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!