Friday Reading

On Catalysts

One of the most interesting things about investing is the range of opinions even in apparently narrow groupings. Even among the blogs in my blogroll, predominantly European based value investors, we all have our own ideas and different views about what will generate the best returns over the next few years (or longer – remember to quantify your timescale!). It’s in that vein, then, that there was a little back and forth between myself and Wexboy in the comments of my twelve for 2012 posts; and, true to word, he posted two articles on a topic that’s always slightly baffled me – catalysts. Here’s Wexboy’s succintly described ‘bull case’ on catalysts from the comments, then:

The issue I’ve had however with a lot of small/neglected stocks is the lack of a clear catalyst. This is something I’ve been trying to focus on a lot more – I try to prioritize stocks with a clear catalyst (even if they have lower relative upside) to improve my IRR, to be more aggressive/defensive (which?) and to be more stock selective.

I’m a rabid value investor, but catalyst(s) hopefully offer or help me avoid the following: i) realizing a potential 75% upside is not that exciting if it takes 7 years to do it, or ii) I want to add an extra edge to my (hoped for) value edge, or iii) being taken out by a takeover bid if it is only prompted by a further slide in the share price, etc.

In his first post, he basically describes his use of catalysts – as a way of further narrowing down shares from those which are cheap to those which are cheap and likely to realise some of that value in the near future. Neatly, there’s a quick arithemtical example of the perils of buying stocks which won’t realise any of their value in the near future:

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.

It’s that example above, of the realisation of value, that crystallised my thoughts on catalysts. The use of them, I think, is largely dependent on your opinion of the direction of the company and about where the company’s value is coming from. I’ll come up with two examples quickly as an example of where I do and don’t think a catalyst is important. Firstly, then, we’ll take the example of a manufacturer in a dying niche, with property valued at far greater than book, no long-term debt, and a pile of cash acquired over its history. The business trades on a P/B of 0.4 as the market realises that, operationally, the business is going downhill. Secondly, we have a media company with few tangible assets; its value is tied up in customer relationships, a reputation for delivering, and the expectation that it’ll continue to do so into the forseeable future. Company two is in negative tangible equity but trades at a 7x multiple of LY earnings, as it’s expected to grow.

You probably see where I’m going with this. Company one is an example of a company that often flummoxes me – it appears to be cheap. It has lots of assets which could be returned to shareholders, but haven’t been as of yet. How do we know we’ll be able to see the money that’s rightfully ours as owners of the company? The answer to that, I think, is the catalyst. Perhaps you’ve spotted impending management changes that’ll rejig things, or know that an takeover might be pending which you think the market is underpricing. Maybe the property is set to be sold and you suspect the company is minded towards returning cash via special dividends. In the example of company one, I want that catalyst. If the operations are essentially worthless, the company isn’t growing in value – so the sooner I see my capital, the better.

Company two, though, I think is a rather more questionable affair. The ‘value realisation’ factors I’ve highlighted above are all well and good – special situations, I guess they’d get categorised as – but I’m not sure they’re really necessary for me to invest. Like in the case of Cranswick, I don’t necessarily need to know how value will be realised if I can be confident the company will continue to grow earnings and its balance sheet into the future. There is an assumption that, as part owner in a medium-sized business, market dynamics will forcibly reconcile a company’s performance with shareholder performance; just consider how unlikely it is for a company in mid-cap territory to be hugely mispriced. If that was so, there are plenty of funds and takover teams that’d snap up the opportunity.

It’s really a matter of style, then, though I’m never one to espouse blind egalitarianism and say one is as good as the other. If I could identify companies with obivous catalysts for short-term returns, I would! The problem is simply that I can’t. In Wexboy’s second post, he gives the example of Interior Services – a company I once looked at and came close to buying – as a company with a catalyst. The problem is that I struggle to be as bullish as he is on the company; where he sees a pile of net cash which can be returned to shareholders, I stare down the extensive liabilities and think the company appears to be continuing to walk a tightrope that can only be financed by growing sales. That may or may not happen. In reality, I suspect it might, and as such it is something I’m looking at again – but in reality I’m far more comfortable with buying the companies which are far more boring.

Like Communisis or Morson, with no obvious catalysts, only my expectation that the market will eventually realise it’s worth more than it’s currently saying. I don’t mind as much if that takes one year or three, because I’m buying the operations of the company and not the assets – a key point for me – and I think both will continue to generate cash into the future. I wonder, fundamentally, if those catalysts can every really coexist with the sort of companies I like to buy. Surely if their ascension was imminent, it would be priced in?

As many questions as answers, I’m afraid, but I’d love to hear your thoughts! Have I got my head in a twist on a simple concept?

Either way, I should note that Wexboy doesn’t appear to be finished – so I may be baffled even further in the coming days!

7 Replies to “Friday Reading”

  1. Mark Carter

    An interesting example of a lack of obvious catalyst was this very day: RWD (Robert Wiseman Dairies). It announced today that it had been approached as a takeover target. Bam – up goes the share price 34%. I looked at LSE, and nobody was talking about it being a possible takeover candidate before then.

  2. Wexboy

    Riddle me this..! Bit of a slippery subject, eh?! And one man’s catalyst is another man’s ‘so what’… Great post, Lewis – reading above, I think we actually have pretty convergent views on the subject. I’m hoping we’ll see more posts & commentary about this, it’s an important (sometimes ignored) subject: Value Investing Squared, I think!

    Can I beg your indulgence on one point: I think ISG has no catalyst (I should have been more definitive and omitted the word ‘apparent’)…I wanted to highlight I couldn’t resist ISG (because of its dividend yield) despite this lack of a catalyst. A further clarification from me should have been: An imminent return of ISG’s Cash to shareholders would definitely be a catalyst – and there’s no history/sign of that – the fact they can sustain their dividend, if they so wish due to this Cash, is not actually a catalyst.

    I think it’s all about stock selection (and cash ‘rationing’) – IF you only had the cash for 1 new stock pick, how do ISG and Timeweave stack up?: Well, both are equally good/cheap/cash rich businesses, but I think Timeweave wins hands-down in this scenario as it is has a ‘clear & present’ catalyst!

    To repeat myself, if I look personally at all 3 stocks mentioned:

    i) Cranswick: Big fan. Like the business, like management, like the metrics, like the value (and likely a safer business than the other 2 businesses). But it has no catalyst, so who knows when value will out, so I don’t own it.
    ii) ISG: Same again for ISG (I know the bear/risk case on this one, but management has impressed me consistently over the years (navigated 2007-09 pretty damn well)). But it has no catalyst – so the only reason I own it is the whopping great yield.
    iii) Timeweave: Same again for TMW – I own it because of the identified catalyst (and even better yield, dahmn!)

    No knocks on Cranswick, and I absolutely agree value should be realized eventually – but I just don’t have room for it in my portfolio when I stack it up agst ISG, TMW and many others. And if I was forced to sell ISG or TMW, I’d shed a tear and dump ISG, without a doubt – even though I see much more upside price target potential to ISG than TMW..! – but TMW’s catalyst wins out as it offers a far superior upside on an IRR basis.

    • Lewis

      Nice to have a comeback and sorry about the ISG error!

      Looking forward to seeing if any of the catalysts you’ve identified get realised in a short time frame, in which case I suspect you’ll have done very well. One last query on ISG, though; I do like their cashpile, but their short-term liabilities are rather large – the cash, if I recall, is more or less sitting there as cash they’ve taken in advance of starting work. Is this really so fundamentally different from being paid after having rendered the work – and isn’t using that cash to pay out in dividends a little.. dicey? Obviously it’s a common business model, but it still seems fundamentally rather cracked.

      • Wexboy

        Well, I’ve agonized over that in the past, but I’ve been impressed by management over the years. Part of that is down to their excellent cash management. I agree there are substantial (and slightly hair-raising) Trade/Customer Payables liabilities on the B/S, but a substantial portion is offset by Trade/Customer Receivables on the B/S also. This is pretty much the norm in the industry – ISG is billed by the contractors it hires, and in turn ISG bills its clients – some companies in the industry, of course, are better than others at the actual task of collections/payments/net cashflows..!

        What impresses me is how tightly ISG controls this, particularly with Revenues rising/falling in the past 5 years. In fact, despite that, their average Receivables/Payables has tracked v tightly around a 74% rate over those years (I’ve sent you a small spreadsheet for reference).

        If we ever see a bid launched for ISG by one of its larger peers, I don’t think this B/S feature will be a surprise to the bidder, and I don’t think it should cause a valuation penalty.

        In most business scenarios, it therefore appears this excess of Payables will not be unwound, therefore the Cash will continue to remain available. Continuing to acquire overseas companies (to diversify away from the UK) is fine with me, but there’s obviously huge scope for a share buyback/tender. Let’s argue it another way – let’s say the company decided to aggressively use up its Cash (and think how much shareholder enhancement that offers at today’s price!). And let’s assume that Payables/Cashflow then starts to hurt for some reason…well, obviously ISG is capable of carrying quite a bit more Debt, so having a committed/un-utilized Debt facility in place would be a v suitable safety measure to go with that whole strategy.

  3. Trevor Brown

    The whole basis of modern ‘investment’ in equities is fundamentally flawed. There is arguably too much saving capital chasing too few investmentsand there is also qualitive problem not just a quantitive one. Gains stay elusive even when value entices, value in all of the cases discussed is relative and can never be absolute.

    Capital used to be scarce and that is why companies floated. The entreprenuers had no other way of converting their income streaming businesses into capital.

    Companies now float for other, less investor friendly reasons, selling a good business for a decent price is not difficult and need not involve the stock market

    Ask yourself why Ocado floated!

    • Lewis

      Thanks for the comment Trevor.

      I agree with you to some extent – there’s certainly more than a few situations where I put myself in management’s shoes and ask what the point of floating was. Debt often appears a cheaper way to finance what they’re trying to do, which leaves both shareholders and management in a strange position.

      In that context, do you invest in equities at all or do you think the whole asset class is overpriced?

      • Trevor Brown

        Lewis,

        Since 2010 I have reduced the proportion of my investment capital I use for equities, instead I have been increasing direct, tangible investment – for example buying property without gearing (res in Germany).

        I have been an equity investor for a long time, and realize that in the UK at least, nearly all the ‘good businesses’ have gone, any any remaining have been saddled (see Marks for example) with absurd and irrelevant debt from financial engineering.

        What’s left is of poor quality relative to even ten years ago. The modern FTSE says it all very eloquently!

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