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 (NYSE: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.