Someone emailed me this question:
“Do you ever invest with a catalyst in mind?”
Yes. Although it depends on what you mean by catalyst. My three largest positions are: Frost (CFR, Financial), BWX Technologies (BWXT, Financial) and George Risk (RSKIA, Financial). In a sense, all of these investments were based in part on the possibility of something happening in the future that would cause the market to re-value the stock. Let’s start with George Risk. I bought George Risk when it was a net-net. This was back in 2010. I probably paid something like $4.50 a share for a stock with $4.75 a share in net cash (actually investments in mutual funds, bonds, etc.). There was an operating business too. The operating business had demand that was somewhat tied to housing. So, in 2010, it was probably underearning what I thought it could earn. In normal times, I thought it would earn about 40 cents a share pre-tax.
George Risk is a micro-cap that is mostly family owned. It’s illiquid. So, I’d say it probably tends to get ignored as a stock. For that reason, it might never trade at a “normal” multiple of about 15 times earnings. However, if it did – you would expect the stock I paid about $4.50 a share for to be worth about $8.75 a share or something like that. An operating business that earns 40 cents a share pre-tax should be valued at about 15 times after-tax earnings, which is about 10 times pre-tax earnings. So, that’s $4 a share. And then $4.75 a share – or whatever it was – in investments should be valued at their market value. Here, the question was all about a catalyst. If I had somehow known ahead of making this purchase that the family intended to make an offer for all the stock held by minority shareholders, or I had known it was going to pay out all its cash in a special dividend, or I had known it was going to acquire another business at 10 times pre-tax earnings – obviously, I would have bought a ton of the stock and known I’d make money. Anyone would have done that. I didn’t know if any of those things was going to happen. As it turns out, they didn’t happen. In the almost seven years I’ve owned the stock, it’s basically paid out what it’s earned in cash dividends. However, the investments it holds have increased in value. And the company has done nothing to disgorge the cash it already had. So, the securities portfolio per share is even larger now than it was in the past. The dividend is higher. I think the dividend yield is now a little over 4% on a stock price that’s a little less than twice what I paid for the stock. I’d say the annual dividend yield is 7% to 7.5% of my cost in the stock.
The book value of the securities portfolio also grew. So, you can work that out in your head as meaning that the rate of intrinsic value growth in the stock relative to the price I paid for it was higher than 7% to 7.5% a year. Let’s say the growth in the securities held per share has been about 5% a year and the dividend yield has been about 4% on the current stock price and about 7% on my original investment. You can see that the underlying business has performed in a way that should have delivered returns to me of 9% to 12% a year regardless of what the stock actually did. If the market valued the stock at a higher price relative to the operating business and the securities portfolio, my own return would be higher than that 10% plus or minus a few percentage points a year return. Likewise, if there had been some sort of catalyst – my annual return would have been much higher than the roughly 10% number I mentioned. So, a catalyst would have helped. And a re-valuation by the market (a change in sentiment) would have helped. But, I did the math when I first looked at the stock, and I figured that even if I held the stock for 10 years and there was never any catalyst at all – I still expected to do 7% a year or so. In other words, I thought my “downside” was an outcome where I was going to make something like 7% a year from 2010 through 2020 in this stock.
The upside was that something might happen sooner. The market might re-value the stock upwards. The family might buy out minority shareholders and take the company private. The family might sell the company. They might pay a big special dividend. Or they might use the securities portfolio to fund the acquisition of another operating business. Any of those things could have easily caused a 7% type long-term return in the stock to become more like a 15% return over a shorter period of time like a 3-5 year holding period. Obviously, that didn’t happen. Actually, that’s not true. It did happen. The “market” – there isn’t really much of a market in George Risk stock – did re-value the business up a lot pretty quickly. If we take the mid-point of a three-to-five-year holding period (so four years exactly) I could have theoretically realized a 15% annual return by selling George Risk stock four years after I bought it. There were also dividends. So, the actual return could have – even if my selling put a bit of downward pressure on the stock – been in the 15-20% a year range. There was really no catalyst in this case. So, it’s possible to make 15% or more a year over four years in a net-net even when there’s no catalyst.
So, yes, a catalyst helps. But, it’s not necessary. In this case, I obviously would have been better selling George Risk after four years of holding it instead of keeping it for more like the seven years I now have kept it. Over those seven years, the stock really hasn’t outperformed the market. But, I always felt better holding George Risk than holding the market. So, there haven’t really been times where I was tempted to sell the stock. Nor have I really regretted the decision to buy it. Also, it would be wrong to regret buying it. On a probabilistic basis, it was obviously a good investment. We are talking about the investment seven years later knowing that no catalyst ever materialized. The stock still did fine. It caused minimal drag on my portfolio versus the market – and that was without any catalyst over seven years. The odds of a catalyst happening had to have been more than 0% back in 2010. So, in hindsight, we can see that the “bad” outcome did fine. And there was some chance of a better outcome that never happened. So, I’d have to score George Risk as a correct decision even if it underperformed other things I could have bought. We only know that in hindsight. There was no way to know that there definitely wouldn’t be any catalyst.
The catalyst for Babcock & Wilcox was clearer and more certain. This is a stock that I wouldn’t have bought if there wasn’t a catalyst. Well, that statement is sort of true and sort of not. Let me explain. I would have kept Babcock if the spin-off had fallen apart. For example, if the IRS had said the transaction would be taxable, or the U.S. government (Babcock’s key customer) said they didn’t want the spin-off to happen, or something like that. So, I didn’t need the spin-off. But, there was a catalyst – in my view – whether or not there was going to be a spin-off. I really, really liked one part of Babcock. That part is what now trades under the ticker BWXT. I thought this was an absolutely wonderful blue-chip type business.
I looked at companies like Pepsi (PEP), Coca-Cola (KO), McCormick (MKC), etc. which trade at like a P/E of 20-30 (so let’s say 25 times next year’s earnings guidance) in the kind of market we’re in now. I looked at those companies, and I said they’ve all clearly got nothing on BWXT. If BWX Technologies was a stand-alone business and it had the kind of capital allocation and focus (the focus part was key here) that I hoped it would – the stock deserved to trade at 25 times earnings or more. In fact, I actually thought that if it traded at a P/E of 25 today, it would outperform the market over the next five years. OK. So, that’s what I wanted to own. I also wanted BWX Technologies to limit itself to certain activities. I didn’t want it to build new civilian reactors.
I really didn’t want it to acquire the nuclear related business of any of the handful of companies that are involved in new build nuclear for civilian customers and other speculative activities like that. I wanted Babcock to build nuclear reactors and provide other key components for the U.S. Navy’s three most important programs: aircraft carriers, ballistic missile subs, and attack subs. I was fine with Babcock managing sites for the U.S. government and doing nuclear weapon related work like tritium production, down blending uranium to the point where it was no longer weapons grade, and working on CANDU (Canadian) reactors. For historical reasons, the CANDU business is unlike other nuclear work. So, basically, I wanted Babcock to just focus on three kinds of U.S. Navy ships, handling nuclear work for other parts of the U.S. federal government, and maintaining nuclear reactors in Canada (which again, were built to a different plan than civilian reactors elsewhere). That’s what I wanted. And, it turned out, that’s what BWX Technologies has seemed interested in so far. It did do an acquisition. But, the acquisition was CANDU related – which I liked. And it’s talked about doing some more contracts – but those contracts are really just doing more on the three U.S. Navy ships I like. So, the catalyst of Babcock’s break-up created the ideal stand-alone company I wanted to own. BWX Technologies also used some money to buy back stock – which, as you know, I’m always for.
Now, what did I have to endure to get this? One, I had to take shares in B&W Enterprises. I just sold those at a big loss from where the spin-off happened. The loss is not significant when compared to the gain in BWX Technologies. Also, Babcock had to stop spending on mPower. That was a modular nuclear reactor project they had lost significant amounts of money on just prior to the spin-off. To make the investment in Babcock, I did need to have confidence they wouldn’t relentlessly pursue mPower for like technology reasons, prestige, etc. At some point, I needed to know they’d run a DCF and admit that mPower wasn’t – even in the best case – going to start producing free cash flow soon enough to justify putting any more money into it. They did that. But, that wasn’t a surprise. My newsletter co-writer, Quan, and I were confident reading earnings transcripts, things management said, etc. that Babcock was being run the way we wanted it to be. I should mention that we looked at some peers of Babcock around the world. We wouldn’t have invested in any of those businesses. They weren’t being run the way we wanted them to be.
So, BWX Technologies was an investment based on a catalyst. It was based on a catalyst in two ways. One, I really believe there was no way I would have ever been able to get a positon in BWX Technologies at such a low-cost basis unless it had been part of a group that included B&W Enterprises and mPower. I also think the relatively short history of Babcock as an entity – it had been part of a larger company that needed to divest Babcock due to government rules – made this investment possible. If Babcock’s U.S. Naval operations business had been a stand-alone business for 10 years or something reporting EPS and giving guidance each year, it would have probably had a P/E of like 25 or 30.
Now, you could say the annual return I’ve gotten in BWX Technologies – for example, the stock has been up 50% over the last 12 months – is due to a catalyst. Basically, we have now reached the point where BWX Technologies is a “clean” spun-off company that everyone is used to seeing report alone, guide alone, etc. without any references to its parent or restructurings or anything. No one cares where it came from now. So, that’s a one-time change. The catalyst is what caused the gains here to come quickly. But, honestly, I think the stock would work out fine if the market hadn’t reacted quickly to this catalyst. BWX Technologies just gave full year results and specific guidance for 2017 and then more general guidance for like the next five years. If you take the bottom end of their guidance for 2017 EPS and compare it to the stock price today, it’s about 26 times next year’s earnings. I said a P/E of between 20 and 30 always sounded right to me for BWX Technologies as a stand-alone company. So, it’s now in line with where I expected it to be valued by the market. However, it also guided over the next three-to-five years for “low double-digit EPS growth”. If it can still trade at a P/E of 25 in like five years, it’s not unreasonable to expect further gains of around 10% a year from 2017 through 2022. I don’t expect the market to do that.
So, yes, a catalyst may have given you 50% returns in one year. That’s better than you could hope for in any long-term investment. But, if we take something like a six-year period from the time of Babcock’s spin-off and use the idea the company might be able to grow EPS by about 10% a year for about 5 years – you’d still get about a 15% return over six years. So, yes, a 50% a year return over one year is better than a 15% a year return over six years. But, I can live with either one. Returns are always lumpy. The idea that you can know what is going to give you your return so quickly you can sell it at a 50% return after one year rather than make more like 15% a year over five years or so is just unrealistic. I can calculate what a stock should make over about five years. That’s about as finely as I can slice an investment projection. I can’t guess what it will do in one year. But, yes, the catalyst of the spin-off obviously provided better annual returns here than just buying the stock and holding it for five years or so will. I mean, I have no plans to sell BWX Technologies right now. But, I also know that future returns in the stock will be – if I’m lucky – more like 10% a year rather than anywhere near 50% a year. So, if you want to make 50% a year – yes, you have to buy things with catalysts.
Finally, there’s Frost (CFR, Financial). Frost is my biggest holding. It’s also sort of a catalyst. The catalyst here is the Federal Reserve raising interest rates. The simplest way to explain this is that between about 2008 and 2015, I believe Frost more than doubled in intrinsic value per share. The stock didn’t double at all. It traded at maybe 10% more than it had 7 years before. Why? Because interest rates fell. Frost is a very, very interest rate sensitive bank. When interest rates are at 0% for multiple years in a row, Frost earns a decent ROE. When interest rates are at 5% or so for multiple years in a row, Frost earns one of the biggest ROEs you’ll ever see on a bank.
Most of the time, the situation is somewhere in between. A couple years ago, I thought the Fed Funds Rate was as low as it would ever be. I also thought it had been low for a while and so Frost’s loans and securities portfolio were yielding as little as they ever would. For that reason, I believed that Frost was earning the least per dollar of deposits it had that it likely ever would. It was a one-time event that was disguising what I thought was Frost’s earning power in normal times. Now, I’ve said this many times before. So, I’m sorry if you’re tired of hearing it. But, it’s the one thing that most differentiates my approach from other investors. I don’t care what a company reported in EPS last year. I don’t care what a company is guiding for EPS next year. It could say we lost $1 last year and we’re going to lose $2 next year. As long as I believe the company is clearly going to earn $10 a share five years from now, I value the company on that $10 it’s going to earn in five years. That’s all I care about. So, if I look at something trading at 12 times earnings and earning $4 a share, I don’t think of it as having a P/E of 12. I ask: will it be making $8 a share in five years. And then, when it’s in that situation five years from now, will investors value it at 16 times earnings. If the answer is yes, I say the stock will trade at $128 in five years. So, now the only question is what I’m paying today for what I’m getting in five years. Everyone else is worried about last year and next year. Even value investors are obsessed with the current P/E ratio. So, I’m specifically trying not to think about those things.
Frost’s price was being influenced by two things. One, the Fed Funds Rate was 0%. Two, oil prices had dropped from like $100 to $30 or something like that. I figured that in five years, the Fed Funds Rate was likely to be 3% rather than 0%. I also figured oil was likely to be at $50 rather than $30. Frost makes a lot of energy loans in Texas. These are loans to oil producers. These producers make nothing at $30 oil. They make a profit at $50 a barrel. So, if you could really convince investors that the Fed Funds Rate would tend to be 3% in the future and oil would tend to be $50 a barrel – they’d probably agree with my valuation on Frost. You could say that there were two catalysts here. I was betting on The Fed Funds Rate going up and I was betting on crude oil going up.
I kind of think of it as the reverse. To me, investors were valuing Frost in a really weird way. They were saying the Fed Funds Rate would always be about 0% and oil would always be about $30. Neither of these arguments make sense. You can’t keep oil at much below $30 for any length of time, because you can’t find and develop a marginal well of oil for less than $30 a barrel. Likewise, the Fed would have trouble implementing a negative interest rate. Also, in both cases, other factors involving the supply and demand for oil and money just seemed to have always suggested a “normal” Fed Funds Rate was something like 3% and a normal oil price was something like $50 a barrel. I don’t think of this as betting on a catalyst. Because, historically oil has often traded between about $30 and $70 a barrel in real terms. And, I’ve been equally convinced that $30 to $70 was a good range when oil was $100 and when oil was $30. The Fed Funds Rate should be even easier to predict. It’s unreasonable to believe the odds of rate cuts at 0% are anywhere near as high as rate increases. Therefore, the P/E of an interest rate sensitive bank should be higher when the Fed Funds Rate is zero than when it is at a more normal figure like 3%. This is just common sense.
So, here, I think of it more like I would never have gotten the chance to buy Frost unless The Fed was keeping rates lower for longer and oil prices were falling. Those were the two things that made the purchase possible. It’s also worth mentioning that for something like 6 months to 18 months, I was “wrong” in the sense that the Fed didn’t start raising rates as quickly as I thought they would and oil fell a bit further at one point than I thought it would. But, when I say “thought it would” I just mean what I thought the normal future level would be. I thought long-term normal for the Fed Funds Rate was 3% and I thought long-term normal for oil was $50 a barrel. I didn’t actually have any predictions of whether oil could go from $100 to $20 and then to $50 – or if it got there some other way. Likewise, I didn’t have a prediction about exactly when the Fed would start raising rates. I probably would have guessed sooner than they did. But, it doesn’t make a big difference to how much I think Frost is worth.
So, catalysts are an important part of how I invest. The possibility of a catalyst at George Risk meant it might have market beating upside and would likely have market matching performance without a catalyst. The break-up of Babcock into B&W Enterprises and BWX Technologies meant BWX was quickly valued upward. That has made the annual return in the stock much higher than the annual gain in intrinsic value at the company itself. And then the Fed Funds Rate near zero was what made Frost’s ability to grow earnings quickly – as the rate rises over the months and years ahead – a possibility. But, it’s important to note how rare these kinds of catalysts are. There are a ton of spin-offs each year. I try to look at most of them. BWX Technologies is the best business segment I’ve ever seen result from such a separation.
Obviously, you could live the rest of your life without ever seeing a Fed Funds Rate as low as it got after the financial crisis. So, the Fed Funds Rate starting near zero and rising from there is the kind of catalyst that might literally be a once in a lifetime opportunity. This is something Charlie Munger (Trades, Portfolio) always talks about. Most value investors understand it intellectually. But, I’m not sure we internalize the lesson. It’s really rare to see a business like BWX Technologies or Frost offered at those kinds of prices. Yes, there were the catalysts of a spin-off and a rising Fed Fund Rate. However, those kinds of catalysts are really rare. You might find something with a catalyst like that every 2 years or so. Maybe not even that. I haven’t had success finding something like BWX Technologies or Frost every year.
So, you have to be willing to bet big when you see a good business with a catalyst. You also have to be willing to do nothing for at least a year. And, really, if you’re looking not just for good stocks but good stocks with a catalyst – I think you’ll usually be waiting more than one year between the times you get the chance to do something smart. There are always catalysts out there. But, I think most of the stocks I see written up with the idea of a catalyst as the rationale for the investment just aren’t very good businesses. Those kinds of stocks won’t provide great annual returns unless the catalyst is realized and pretty quickly. It’s better to look for something that would do okay – return 5% to 10% a year – if the catalyst never happens. Then, you might make 15% or 20% if the future event you were counting on happens quickly. But, if the catalyst is slow to materialize, you’ll still feel fine owning the business you bought.
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