Value investing and the role of catalyst

As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.