A catalyst is a substance which increases the rate of a chemical reaction, according to wikipedia. In the realm of value investing, a catalyst is an event that brings the price of a traded security more into line with its fair value. The catalyst gets the reaction started …
Why do we need a catalyst?
Buying a security at a discount to its underlying fair value, believing that the price at which you can buy or sell this security is apporaching its fair value over time, is the essence of value investing. This way value investors want to participate in future price appreciation hoping for above average returns at below average risks. Based on thorough analysis securities are bought if we can buy them at a significant discount to fair value. Based on this discount we form our return expectations (first dimension). But, another dimension to be taken into account is time. Returns or performance measures are usually normalized to compare them on an annual period. We would prefer buying a security today for 50 cents and selling it for one dollar in one year instead of selling it for one dollar in two years.
We buy into a business because we believe that ‘the market’ currently undervalues the company, compared to its true value. It might be reasonable to ask: If market participants do not get it currently, why should they wake up to reality any time soon? The answer may be a catalyst. The below quote (see my quotes selection) from Jim Grant might be true in many instances. But in other situations catalysts might be needed for price appreciation towards underlying fair value. We will discuss some of these catalysts below.
What’s the catalyst? – I don’t need one. Good things tend to happen to cheap assets.Jim Grant
Undervaluations get cured eventually. According to Vitaliy Katsenelsons very much recommended email-series 6 commandments (#6), this can happen over time through (a) the company buys back stock, reducing the number of shares outstanding dramatically, with the result of much higher earnings per share, or the company (b) pays out its earnings as dividends, creating yields that the market will not be able to ignore, or (c) competitors will buy the company, since it is cheaper than to replicate its assets.
I like undervalued companies buying back their stock very much, since it is often more tax efficient than paying dividends and it happens automatically without the need for me to take any action.
Dividends are a very tangible way to cure undervaluations and to put cash into shareholders pockets. I like dividends coming into my account, especially when I own companies with some political risks attached (such as Gazprom), where you never really know what the government is going to do with companies (partially) owned by foreigners. So I like excess cash in my pockets instead on the company balance sheet.
Competitors buying an undervalued company is a very real possibility and proof that capitalism works, but you can never be entirely sure that the acquirer pays a price high enough, or deemed acceptable to you. Though, I guess most of the time, the acquirers pays a price too high. Sometimes (new) investors step in and ask for a higher price.
Some More Catalysts
When reporting is lagging reality good performance is not apparent when looking at financial statements, even though the company is doing very well fundamentally and underlying trends are all positive (i.e. software companies showing low growth during a transition period to subscription services). Based on the less than stellar financial reporting, investor perception might be negative. After a while (the transition period), the company might report higher growth trends yet again and investors perception might change, resulting in a re-rating of the stock and corresponding re-pricing.
Releasing hidden economic value could happen as follows. Imagine, a group entitiy that show average profit margins calculated from the consolidated financial results. And now imagine the underlying two segments: The cc-segment earns very high margins, is low-risk and needs no investments. It is a real cash cow. The other is called ft-segment, spending heavily on research and development (R&D) and incurs high fixed costs resulting in operating losses today, but monthly subscriptions for its future-tech product are growing quickly. Each segment on its own would fetch a high valuation if priced vs comparable peers. So the obvious catalyst here is, that the segments will get separated, spun off, listed, what ever… (there is a great read about Bollore from Vitaliy Katsenelson)
Overstated consolidated debt might mislead (potential) investors. Consolidated number might not reflect true economic reality. This applies to both, consolidated reported earnings as well as consolidated balance sheet figures. (there is a great read from Vitaliy Katsenelson explaining how Softbanks debt was overstated by consolidating Sprints non-recourse debt)
Time to Reaction
Your returns will depend on the two dimensions discount to fair value and time until the former disappears (like written above, but it is worth to be repeated). This is why you want to have a vague feeling when a catalyst might set the (price) reaction in motion … just as in the chemistry lab.
Howard Marks talks about catalysts at google, stating that you can never know how long it will take to close the gap between value and price. With a bond it is obvious, since it has a maturity date. But with equities it is way more difficult… One realistic catalyst today is that activist investors get involved.