I saw an interesting comment on a value investing oriented message board the other day. The comment was directed toward a discussion about a particular company. During the course of the discussion, one of the other commenters asked the thread’s author what the catalyst for this particular situation was. The author replied that “value was its own catalyst.”
I love the way that sounds. I think that has a nice ring to it. So much that I’d be tempted to start saying it, except for one thing – it typically isn’t true. Value often is not it’s own catalyst. Some undervalued investments are what I commonly hear referred to as “value traps.” In case you aren’t familiar with that expression, a value trap is a company that looks extremely undervalued. You’ve studied the balance sheet and cash flow statement. It’s trading at a low price to earnings ratio. Perhaps it’s trading below it’s book value. There’s a significant margin of safety with regard to it’s discounted cash flow analysis. You think there’s a sound economic reason for it to remain viable going forward. So you buy it. And it decides to move sideways for the next several years – while you stubbornly hold it while stocks with less attractive valuations outperform it.
The fact of the matter is – even if you’re correct in your valuation and outlook, you don’t necessarily make money on a value stock without a catalyst (at least not for a period of time). A catalyst is a situation that causes the market to take another look at the investment and re-evaluate its worth. Many well-known value investors have altered their strategy to include looking for undervalued companies that have a catalyst or potential catalyst instead of simply adhering to a ‘buy and wait for the market to come around to my valuation’ approach.
In the General Growth Properties (GGP) situation that I discussed in my last two posts, there are actually multiple catalysts. One of the catalysts is the involvement of activist investors. Activist investors can be a powerful catalyst if their interests are aligned with yours. An activist investor can serve you by either unlocking hidden value or creating value.
Carl Icahn is one investor that stands out to me as routinely taking an activist role in the companies that he invests in. When Yahoo! (YHOO) turned down Microsoft’s (MSFT) takeover bid, for instance, Icahn did everything within his power to oust then-CEO Jerry Yang and put in his own board of directors and management. Usually activist investors are large shareholders who want their shares to do well. And if they’re shares do well, your shares do well.
Most recently Icahn has tried to impose his will on the management of Lions Gate Films (LGF). LGF wants to take on additional debt in order to purchase the rights to more films and television shows from MGM. Icahn does not think this is a good idea, and recently launched a hostile takeover bid for the company at $6 per share. This immediately unlocked some value – as the shares jumped about 24%, from $4.85 to $6.00 per share.
Many other investors have taken an activist role at one time or another. Bill Ackman and Bruce Berkowitz have taken something of an activist role in the GGP situation. Seth Klarman took an activist role in the deal for Facet Biotech (FACT). Warren Buffett has taken many turns as an activist investor – most recently speaking out against Kraft’s (KFT) offer for Cadbury. Earlier in Buffett’s career he has been involved in choosing management for companies (most famously Coca-Cola), and has even been the management for a company (Salomon Brothers). Some companies are more shareholder friendly than others. The nice thing about following one of these investors into a deal is that they’ll sometimes force the company involved to be more shareholder friendly – working as a catalyst and unlocking value for you.
Another catalyst in the GGP deal is the potential merger/buyout pending with Simon Property Group (SPG). Many special situations can act as a catalyst to unlock value. Buyouts are one. Spin-offs are another. If a company feels that it is not being properly valued on Wall Street, it might spin-off a division of the company so Wall Street can better evaluate the separate branches. Cablevision (CVC) recently spun-off Madison Square Garden (MSG), for example. Spin-offs need to be carefully evaluated to make sure that the company isn’t simply spinning off debt and bad assets. If they’re truly spinning it off in an attempt to unlock value this can be an excellent catalyst for a big price increase.
One of my favorite catalysts, and one of the simplest, is a dividend declaration or increase. If a company that doesn’t pay a dividend begins to pay one or a company that already pays a dividend increases it, this will often act as a catalyst for the stock involved. I love dividend increases because they demonstrate a commitment to return capital to shareholders. Home Depot (HD) (among others) recently increased their dividend and has seen a nice run on its shares since the announcement.
In the same category as dividend increases are share buybacks. These are not quite as shareholder friendly as dividend increases, but in theory they’re great. This is how they’re supposed to work: A company buys back it’s shares, reducing the total available shares and increasing the value of the remaining shares. Theoretically this should be done when a company feels that they’re shares are undervalued. As a practical matter, companies tend to conserve cash when they’re shares are extremely cheap and buy them when they’re expensive. Making things worse, many companies give so many options to their executives that share buybacks actually don’t accomplish anything more than maintaining the status quo.
There are many other catalysts as well. Top-down investors look for macro-economic events that will change the investing landscape. Changes in taxes, interest rates, regulations, political events, etc. could all be catalysts for one thing or another. One thing that is in the news right now is the possibility of the US Postal Service no longer delivering on Saturdays. This could, for instance, be a catalyst driving the price for the services of the companies that do deliver – such as FedEx (FDX) or UPS.
Having a catalyst is important. At some point, being too early becomes no different from being wrong. There are, after all, opportunity costs. That’s why it’s nice to have a catalyst. In most instances, buying undervalued stocks will get the job done. A catalyst can just give you that extra kick to make sure you make a reasonable return within a reasonable time period. Thanks for reading.
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