How to be a Catalyst and Milestone Focused Investor
By: J. Dennis Jean-Jacques
Author of “The Five Keys to Value investing,” McGraw-Hill 2003
By Sandra James
Brexit. Trump. Change is the only constant in the world and the stock market is not immune. Invest in it. ETFs and passive investment strategies are great vehicles to capture these directional bets, if you are lucky. But in order to truly outperform, you need to go where traditional investors are not and where ETFs, quantitative funds and passive managers cannot go.
It was a cold and windy night at Chicago’s O’Hara Airport. As the snow came down on the tarmac and the flight delays piled on, I was anxious to get back to New York. The date was March 2nd 2009 and the Dow Jones Industrial average had just hit 10-year lows. I came to Chicago earlier that day for only one reason: to attend a very private, value investment retreat where the economic environment was to be discussed and for core lessons of Buffett and Graham to be reinforced. It was the ideal setting to think and debate about what was transpiring in the market place all around us. That was then. Today, the stock market is at all-time highs, yet “change,” is still upon us.
Recent global political shifts affecting sentiment on economies throughout the world may be the dawn of an unprecedented era of real transformation. Again. Increasing deficits, new financial regulations repealing and replacing old ones; in regards to the stock market, the evolution of new, untested quantitative investment strategies, add to this modern age of complexity and risks for all investors. Some of these complexities are human borne, others not. It has been reported that high-frequency trading (computer-run programs that trade hundreds of stocks in nanoseconds) account for nearly two-thirds of the volume in the stock market in any given day. This can cause significant swings in share prices based on a variety of macro and esoteric factors. A few years ago, this phenomenon was being associated with what institutional investor, Pimco labeled as the “New Normal;” an environment they suggested would generate slow economic growth and higher levels of volatility in the market place. That was then. Today, the guys at Pimco introduced a new term: the “New Neutral,” an environment with absolutely no growth at all. Yikes.
This is consensus thinking; and is exactly why you can compete with the professionals. As an independent thinker, this is your advantage. Investing in the market is not like other professions because a lot of your success will be based on your ability to have a differentiated view from consensus’ current thinking. For example, lawyers may huddle together to find out what the latest consensus view is for the best possible outcome is on a particular legal case and implement the same thinking. You would also want your dentist to get the most widely used procedure and information during your root canal operation to remedy the problem. In most professions, profits are not based on having a different perspective from your peers. In the stock market however, much of consensus thinking and point of view is already in the stock price. To outperform the stock market, you have to think differently from that of consensus – to have a differentiated point of view that will be proven correct. Undoubtedly, you will have many setbacks going against the crowd. The goal, therefore, is to use a process to minimize mistakes.
Over a decade or so ago, I wrote a book about a unique strand of value investing that operates outside the mindset of the general investment public. A discipline based on having a different perspective from the crowd on the change agents affecting the value of a company. Some have called this approach narrowly as event-driven or special situations. Yet, the best opportunities are often not one-time “events” or anything “special” about them. It could be as boring as a company being able to raise prices to catalyze future profits. As such, I prefer the broader term: “catalyst and milestone-focused.”
How to be a Catalyst and Milestone Focused Investor
The Old Normal –investing with catalysts and milestones
The catalyst and milestone focused approach is not new; it has been practiced by a sect of value investors for quite some time because of its emphasis on independent thinking and gauging predictability. Benjamin Graham is widely regarded as the father of value investing. In 1949 in his classic book “The Intelligent Investor,” Graham reminisced about investing in a manner that worked regardless of the changes in the environment. He said, “Not so long ago, this was a field which would generate an attractive rate of return to those who knew their way around in it; and this was true under almost any sort of general market conditions.”
After careful thought, one of Graham’s students formed a hedge fund to invest in companies with catalysts and milestones. His name is Warren Buffett and his fund was called the Buffett Partnership Ltd. Read every partnership letter you can get your hands on (this is not to be confused with the well-known and admired Berkshire annual reports). I am talking about the partnership letters. Nowadays, you can get the letters at a variety of websites. When you get them study each one carefully, particularly those covering the two difficult years of the Partnership. Try to reengineer or recreate the analysis Buffett might have done on a few of his investments at that time.
Understand clearly what a catalyst is and is not. There are misconceptions about what a “catalyst” is even among value investors. Catalysts are not only one-time events such as news about a merger or an announced restructuring as one might believe. Indeed, such catalysts would instantaneously be reflected in the stock price, leaving little time for non-quant traders to participate as the stock price rises or falls on the news. Luckily for those of us without supercomputers, catalysts also include “long-dated” opportunities: situations that while may have a pre-defined timeframe, take a longer time to develop and are often overlooked by an impatient market place.
Investors have always had questions about catalysts and milestones, even Buffett’s own shareowners in his fund. In his January 18, 1963 letter to his partners, Buffett tries to clarify his activities in this area: “These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart.”
Catalysts are situations that will move a stock price up or down over a period of time based on certain milestones. It forces you to invest bottom-up, company by company with a clear attraction on what will make a company’s value go up (or down) over time, and what to monitor. Opportunities in this area are abundant due to structural reasons and less competition. Computer programs for example, can not screen for these opportunities because the ideas are not based on purely quantitative factors such as how cheap a company is trading or how fast revenues are growing. Key milestones must be harnessed creatively through pages of reading from various articles and news outlets to form a picture of what is going on in a particular company and what is likely to happen going forward. Computer-run trading programs may be disadvantaged here.
How to be a Catalyst and Milestone Focused Investor
Finding Investment Opportunities
Go where the crowd is not looking. Perhaps the most important premise to catalyst and milestone focused investing is the fact that change is constant in good and bad markets. While ETFs continue to drive efficiency in the market place, there will continue to be pockets of opportunity for investors who know when and where to look for them. As a helpful tool, read financial publications such as the Wall Street Journal with a keen eye towards long-dated catalysts. Focus on where change is happening and how potent it might be.
Legendary investor Peter Lynch once stated that the very best opportunities are often revealed from the companies that are familiar to you. Learn to read the paper effectively. Compile a list of companies undergoing situations that you deem would cause significant gaps in points of view on the outcome. There, you can select a couple companies with products you are somewhat familiar with and are likely to undergo significant change. Start with one, big or small company – it does not matter. Visit the company’s website; the investor relation section, in particular. Look for any transcripts from past conferences and quarterly conference calls. Read carefully any consensus discussions about the situation that you have identified to gain a firm understanding.
Most institutions spend less time focusing on these situations because catalyst and milestone focused ideas do not fit nicely into any specific category such as small-cap, growth, large-cap equities, etc. That does not mean institutional investors do not own similar companies, they are just likely to own them for different reasons. Understanding why institutions own shares in a company undergoing a given situation is an added benefit to catalyst and milestone focused investors because large shareholders are often forced to sell at the wrong time. Valuable spun-off companies for example, are often sold at unreasonable valuations once institutions get shares of these small companies. In fact, such institutions are almost non-existent in the “when issued” market – the market place where shares trade and prices are negotiated before spun-off shares are actually distributed to shareholders.
Cheap valuation is not an opportunity. Understand what is being reflected in a company’s stock market valuation of the company and use it as a proxy for consensus thinking. Companies and entire sectors of an industry can stay cheap for a long time. It is the differentiation in thinking between you and consensus that drives outperformance.
When you are ready to dig a little deeper into an opportunity, use a disciplined but flexible analytical process. Gain a solid understanding of the business and its cash flows given the company’s economic reality. Next, determine whether or not the shares are cheap and how the general market is valuing the business to get a sense as to what is “priced-into” the shares. Remember, the purpose of catalyst and milestone focused investing is to look at companies that are likely to undergo significant change that will often revalue the business. It is important to ascertain whether or not such potential catalysts are already reflected in the stock price. Stick with situations you are familiar – maybe turnarounds of retail stores, business combinations, etc. If you are not familiar with any common catalyst situations, select a couple and read up on how they work. Reengineer a few of investments of those who have invested in those particular situations in the past. Know a few situations very well. Over time, this will be become your advantage.
Once you have analyzed the business, make a variant assessment – something that the market may have overlooked and therefore, has not yet priced into the shares. Remember, there could be structural reasons why this could happen. Next, make an assessment of what you think the business will be worth under normal circumstances. Finally, determine what Ben Graham called your “margin of safety” just in case your analysis is wrong or if the catalyst you identified is less potent then you previously assumed. All together, the analysis should give you greater comfort before you invest.
In summary, adapting to catalyst and milestone focused investing will not only put an emphasis on traditional approaches such as fundamental analysis but also on monitoring the differentiating factors that impact the value of companies. You do not have to be an expert in all special situations to be a good catalyst and milestone focused investor. Concentrate on one or two areas and know where to look for ideas. If you choose not to invest actively yourself, soon you will be able to choose among a handful of mutual funds who have adopted a similar approach. In fact, there are some mutual funds labeled “go anywhere value” funds who practice some form of catalyst and milestone focused investing both in buying and shorting stocks.