Hey monkeys - would someone please explain to me the concept of catalysts in equity investing? I understand some strategies (event driven, special situations) rely specifically on catalysts to produce their alpha. What catalysts/events are looked at and ? Macro? Industry & Company specific? Unique catalysts? Would appreciate if someone could break each catalyst down and list some examples.
Cheers & SB's in advance.
MM
Comments (11)
As you've already mentioned, catalysts are the core of an event-driven/special-situations strategy, as the basis for making an investment is heavily predicated on an "event" that will (expectedly) make an equity appreciate in value.
For the purpose of answering your questions, I will use biopharma/pharmaceuticals as an example.
From a Macro perspective, catalysts in question could be an expected increase in the incidence of a certain kind of Cancer (perhaps scientists conduct research and find that XYZ cancer is expected to spread in SE Asia due to a genetic anomaly). If you're a company that is attempting to cure XYZ cancer in a disruptive way, this would be a positive catalyst for you.
From an industry specific perspective, a catalyst could be the fact that the Standard of Care for treating XYZ cancer is going off patent/generic in a year, which would mean that the markets will be flooded with multiple renditions of the same drug (this could potentially necessitate the need for a new and differentiated therapy).
From a company specific standpoint, catalysts will traditionally be potential licenses, commercial partnerships, a potential buy-out by a big pharma company, statistical significance in clinical trials/strong data readouts, good safety profiles/low incidences of adverse events, etc.
Unique catalysts could include a pharmaceutical company in-licensing/acquiring a novel technology/therapeutic that could redefine the company's business model (executing a reverse merger to accomplish this end), a CEO change, reduction/apt management of expenses (I personally don't view this as a "hard" catalyst), or a large fundamental investor taking a significant stake in the company (active or passive) to name a few.
Hope this helps.
Awesome - thank you for the detailed breakdown! From what I can gather, the catalysts vary from industry to industry?
Remember, the grass is always greener on the otherside because it's fertilized with bullshit.
Absolutely, many catalysts will vary based on sector/industry/company.
From a broad basis, I'd say examples of catalysts that are common across industries include: Potential mergers/acquisitions of companies (a consolidation or buy and build play), a strategic pivot of a business model, partnerships/collaborations with notable industry players (think Amazon partnering with an IT company to roll out XYZ), an outright buy-out from a PE firm/HF/strategic, a large stake initiated by an Activist/well known investor a corporate divestiture/spin-off, and management changes. This is not a limited/all inclusive list, but just some examples to give you an idea.
As an active investor, you depend on market efficiency. If you are able to identify a true mispricing, the only way you can realize alpha is for that mispricing to eventually be corrected and for the security to become efficiently priced. So your first task is to identify why the security is mispriced? What is the market missing (or is my value estimate even correct)? If you can identify the source of the mispricing, the only way you can realize the difference between your estimate of value and the security's current market price is for the market to also become aware of the mispricing, and to act on it until price converges to your estimate of intrinsic value. An event that causes the gap between market price and intrinsic value to close is a catalyst. In the most general sense, a catalyst is information that the market does not have, or has not appropriately discounted, that works to move the consensus in your favor once the market receives, or better processes, said information. Value investing is not simply buying cheap securities, it is buying securities that are undervalued relative to their intrinsic worth (generally based on cash flows). There is always a reason that something is mispriced. Just because you think a stock is undervalued does not mean that the market will magically gravitate to your estimate. The catalyst is the kick in the ass the market needs to correct a mispricing.
Excellent post.
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Simply relying on the rest of the market to become aware of a valuation mispricing isn't a real catalyst, in my view. True hard catalysts are event-driven, such as M&A, LBO candidate, bankruptcy, debt refi. (Successful) event-driven guys like Elliott aren't buying equities hoping the rest of the market sees some underappreciated nuance.
Well in many cases Elliot IS the catalyst. In others, yes, it's very easy to spot catalysts in an event-driven strategy. I think if your time horizon is 2+ years, then the need for a hard catalyst isn't quite as important, as the market will re-rate in the LT.
catalyst is an event that bridges the market value and the intrinsic value of the business. It's philosophical in a sense: you believe something is worth X, but the market believes now it's worth Y ("voting machine"), you need an event that makes the market participants in aggregate value the business at X, that event is a catalyst.
Things off top of y mind:
industry specific:
- regulatory (law that impact the intrinsic value of the business and the industry it operates in)
- competitors M&A / bankruptcy (which can be good and bad - good as in reduced capacity in the industry, bad as the new merged competitor has a lower unit cost because of operating leverage; post-reorged companies also have cut their unfavorable contracts to emerge as a much more efficient operator to compete)
company specific:
- M&A / LBO rumor
- spin-off (company believes sum of parts are worth more than the whole)
- divestiture (selling the under-performing division / assets to streamline the multiple for the core business)
- credible activist interest
- debt refi
- apparently hedgies / VC ppl pitching at Sohn conference is a catalyst too: it's a self-fulfilling prophecy where Einhorn and Ackman like something and the stock will go up 10% intraday on the spot
Haha for those guys it's likely down now.
Though ackman has started to turn things around now as he's gone back to strategies he made money on before.
LOL
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