February 2, 2006

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.

4 comments:

Value Investor said...

How about a healthy and steady dividend history for a catalyst?

Regards,
Value Investor

Rohit said...

not sure of that. What i have read about the catalyst are they are unforseen events which act as a positive trigget for the stock.

however a steady / healthy dividend history could act a catalyst when value investing is in favor

ValueArchitects said...

Point 1, wouldnt be a value trap. If the co is losing out and falling in IV irreversibly, then its doomed sooner or later.

Point 2, doesnt matter at all. Marty Whitman says we should be concerned about business risks, not the market risks. Also, as buffett says, in short run, markets are voting machines. So if the business is doing well/growing, and price remains stagnant or falls, then it becomes more compelling buy. Look into companies like Sanghvi Movers, LGB etc - they kept on doing well and price didnt move initially for years; and now....

Point 3, I think management thinking is the one which can define the value trap over a longer periods of time. For example, Kothari products is a company in case. The co kept on doing well, but the apathy of mgmt towards shareholders have not let the price go up (its up, but its not "that up" as it should have been considering its intrinsic value!!). Another case in point is Bharat Seats, whose management thinks that "only the people who applied in their IPO in 1980s, are the real shareholders - rest are traders about whom they should not be worried" :)) The insurance value of their plant is worth 40-45c, when the market cap is just 30c, they are sitting on portfolio worth 17c and cash profits are close to another 10c. If they burn their plants, and disolve the co, shareholders can get atleast twice of present price.

I think, lendin money to such fools is the biggest trap one could get into.

Jeff said...

Hi

this is my 1st time to your blog. your posts on value investing really make many sense.

I'm a follower of martin whitman. I've read his "The Aggressive Conservative Investor" from cover to cover for more than five times.

If you have time, pls come to my blog and leave your comments:

http://hk.myblog.yahoo.com/assets-conversion

Cheers
Jeff