In an earlier article I explored a couple of characteristics that investors seek when looking for real value in an investment.
Regardless of what the numbers say, at the end of the day, an asset's financial value is what the next buyer is willing to pay for it. Homeowners, much to their pain, know what I mean. It doesn't matter that the house you bought last year was appraised at $1 million. If buyers are offering you less than a million bucks today, then that is the current market value of your house.
It's not until the perception changes that an investment appreciates. Value investors approach the stock market the same way. They seek investments that are both selling at a discount to intrinsic value and are embedded within a catalyst that will unlock this value over time.
The simple and more commonly spotted catalysts include new management, improved industry fundamentals, or potential new markets. Yet investors who truly desire to outperform Mr. Market devote serious effort and analysis to uncovering investments with special catalysts not driven by the market.
Other than the catalysts mentioned above, special situations exist that can offer very enticing risk/reward profiles. Examples include:
- Workout investments.
- Merger arbitrage.
- Asset plays.
What makes these opportunities so appealing (and so profitable) is that investing in them is dependent on a specific corporate activity rather than the supply-and-demand mechanisms of the overall market. In other words, investments based on an event-driven catalyst are not nearly as dependent on the current market environment. The investment plays out regardless of bull or bear.
As you might guess, value investors prize these types of investments, given the degree of risk involved relative to potential return. Warren Buffett, during his partnership years before Berkshire Hathaway
Consider Pabrai's investment in Pinnacle Airlines
True, if the situation with Northwest went unresolved, the company would probably go under. Pabrai discovered that the odds of that happening were slim, but more importantly, Pinnacle's sound balance sheet provided a substantial margin of safety. The investment thesis was based on a catalyst involving Northwest that would unlock a lot of value.
Months later, Pinnacle resolved its contracts with Northwest, and the stock more than tripled in the following months. Since disposing of his shares, Pabrai has recently jumped back into Pinnacle, which now trades around $16, a premium from where Pabrai bought in.
The idea here is straightforward. Company A decides to buy Company B for $20 a share. Most of the time, B's shares will jump to $20 and stay there until the company is acquired. Occasionally, the market has doubts that the deal will proceed, and as a result the target's stock price hovers below the proposed acquisition price.
A glaring example of this occurred earlier this year, when Rupert Murdoch's News Corp.
Protect your assets
The opportunity here is when investors perceive a company's parts to be worth more as separate businesses than if they were operating as a whole. Look no further than Citigroup
On one side, investors feel that Citigroup would unlock value if split into its various business divisions. The argument is that as separate entities, the divisions would be easier to understand and thus be awarded higher multiples. But those who favor Citigroup as it is feel that once the credit storm dies, Citigroup will once again ascend. Anyway you dice it, someone has an opinion.
Ultimately, the primary goal is to stick to good businesses you know and understand. Don't try to create catalysts if there aren't any. Usually a catalyst is easy to spot. The key then, is to assess whether it is worthwhile from a risk/reward point of view.
For related Foolishness:
Berkshire is both a Stock Advisor and Inside Value recommendation.
Sham Gad is managing partner of Gad Partners Fund, a value-centric investment partnership operating in similar fashion to the 1950s Buffett Partnerships. Sham has no stakes in the companies mentioned. He can be reached at firstname.lastname@example.org. The Motley Fool holds stock in Berkshire Hathaway. The Fool has a disclosure policy.