Why Catalysts and Context Matter

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Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 14 years of industry experience, 7 at Heartland.

Well, the market has been driven by macro forces for several years now. 

Our view is that a transition to a more self-sustained economic recovery could lead to a much more favorable environment for active management over passive management—and make stock-specific catalysts, internally-driven catalysts, far more prevalent.

Catalysts are important because without something that drives a change in perception, a cheap stock can stay cheap indefinitely. Our job is to identify what will change the market’s perception and cause a re-rating of a stock.

Silver bullet catalysts certainly provide more immediate gratification and instant upside. We often benefit from these. Examples include mergers or acquisitions, where one of our holdings gets bought by a larger company or by private equity. Other examples can include big regulatory decisions or product-specific news flow. Those are the most exciting type of catalysts, but it’s actually more often that our catalysts play out over an extended period of time.

We focus on drivers that will change key line items in our holdings. These line items include organic sales growth, gross margins, operating margins, earnings per share, and returns on capital. In essence, we are looking for drivers that will lead the market to conclude that not only is business getting better, but a company’s future prospects are getting better. That’s what really drives a re-rating of a stock.

Regardless of the qualitative aspects of our catalysts, the quantitative aspects of the 10 Principles of Value Investing™ are foundational to us. Low P/E, low price-to-book, low price-to-cash flow are the key valuation parameters to start any investment discussion. We marry this with a financial soundness assessment. That’s a process that assesses the quality of the balance sheet combined with the quality of the income statement. We’re looking at metrics such as debt-to-capital and interest coverage ratios to identify the financial soundness of a company.

We combine qualitative and quantitative aspects to answer three critical questions:

  1. Are valuations and expectations low enough to warrant purchase in the first place?
  2. Do I believe that this company and its managements can reasonably achieve the milestones to change the market’s perception?
  3. If I am wrong, how much probability-adjusted downside is there relative to the upside of being right?

The market has been extremely macro driven for several years now.

The combination of internally-driven catalysts and valuations in a market less driven by Fed policy could provide the best path to capital appreciation.

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