On paper, value investing seems easy. You do your due diligence on a company, figure out whether it is undervalued in the here and now (without trying to predict too much what it might do in the future) and invest if it fulfills that criteria - and has a large margin of safety. In practice, things are a little more complex than that. Markets can be inefficient sometimes, but a lot of the time, the people on the other side of your trades will be just as smart and well-researched as you are, so you have to be sure that you have really done your homework.
Occasionally, you might find a value opportunity lying on the surface - it is a growing and profitable business that for some reason is currently undervalued by the market. But such occurrences are very rare, and when they do exist, the discount to intrinsic value is usually not too big. Most value opportunities are found in esoteric special situations where the analyst has to do a lot of digging.
Look for catalysts
In his book "Margin of Safety," value investor Seth Klarman (Trades, Portfolio) dedicated an entire chapter to areas of opportunity, which I believe is one of the most insightful sections of the whole (excellent) book. In it, he talks about events that can cause the stock price of a value investment to rise rapidly - catalysts.
Generally, value plays fall into one of two categories - those with catalysts and those without them. In the latter case, investors - if their thesis is correct - must wait patiently for the market to correct its own inefficiency and correctly price their holdings. This usually happens very gradually. In the former case, a catalyst can occur, which causes market participants to rapidly reassess the company.
Small capitalization, research-stage biotechnology companies are a classic example of businesses that can benefit enormously from a single event. Often these businesses will have just one drug in the pipeline that needs the U.S. Food and Drug Administration's approval - the catalyst. This type of binary event obviously has a huge impact on the future of the business - either it has the green light to manufacture a patented new compound, or it might be ruined. The role of the analyst in this situation is to figure out which outcome is more likely.
The small-cap biotechnology catalyst is an extreme example, as there is significant downside in trying to predict what an opaque agency like the FDA might do. Klarman gives some other examples of catalysts that apply to companies in other sectors:
“Some catalysts for the realisation of underlying value exist at the discretion of a company’s management and board of directors. The decision to sell out or liquidate is made internally. Other catalysts are external, and often relate to the voting control of a company’s stock. Control of the majority of a company’s stock typically allows the holder to elect the majority of the board of directors. Thus accumulation of stock leading to voting control, or simply management’s fear that this might happen, could lead to steps being taken by a company that cause its share price to more fully reflect underlying value”.
In the next few articles, I will be taking a deep dive into different types of catalysts and areas of opportunity that analysts should be on the lookout for. They may seem complex, but these are the weeds that value investors need to be able to wade through on the path to success.
Read more here:
- An Old Question Revisited: Is Value Investing Dead?
- Howard Marks: Can the Government 'Simulate' the Economy
- Jim Chanos Is Still Shorting Grubhub
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