Continued from here: OK, so we’ve defined what a stock catalyst is, and also recommended you evaluate catalysts from an IRR perspective. This is the best way to highlight how they can deliver a dramatically improved return, due to the (potential) acceleration of value realization.
If you really want to complicate your life, you could also layer in an EV approach…the analysis that is, not the blog! Let’s not dig into the math/mechanics here, but it spotlights another attractive feature: A catalyst may prompt you to attach higher probabilities to positive/specific/increased return scenario(s), thereby increasing the Expected Value of your investment return. For example, Risk Arb (and many Event Driven) opportunities offer a specific price ‘target’ and timeline, with a high probability attached to this outcome, so EVs (and, of course, IRRs) can be pretty tasty!
Let’s look at a Risk Arb Investment I’m currently working on, for which a Recommended Cash Offer has already been announced. I can’t disclose the name yet, as I’m still painfully building up my position, but I can walk you through the math. Based on the average purchase price to date, and presuming the Cash Offer price is realized, Gross Return will be 16.3%. Considering all aspects of the deal (reputation and financing of the bidders, irrevocable undertakings, conditions and terms of the Offer, etc.), I attach a 96% probability to the Offer going through, and 4% to a deal failure. Hmm, such precision..!?! I estimate failure would lead to a 30% loss, so the Expected Value of the Gross Return works out at 14.5%. In terms of a timeline, I expect receipt of Offer proceeds in 35 or 55 days, so assuming the later date we can arrive at an annualized Gross IRR of 170%+. Wow! Of course, actual evaluation on a Net basis is recommended, factoring in your specific dealing costs, stamp duty, any FX spreads/risk etc.
OK, still a little fuzzy so far? Sorry, it’s me, not you… Let’s just get some misconceptions out of the way first, and then we can start running through some examples. Don’t mistake most aspects of a business story as a catalyst, even if something’s a little unique or unusual. It depends on size and circumstance, of course, but in most instances management changes, rationalizations, new products/services or market entries, acquisitions/divestitures etc. are what you’ve already paid for – it’s in the price, or at least in your price target. I don’t consider high dividend yields a catalyst either; they’re usually just a function of a depressed share price.
But then again, who can resist a good yield?! I don’t home in on dividend yield much, but occasionally when it’s a specific focus for me, I demand a pretty hefty 8.0%+ yield. On the other hand, I’m probably a bit softer than most when I look at Dividend Coverage. Presuming the business isn’t in some obvious distress, I prefer to measure the Coverage provided by Gross Cash rather than Earnings. Of course, this does imply a significant judgement call on management’s strategy and attention to shareholder value..!
Interior Services Group (ISG:LN) is an excellent example. There’s no apparent catalyst, but it has a great Margin of Safety in its GBP 36.1 mio of Net Cash (vs. a GBP 49.0 mio Mkt Cap) and a whopping 10.3% dividend yield. With an annual cost of GBP 5.0 mio to ISG, and Gross Cash of GBP 44.6 mio on hand, management could merrily pay this dividend for the next bloody 9 years even if the company never earned another penny!
Timeweave (TMW:LN) is an even better example. It has GBP 28.5 mio of Cash (and no Debt) vs. a GBP 52.1 mio Mkt Cap, an even better 11.3% dividend yield (covered for 5 years), and yes, it has a lurking great catalyst in the form of a key activist shareholder. Joe Lewis has a 29.99% stake in the company. After an initial flurry about a potential bid, Lewis has been pretty quiet to date, though his fingerprints appear to be all over some management changes in the past year or two. Interestingly, Leo Fund Managers recently turned up with a 4.9% stake. They joined in the whole Mitchells & Butchers kerfuffle, alongside Lewis and Magnier & McManus, so I think we can assume they’re activist in their intentions also (…perhaps in concert with Lewis?!). Also, GAM Holding and Goldman Sachs have 9.2% and 6.0% stakes respectively. They’re not known for public activism, but they’re clearly sharp (elbowed) shareholders and would obviously play a role in the event of any corporate activity.
So, TMW has 4 v savvy/activist shareholders who’ve been pretty quiet to date, but must surely be losing patience at this point..? Obviously, they can trigger significant value appreciation at any time through pushing for a substantial return of capital and/or by scaring up an offer for the company. Lewis obviously has the firepower to bid himself, or he may just prefer to shop the company ‘round. Meanwhile, there’s the dividend yield to enjoy.
I’ll continue on from here a little more systematically, with examples to match.