By: J. Dennis Jean-Jacques, author, The Five Keys to Value investing – full bio at bottom
Brexit. Trump. The Fed. Change, whatever it may be, is the only constant in the world. The stock market is not immune, invest in it. ETFs and passive investment strategies are great vehicles to capture directional bets – positive ones, 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.
March 2nd 2009: It was a cold and windy night at Chicago’s O’Hare Airport. As the snow piled up and the flight delays piled on, I was anxious to get back to New York. The Dow Jones Industrial Average had just hit 10-year lows. I had come to Chicago earlier that day to participate in a private, investment retreat to discuss the economic environment and to debate the applicability of core value tenets. The snow delays presented an ideal setting to think about what was transpiring in the marketplace. It was, quite frankly, a blizzard.
That was then. Today, the stock market is at all-time highs, yet “change” is still as present as ever.
Recent political and economic shifts suggest we may be in the dawn of an unprecedented era of real transformation. Again. Increasing deficits and new financial regulations repealing and replacing old ones. In regard to the stock market, the evolution of new, untested – “fake news” prone – quantitative investment strategies add to the complexity and increase risks for investors. Some of these complexities are man-made, 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 on any given day. This can cause significant swings in share prices based on a variety of macro and esoteric factors. A few years ago, investment giant PIMCO labeled this phenomenon the “New Normal,” an environment slow economic growth and higher levels of volatility.
That was then. Today, the guys at PIMCO have introduced a new term: the “New Neutral,” an environment with absolutely no growth at all. Yikes.
This is consensus thinking, and is exactly why better-resourced firms can offer you the competitive advantage of independent thinking. Much success in investing, unlike in other professions, is based on your ability to have a different view from the consensus. For example, lawyers may huddle to find earlier precedence and base their arguments on similar logic. You would also want your dentist to be expert in the most widely used procedure prior to your root canal surgery. In most professions, achievement is not based on having a different perspective from your peers. In the stock market, however, the stock price already reflects the consensus perspective. To outperform the stock market, you have to think differently from that consensus – to have a distinctive point of view. Undoubtedly, you will have many setbacks going against the crowd. The goal, therefore, is to use a process to minimize mistakes.
Over a decade ago, I wrote a book borne from the private teachings of legendary investor Michael Price 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 about the change agents affecting the value of a company. Some have labeled this approach narrowly as event- driven or special situation investing. Yet, the best opportunities are often not one-time “events” or anything “special.” The best opportunities often stem from something 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.”
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.”
One of Graham’s most attentive students formed a hedge fund designed specifically to invest in companies with catalysts and milestones. His name is Warren Buffett. I urge you to read every Buffett Partnership letter, available on a variety of websites that you can get your hands on. (The letters are not to be confused with the well-known and much-admired Berkshire Hathaway annual reports; I am talking about the Partnership letters.) Study each one carefully, particularly those covering the difficult years of the Dow Jones including 1966 when the market was down -15.6% and the Buffett Partnership was up +16.8%. Try to reengineer or recreate the analysis Buffett might have done on a few of his investments at that time.
Even among value investors, there are misconceptions about what a “catalyst” is, and so you will be ahead of the game if you understand clearly what a catalyst is and is not. Catalysts are not only, as one might believe, one-time events such as news about a merger or a restructuring announcement. 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 may have a pre-defined timeframe, but that take a longer time to develop and are therefore often overlooked by an impatient market place.
Investors, even Buffett’s own shareowners, have often questioned catalysts and milestones. In his January 18, 1963 letter to his partners, Buffett tried to clarify what he viewed as catalyst and milestone opportunities: “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. Such a discipline forces you to invest bottom-up, company by company, with a clear understanding of what will make a company’s value go up (or down) over time, and what metrics you will use to monitor that progress. Opportunities in this area are abundant due to structural reasons and less competition. Computer programs simply cannot 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 can only be defined after careful research using multiple sources. They require creative thinking and are based on a thorough understanding of what is going on in a particular company and what is likely to happen going forward. Computer-run trading programs, therefore, are at a significant disadvantage.
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 marketplace, there will always be pockets of opportunity for investors who know when and where to look for them. Financial publications such as the Wall Street Journal can be helpful tools in identifying long-dated catalysts. Learn to read the news with a keen eye. Focus on where change is happening and how impactful it might be.
Highly acclaimed investor Peter Lynch once stated that the very best opportunities are often found in companies that are familiar to you. Compile a list of companies undergoing significant change, the outcomes of which people disagree widely. Focus on one company, big or small, that you’re familiar with. Visit the company’s website, in particular the investor relations section. Look for 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 of the issue.
Most institutions spend less time focusing on these opportunities because catalyst and milestone companies do not fit nicely into traditional investing categories 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 companies that have been spun off, for example, are often sold at unreasonable valuations once institutions get shares of these small companies. In fact, such companies are almost non-existent in the “when issued” market – the marketplace where shares trade and prices are negotiated before spun-off shares are actually distributed to shareholders.
Cheap valuation alone is not an opportunity. Understand what is being reflected in a company’s stock market valuation 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 difference in thinking between you and consensus opinion 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, since the purpose of catalyst and milestone focused investing is to look at companies that are likely to undergo significant change that will result in a revaluation of the business, it is important to ascertain whether or not such potential catalysts are already reflected in the stock price. Stick with situations with which you are familiar – maybe turnarounds of retail stores, business combinations, etc. If you are not familiar with any common catalyst situations, identify a few and read up on them. Reengineer investments made by experts who have profited from those particular situations in the past. Familiarize yourself with a few situations very well. Over time, this will become your advantage.
Once you have analyzed the business, make an alternative assessment, based on 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 be the case. Next, calculate 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 the catalyst you identified turns out to be less potent then you previously assumed. This exercise should give you greater comfort before you invest.
In summary, catalyst and milestone focused investing not only emphasizes traditional approaches such as fundamental analysis but also incorporates monitoring the distinctive factors that impact company value. 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, choose among a handful of mutual funds that have adopted a similar approach. In fact, there are “go anywhere value” mutual funds like David Marcus’ five-star rated Evermore Global Fund; or Joel Greenblatt’s highly regarded Gotham Funds that utilize a form of catalyst and milestone focused investing to both buying and shorting stocks.
About the author: J. Dennis Jean-Jacques is President and Chief Investment Officer at Ocean Park Investments LLC. His perspectives have been featured in major financial publications including Barron’s, Fortune and The Wall Street Journal. He is the author of the widely acclaimed, “The Five Keys to Value investing,” McGraw-Hill 2003.