In my last article, I described how value investors tend to be fairly agnostic to market conditions. Instead of spending a lot of time predicting inflation, interest rates, or when the market will bottom, they focus on buying businesses when they appear cheap during periods of worry and selling them during periods of exuberance.
Many investors will have been hunting for bargains amid the market downturn. However, markets can remain in the doldrums for extended periods. Waiting for the market to recognise undervaluation may require a long wait. For this reason, many value investors also like to search for catalysts.
Catalysts
A catalyst is a specific event that may be foreseen by an investor that may cause other investors to notice that a business is undervalued. Modern markets generate so much information, from specific company results to economic data, and an investor can't hold all that in mind. Hence it is unsurprising that many companies become overlooked. This is even worse amongst the smallest companies where professional research (if it exists at all) may consist of a hopelessly biased house broker note. Identifying factors that can shine the spotlight on undervalued companies can therefore accelerate price discovery. Investors who consistently find undervalued companies with near-term catalysts will generate very good returns.
Typical examples of things that are likely to act as catalysts are:
- Positive results that are unexpected by the market but have been anticipated by the investor.
- Broker upgrades. This effect is particularly prevalent in mid-caps, where smaller funds tend to rely on the broker views much more due to their smaller internal research teams.
- The presence of an activist shareholder on the share register. Such a shareholder will publicly or privately push the management to improve shareholder value.
- Stake-building by a known acquirer. While not every stake ends up in an offer, some funds and companies are known to be serial acquirers of listed businesses. Therefore, when they appear on the register, it could indicate an offer is being considered.
While the logic behind investing in a company with a potential catalyst is sound, value investors often overweight the potential of a catalyst in their investment decision-making. This is because for a catalyst to be effective, it must be anticipated by the investor but not by other investors. Unfortunately, finding such an analytical edge around short-term events can be rare. Also, investors cannot discount the…
