Investment Catalysts: Closing the Gap Between Price and Value
Being patient and waiting for a catalyst to occur can be one of the most difficult but also one of the most rewarding aspects of value investing. As the saying goes, price is what you pay, and value is what you get, although value is realized only through some change in market expectations, or what is known as a catalyst, assuming you, like I do, believe markets are manic depressive. I think it was Mario Gabelli who gets credit for coining the term catalyst within the value investing community, and GAMCO uses it as part of their research process. Here I define a catalyst as material events or changes impacting future cash flows that can potentially be anticipated ahead of time by a thoughtful investor, not currently captured in the share price, which closes the gap between price and value. I would argue that there are 3 general categories of catalysts, consisting of (1) company specific events; (2) industry changes; and (3) the passage of time.
Company specific events generally consist of some type of corporate reorganization (spin-off, sale of the entire company, recapitalization, etc.), but also include the introduction of new products, new management, the unification of a dual class share structure, or some event unique to an industry like the discovery of a new oil field, or the approval of a new drug. Other events include special dividends, share repurchases, sale-leasebacks, liquidations, and other types of liquidity events. Shareholder activists can also be a potential catalyst and could be a cause one of the company specific events mentioned above. One advantage of this type of catalyst is that the event creates a pay-off route that is not solely dependent on the overall direction of the market. Another advantage is that these types of investment opportunities stare you right in the face and can be found in the headlines or front page of the WSJ.
Industry changes also can have a transformational effect on value. The most typical type of situation encountered in my experience would be the consolidation of a fragmented industry, which helps create pricing power and typically economies of scale in the form of large distribution channels. These industries are often in the slow growth category and as a result can get overlooked by the growth obsessed Street. A good example of an industry roll-up here would have to include Service Corporation (SCI) and the death care industry as well as Waste Management (WMI) and the garbage industry. Other situations usually involve the re-acceleration of business activity in a cyclical industry, or more typically atleast a flattening of YOY comps. While timing these sorts of things isn’t a useful activity, recognizing opportunities in cyclicals when they go out of style and doing intensive research to verify estimates of intrinsic value can be profitable. These types of opportunities can be found in the raw materials, semi-conductor, transport, industrial, and consumer discretionary sector, among others.
These are generally cyclical, commodity like industries, although the best of these opportunities are in niche type companies within these sectors that get overlooked by less observant investors. An example of this kind of niche company would be Synopsis (SNPS), which makes design automation software and provides other services used to design semi-conductors. Niche industrials like Graco (GGG), which provides fluid handling solutions to a variety of industries, also get overlooked occasionally. Further opportunities that are in this category can consist of major geopolitical changes, demographic changes and regulatory changes, and have also been described as investment themes, a topic for another post.
A lot of the time you have to just sit back and let the paint dry through the passage of time. Eventually market prices ought to catch up to underlying economic values and no specific event or industry change will be present. Sometimes the company is simply misunderstood. Other times, not that many investors are familiar with the company due to a lack of sponsorship, or can’t own the shares because they trade below some arbitrarily chosen price or market cap. Some change in expectations by market participants in some form or another has to occur, and in the case of this category may simply be ambiguous.