occasions. What’s the solution? I believe that focusing on stock catalyst(s) is the answer. That’s what the best/most aggressive hedge funds do and/or, failing that, they become a catalyst themselves! What exactly do I mean by a catalyst? Hmm, tough – I guess I’d say:
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.
Think about all of this in terms of an Internal Rate of Return (IRR) on your investment – and that’s why I mention hedge funds, their performance anxiety pretty much forces them to think about stocks in this fashion. Having a catalyst can radically alter expected or actual IRRs, and/or provide defensive price support.
Take your average value investment: You’ve found a neglected jewel, and based on your value investing acumen (and a decent Margin of Safety) you confidently expect that will ultimately capture an upside of, say, 75%. But when will that happen? In 3 yrs, 5 yrs, 7 yrs..?! Those periods equate to IRRs of 20.5%, 11.8% and 8.3% pa respectively. Now assume a catalyst exists that’s successful in prompting a realization of that full 75% upside within 1 year. That is, of course, a 75% IRR! Wow, radically different investment results from the same stock/upside.
You’ve 20 stocks to choose from? At its simplest, a catalyst can represent the deciding factor in making a stock choice. (And a catalyst would be a v compelling part of a 2 minute monologue – see Richard Beddard’s NY’s resolution here). It may also enhance your Margin of Safety. Even better, it can be a marvelous stock selector in terms of respective IRRS. It’s simple to see that a catalyst that shortens your prospective holding period can easily produce the most attractive IRR, even for a stock with only half the upside potential vs. some other stock choices. And what about that difficult stock you fell in love with? Same thing. You better goddamn have a gigantic upside pegged for it, ‘cos otherwise it’s not going to stack up so well (in IRR terms) against any kind of (demure) stock you find with a catalyst.
Of course, you will recognize that any type of Risk Arbitrage or Event Driven investing is a very specific form of investing in stocks with a catalyst, and IRR is the de rigeur analytical framework for this type of investing.
Part II: I’ll cover the various types of catalysts I look out for, and provide and discuss as many real-life examples as I can come up with.
** The (other) obvious answer is to MOVE ON! If a stock’s (too) difficult, don’t take it up as your own personal crusade. There’s always going to be a much better/friendlier stock, with just as much upside, right ‘round the corner – you might just need to look a little harder.
Wexboy 
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Got a good mention here in Gurufocus:
http://www.gurufocus.com/news/161041/10-worrying-signs-that-your-stock-may-be-a-value-trap
And I’m rather amused to see Hot Tuna mentioned as a value trap – coincidentally, a stock so pathetic it inspired me to write about it a couple of times..!
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Hey there Wexboy. I haven’t had a chance to read through what looks like to be an excellent post – there’s certainly a mine of ideas to be explored here – but just noticed a little Tweet that looked relevant so I thought I’d give it a quick mention:
http://www.asymmetricinvestmentreturns.com/mathmatical-expectation/dealing-with-uncertainty/
I haven’t read the book “Just One Thing”, but there’s one chapter by Andy Kessler called “Signposts in the Fog”, where he states to the effect that you want to be in the fog, where everything is uncertain, but that there are signposts (which seem to be like, but not equivalent to, catalysts) where you can make money.
It’s also worth mentioning Taleb, who talks about “optionality”.
It might be worthwhile pointing out, though, that Anthony Bolton doesn’t much rate the idea of catalysts.
Thanks!
I’m surprised at Bolton – he was all about special situations, so you would expect that catalyst(s) would be very relevant… Presume this is in the Bolton book? I have to get around to buying/reading it some day to see if it’s worthwhile…
I like Taleb’s ideas, but the main credit I’ll give him is the idea of being a ‘flaneur’ – the minute I read that, I realized that’s always been one of my fond ambitions in life..!
I some times look for catalysts and sometimes dont. Higher quality franchises tend not to need them as they float in and out of favour with the market fashion cycles. But the distressed or off the beaten track type securities need a catalyst.
DO you use technical analysis at all. When I cant find a catalyst, I usually let price action help me out. For example, buying deeply undervalued situations when the price pattern has stopped cascading downards and maybe started sideways move (usually supported by other weekly and montly indicators either turning positive or beginning to signal positive divergences).
I hope I wont be banned from the value invetsors cabal for discussing the witchcraft of TA!!!
How dare you, sir!!!
Yeah, when I went all-in with value investing, I did think that it was my sworn duty to abandon technical analysis. Eventually, though, something stirred in the blood and I don’t hesitate to use it now again, and I definitely think it adds value.
I haven’t commented about it too much to date – I know it turns some people off! And for me it’s a valuable risk and timing overlay, particularly for increasing or decreasing a share stake, so I haven’t really felt the need to highlight it when presenting a stock’s fundamentals. I keep it pretty simple – in terms of the smaller mkt cap and trading volume of a lot of interesting stocks, I think trading systems/indicators are probably not that much use or are even misleading. Old school charting – support/resistance/simple chart patterns – is da bomb though!
Most recent example I’m focused on: FBD Holdings (FBD:ID) – break of EUR 6.90 has given us a quick run up to EUR 7.20-35 and EUR 7.75 should be touched in due course. I was waiting for this break to add to my stake, bt cash is earmarked for plenty of other stocks also…hmm, considering the quick run-up from EUR 6.35, I’ll prob get another chance to buy (and at a slightly better price).
Cheers
Hi Wexboy, very entertaining post, and I look forward to reading about the specific catalysts. I kind of have catalysts (and competitive advantages) in mind when the ‘what the company needs to do’ section of my 2 minute monologue. So, for turnarounds the catalyst will be something like rationalisation, new management, repaying debt etc., for cyclicals it will be a recovery in the market, shrinking inventories, and for stalwarts and growers it’s not a catalayst per se, more a maintenance of the status quo, the company needs to defend its competitive advantage. I guess you could extend the catalyst theme to asset situations (i.e. what’s going to happen to unlock the value in the asset, but I tend just to sit on them and wait for something to happen!)
I wd guess my idea of catalysts is probably slightly biased towards asset situations…
For more earnings based situations, I’m not sure I’d describe some of the things you mention as catalysts – not really a matter of definition/principles (and everybody’s different on this anyway), but more because I think most aspects of a business story can be ‘taken for granted’ (that’s what we shareholders are paying management for, after all!) and are/should be already priced in.
But let me expand on this…Christ, we may get to a Part III..!
Oh, and ta for the Blogroll link!