Do you Really Need a Catalyst?

Mario Gabelli made famous the concept of value with a catalyst. The idea being that you want to buy businesses that are cheap that have a reasonable prospect for repricing from some "event" in the foreseeable future. While it is nice for value to be recognized in some reasonably short period of time we think that the advantage to many value oriented investors today comes from time horizon & temperament. If a business exists that the market can be reasonably certain of a change in earnings the likelihood of the business being cheap is reduced. For example, Micron when it sold for less than book value did so in 2022/2023 because there was no identifiable turn that the market could see in DRAM demand/pricing. Meanwhile, it was fairly certain that economics would improve, that demand would come back and that obsolescence risk was low.

We think the need for a catalyst in investment is a function of the average market participants ability to delay gratification. In my view, the need for a catalyst in value investing is overdone and often times imprecise anyways. Rather than buy a business where the turn is clear and prices are not as cheap, I would rather own a business with no identifiable turn that is trading for a much lower price relative to steady state earnings power. Lets look at housing as a prime example. Inflationary pressures remain high, affordability is a major issue and most homes owned today are locked in at very cheap costs of borrowing. In the meantime, new home starts are below what is required to meet long term housing demand. In this backdrop, many home builders, homebuilding services, and adjacent suppliers are being crushed.

Floor & Decor is down 43% in the last 5 years, Builders is down 30% in he last year, KBH & Meritage both trade below tangible book value despite being highly profitable. Lumber Liquidators went bankrupt in 2024, saw mill operators like Interfor, Canfor, & West Fraser are trading like death. If you ask anyone about housing the answer is yes they are probably cheap but there's a reason so I will wait for the turn. The problem with "waiting" for the turn is that price is forward looking and the market can read 1st and even 2nd order effects fairly well. Therefore we would rather own the businesses that are trading cheap to assets, well positioned by the nature of their balance sheet and product offering, that has low risk of substitution/obsolescence. This will almost certainly hurt your short term performance but the advantage of buying assets at $0.10/$0.20 on the dollar is worth the short term pain.

The nice part about buying cheap also is you can be "wrong" for a long time and still make really strong annualized returns. If you buy $1 for $0.10 and it takes longer than you originally thought to close the price/value gap you will still make extremely attractive risk adjusted returns. If you buy at 10% of asset value and it takes a decade to be priced at assets that annualized return is still 25.9%. (1/0.10)^(1/10)-1=0.2589. In other words, extreme price dislocation comes from uncertainty and an unwillingness to practice a slow capital discipline. Rather than try to find investments that will wok tomorrow I would rather identify what is obviously cheap, gain conviction over time and own more of what I know already as the business recovers and likely gets cheaper.

The market has many blind spots and one of them is it does not recognize or reward asset values explicitly. The only thing the market understands and can value is earnings. When assets are not earning their cost of capital and breaking even or generating negative earnings the market does not keep asset values in the back of its mind when it prices the firm it simply sells first and asks questions later. What that means is if you have a widget factory that is $1,000,000 to build new and makes 20,000 widgets per year that generate $150,000 a year in cash, this is a justifiable investment to make. Therefore to price the equity at roughly $1M makes alot of sense. What happens though is supply/demand becomes challenged and instead of 20K widgets generating $150K maybe capacity and pricing are cut back and you are only able to generate 10K widgets that generate just $75K. In this case the market does not recognize the $1M replacement cost instead because current earnings dont justify $1M asset they will reprice it to $500K. At $500K you have a $0.50/$1 and perhaps pricing continues to be troubled and continues to decline to say, 10K widgets (50% utilization) and only generating $25K or a 2.5% return. Clearly the $1M new build price to get a 2.5% return is now worth it and so the market takes the equity price from $500K to $250K.

All this sudden after 2-3 years of poor pricing I have a $1M asset at steady state that has demonstrated the earnings power. Due to short term/medium term cyclical forces earnings are depressed and so the market takes that out on the equity price. The market does not register that at $500K it was a 50% discount to assets and a $250K its a 75% discount all the market knows is the current earnings and typically just uses multiples for short term valuation. At my 150K earnings and a 7x multiple I'm sitting at $1.05M, slightly above replacement cost. At $75K I am probably not getting my 7x earnings multiple because of the troughing in the business so the market says $75k x 5 or 6x cash flows. Then as the earnings continue to be troubled the market says these are crappy assets that will never recover or we can not see when a recovery will occur so we give it a 3-4x cash flows on the $25K of earnings and I am sitting at $100K of equity value.

This is where we like to get involved. Obviously it is more difficult than this in practice, and asset value is not always a perfect calculation but this is the general framework I use in my process. Sometimes age of assets discounts the price from new build, chang in product type or service can adjust value but the goal is to buy the asset for so cheap that it doesnt matter if you are 10-20% off in either direction. For example we own a business with 4 key assets in a supply constrained market. The current market cap of the business is equal to the cash just 1 of those assets will generate in the next 3-5 years. Meaning, the rest of the assets and cash returns are all free to us. The only problem I will have now is if I allow myself to become impatient for the market to care. I work every day to improve my understanding of the businesses I own and I hope that when the day comes I will have the ability to own more of a cheap asset rather than become worried about short term underperformance.

All of this to say, if you do the research to fully understand the value of a business and its assets why do you need a catalyst? I understand businesses can remain cheap for a long time but the truth is that market is not stupid. Asset values do get realized over a medium/long term period and if you buy cheap enough it doesnt matter if it takes more time than you would like, you can still generate outsized returns. In my view, this is why most investors wont outperform the market even though the opportunity set to do so is ripe in certain parts of the market. There is a crowded game of trying to find the good business cheap on earnings that will rerate quickly. Given that trade is so popular and everyone is looking for it, how likely is it that you or I have an edge playing that game?

Instead, the Russell 2000 has 900-1000 companies that are small/mid cap and have been losing money for a long time. If you spent 6-12 months vigorously researching businesses in that index is there not at least some likelihood that you find something compelling? I have found the majority if my ideas doing exactly this. The Russell is a great index for finding value in the bottom feeders. If catalyst investing is your thing, and you want quality companies that can rerate from some multiple expansion or AI trade, I probably will not resonate with you. That being said, you can make alot of money buying these kinds of situations.

My personal preference is to find absolutely statistically cheap companies that are 1) asset rich 2) well capitalized 3) ran by a somewhat capable management 4) trading at least 50% below replacement cost 5) no/low risk of substitution for the product/service required. There are other things I like including market consolidation, change in underlying economics/right sizing of assets and production by the company, etc. but those things are nice to haves not have to have. Investing is a mosaic but is also iterative. Not only are you appealing to multiple pieces of a puzzle but those pieces must be weighed against a base rate. How likely is it that what you are looking at is a truly compelling opportunity that you have an edge in? How have similar situations played out in the past?