Klarman And Pabrai – Just How Important Are Catalysts To Investing Success

Johnny HopkinsMohnish Pabrai, Seth KlarmanLeave a Comment

One topic that gets a lot of discussion in the world of investing is the importance of catalysts.

A catalyst in investing terms is an event that triggers a change to a stock price. Catalysts can include things like a latest earnings release, a positive or negative result in a lawsuit, or an activist investor taking a position in a company. These events cause investors to become more positive or negative about the future of a company which results in a change in the stock price. To highlight the difference in opinion on the subject of catalysts let’s take a look at two opposing views from Seth Klarman and Mohnish Pabrai.

Following is Seth Klarman’s view, which can be found in his best selling book – Margin of Safety. Here’s an excerpt from his book:

Once a security is purchased at a discount from underlying value, shareholders can benefit immediately if the stock price rises to better reflect underlying value or if an event occurs that causes that value to be realized by shareholders. Such an event eliminates investors’ dependence on market forces for investment profits. By precipitating the realization of underlying value, moreover, such an event considerably enhances investors’ margin of safety. I refer to such events as catalysts.

Some catalysts for the realization of underlying value exist at the discretion of a company’s management and board of directors. The decision to sell out or liquidate, for example, is made internally. Other catalysts are external and often relate to the voting control of a company’s stock. Control of the majority of a company’s stock typically allows the holder to elect the majority of the board of directors. Thus accumulation of stock leading to voting control, or simply management’s fear that this might happen, could lead to steps being taken by a company that cause its share price to more fully reflect underlying value.

Catalysts vary in their potency. The orderly sale or liquidation of a business leads to total value realization. Corporate spinoffs, share buybacks, recapitalizations, and major asset sales usually bring about only partial value realization.

Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced. In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market.

Owning securities with catalysts for value realization is therefore an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value. Catalysts that bring about total value realization are, of course, optimal. Nevertheless, catalysts for partial value realization serve two important purposes.

First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spinoff and other times by reducing the discount between price and underlying value, such as through a share buyback.

Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future. Over the years, for example, investors in Teledyne have repeatedly benefitted from timely share repurchases and spinoffs.

Now let’s take a look at Mohnish Pabrai’s view on catalysts, which can be found in a presentation that he did at Google. Here’s an excerpt from that presentation:

Question: What do you think about the importance of the catalyst?

Mohnish Pabrai: For the most part, you’re right. I have ignored the importance of a catalyst. I think catalysts are not required. In most cases, value is its own catalyst. I would also say that when you’re buying businesses, let’s say below liquidation value for example, in my book, there’s no such thing as a value trap.

I think there are mistakes in investing, but not value traps. So in the end, everything is fairly valued to the extent that you end up with a less than satisfactory return on investment. It probably has less to do with whether the catalyst is there or not and more to do it with just the nuances of intrinsic value of that business.

I have actually found, in many cases, that in fact, the catalyst actually flies in the face of uncertainty. Because if you have a catalyst, you don’t have uncertainty. It’s just the nature of the type of investor I am. I prefer to buy low risk high uncertainty and let the catalyst work itself out.

And it has, for the most part.

I would say that from ’94– which is what? Five years before I started my fund, until 2013, before fees and all that, it’s been a little over 26% a year, and that engine has not needed catalysts. But there’s more than one way to skin the cat.

The Seth Klarman format of investing, even though it’s value investing, because value investing is a very big tent, is very different from the Buffet method of investing. One simple difference is Baupost has more than 100 investment professionals, and at Berkshire there’s one. You might say one and a half, with Charlie. But that’s it.

So I think there are many different ways to skin the cat. A set approach certainly has worked for a long time. But my personal preference and approach is to not bother with catalysts.


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