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Rupert Hargreaves
Rupert Hargreaves
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Seth Klarman on the Importance of Catalysts in Value Investing

Catalysts are required for value investors to achieve the best results

November 13, 2017

Value investing can be a very stressful and tiring discipline. In a bear market, finding value is relatively easy. In today's market environment, however, finding the market's most undervalued equities is a lot harder--you need to dig deep to find the hidden value.

But in any market environment, finding value is only the first part of the whole value process. The most frustrating and challenging part of value investing is having the patience and discipline to wait for the value to be realized, however long it may take.

You may have discovered what you believe is the most undervalued stock in the world, uncovered by Wall Street and hidden on an over-the-counter exchange. But unless the rest of the market realizes the opportunity, the share price will not budge and you might find yourself sitting very patiently for many years.

Still, the returns on offer should more than compensate for the time it takes for value to emerge. Even if a stock does nothing for five years, but eventually returns 100% in its fifth year, that is a compound annual return of around 15%. If you can repeat this over the next five-year period, you will do pretty well for yourself over the long term.

There are two problems with this approach, however. First of all, not many investors can afford to, or have the patience to, wait five years for value to be realized. Second, other opportunities out there may present themselves with the prospect for higher returns. This is why, to achieve the best returns, a catalyst is needed.

Catalysts can take many forms, from a new CEO or a change in business fortunes to Wall Street analyst coverage, but they all lead to the same result: higher share prices.

Klarman on value catalysts

Seth Klarman (Trades, Portfolio) discusses value catalysts in his book, "Margin of Safety":

“Catalysts vary in their potency. The orderly sale or liquidation of a business leads to total value realization. Corporate spinoffs, share buybacks, recapitalizations, and major asset sales usually bring about only partial value realization.”

He goes on to say “value investors are always on the lookout for catalysts” as “realization of underlying value through a catalyst is an important means of generating profits.” Without the presence of a catalyst, value investors could find themselves out of pocket if the situation deteriorates slowly:

“In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market.”

“Catalysts for partial value realization serve two important purposes.

First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spinoff and other times by reducing the discount between price and underlying value, such as through a share buyback.

Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future. Over the years, for example, investors in Teledyne have repeatedly benefitted from timely share repurchases and spinoffs.”

It can be argued that Klarman’s desire to look for a catalyst is based on his desire to minimize risk and turnover value investments. Even though he is looking for the best investments and is not trading for short-term returns, unlike Buffett, Klarman will not be in the stock forever, he will be looking to sell up and move on at some point.

Having a catalyst speeds up this process and allows him as an investor, not a business owner, to compound capital faster.

The most prominent risk value investors face is falling into a value trap. Unfortunately, sometimes it is impossible to spot these pitfalls before it is too late. The slow and steady decline of a share price -- absent of any news -- is the worst possible scenario a value investor could face.

Sometimes the market just hates the company, and you could end up losing a lot if the underlying value erodes as well.

Catalysts are not required for value investing, but they certainly help reduce losses.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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