Catalysts and Five Overlooked Value Areas

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In his 1991 book "Margin of Safety," Seth Klarman explains how market inefficiencies and institutional constraints create situations where securities trade well below their intrinsic value, and how catalysts help unlock this hidden value.

These opportunities exist not because of luck, but because of structural reasons that cause most investors to avoid certain market segments, even in otherwise efficient markets.

This post covers both the importance of catalysts and the five specific areas where Klarman finds overlooked value opportunities, why they exist, and how investors can take advantage of them.

Before discussing the five opportunity areas, Klarman first explains catalysts and their role in value investing.

A true value investment has two requirements:

1. You must buy something for less than it’s worth.

2. There should be a specific event (a "catalyst") that will help unlock this hidden value.

On the importance of catalysts, Klarman states:

Catalysts serve two important functions:

1. They speed up your returns. Instead of waiting years for the market to recognize value, a catalyst can deliver profits much sooner.

2. They reduce risk. The shorter your holding period, the less exposure you have to market crashes, industry problems, or company-specific issues.

Catalysts come in various forms.

Some completely unlock value, like when a company liquidates or sells itself. Others partially unlock value, such as when a company spins off a division, buys back shares, sells major assets, reorganizes its capital structure, or emerges from bankruptcy.

Rather than simply buying undervalued assets and hoping the market eventually recognizes their worth, Klarman advises investors to actively seek investments with catalysts, thereby improving your odds of success.

#1: Corporate Liquidations

Corporate liquidations arise when companies decide to sell their assets and distribute the proceeds to shareholders rather than continuing as “going concerns.”

This means the company sells everything it owns, pays off its debts, and gives the remaining money to shareholders before closing down completely.

Klarman identifies two types of liquidation situations:

• Distressed liquidations: Troubled companies choose to liquidate voluntarily when they lack viable alternatives, hoping to salvage some value for shareholders.

• Strategic liquidations: Companies liquidate for strategic reasons such as tax considerations, persistent market undervaluation, or to escape corporate raiders (investors who buy companies to force unwanted changes).

It’s also worth mentioning that the structure of a liquidation affects its tax implications:

• Single business liquidation: A company with a single profitable business line typically prefers selling the entire business rather than liquidating it, as this avoids double taxation (at both corporate and shareholder levels).

• Conglomerate liquidation: Companies with diverse business lines might find liquidation more advantageous, especially if the process triggers losses that generate tax refunds.

What creates the opportunity for value investors is the systematic avoidance of liquidations by most market participants. As Klarman explains:

Even professional risk arbitrageurs, who typically consider a wide range of special situations, often avoid liquidations because they view the process as too uncertain or time-consuming.

This aversion creates a natural opportunity for patient investors willing to analyze these complex situations.

Klarman describes how this approach is viewed by some:

Notably, unlike other undervalued investments where you might wait indefinitely for the market to recognize their worth, liquidations involve a planned process of converting assets to cash and distributing that cash to shareholders.

This creates a more predictable path to realizing value and reduces the risk of the investment remaining permanently undervalued.

#2: Complex Securities

Klarman defines complex securities as financial instruments "with unusual contractual cash flow characteristics" that often create overlooked investment opportunities.

Unlike standard bonds with fixed payments, complex securities distribute money based on specific events or conditions. Some examples include:

• Participation certificates: Securities that only pay investors when a company reaches certain profit levels.

• Preferred stocks with variable features: Type of stock where the dividend payments or redemption price can change based on how certain assets perform, unlike regular preferred stocks with fixed payments.

• Contingent-value rights: These are like insurance policies for investors. They give the holder the right to receive money if certain conditions happen, similar to how put options work.

These unusual securities typically emerge from mergers, corporate reorganizations, or specialized financial deals. Since most investors focus on traditional investments, these instruments frequently go unnoticed or misunderstood:

Moreover, many institutional investors have strict rules about what they can purchase, and these securities often fall outside those boundaries. Additionally, the specialized knowledge required to evaluate these securities limits the number of potential buyers.

The key takeaway is that complexity alone creates opportunity. Complex securities often trade at prices based on confusion, fear, or neglect rather than fundamentals, creating a disconnect between price and value that patient, analytical investors can exploit.

#3: Rights Offerings

Rights offerings provide existing shareholders the opportunity to buy additional company shares at a discount to the current market price.

Unlike typical share offerings that allow new investors to dilute existing shareholders, rights offerings let current shareholders maintain their percentage ownership if they choose to participate.

Klarman points out that these offerings occasionally create unique bargains for value investors, especially because many shareholders fail to exercise their rights.

To provide an example, if a company trading at $25/share offers rights to buy additional shares at $15, shareholders who don't participate will see their investment diluted after the offering completes. Their shares might now be worth only $20 each because of the dilution effect, representing a significant loss in value.

Why do shareholders often fail to act on their rights? Klarman identifies several reasons:

• Confusion about offerings: Many simply don't understand the offering or its implications. Disclosure documents can be confusing, and companies don't always clearly explain the consequences of not participating.

• Limited trading windows: Rights often trade for very short periods in obscure markets with limited visibility, causing many investors to miss the opportunity window.

• Lack of coverage: Smaller or unusual rights offerings receive minimal attention from financial media and analysts, leaving investors unaware of their options.

When shareholders fail to exercise their rights, they essentially leave money on the table. This creates an opportunity for alert investors who understand the value of these rights.

The rights themselves might initially trade for pennies, but their actual value—when properly analyzed—can be many times higher, creating significant profit potential for investors willing to investigate these specialized situations.

#4: Risk Arbitrage

Risk arbitrage involves investing in announced takeover transactions. It differs significantly from regular arbitrage, which refers to riskless transactions that profit from temporary pricing differences between markets.

Klarman explains that spinoffs, liquidations, and corporate restructurings also fall into this category, sometimes referred to as "long-term arbitrage."

What makes risk arbitrage different from typical stock investments is that your profit or loss depends more on whether a specific business transaction completes successfully than on the company's fundamental performance.

The main factor determining your return is the "spread" - the difference between the price you pay and the amount you'll receive if the transaction goes through.

The downside risk is that if the deal falls apart, the stock typically drops back to its previous trading level, which is usually well below the takeover price.

The fast pace and high stakes of takeover investing have attracted many individual investors and speculators alongside professional risk arbitrageurs. However, Klarman points out that large professional investors have significant advantages in this space:

Clearly, this informational edge makes it difficult for smaller investors to compete in many risk arbitrage situations.

Regardless, Klarman identifies several areas where smaller investors can still find good opportunities:

• Long-term liquidations: Situations where companies sell off their assets and distribute proceeds to shareholders over an extended period, usually taking several years to complete.

• Corporate spinoffs: When a parent company distributes shares of a subsidiary to its existing shareholders, creating a new independent company (discussed below).

• Large friendly tender offers: Takeover situations where one company makes an offer to buy shares directly from another company's shareholders with the approval of the target company's management.

In large friendly corporate takeovers, for example, professional arbitrageurs often use up their available funds relatively quickly, leaving attractive spreads for other investors. A careful and selective smaller investor can profitably exploit these opportunities.

Lastly, Klarman notes that during times of high investor uncertainty, risk-arbitrage securities can become unusually attractive, creating situations where the potential reward significantly outweighs the risk.

#5: Spinoffs

Spinoffs occur when companies distribute shares of a subsidiary to their existing shareholders. These situations frequently create bargains for value investors because of how the market systematically misprices these newly independent companies.

Companies initiate spinoffs for various reasons:

• Divesting businesses that no longer fit strategic plans.

• Removing poorly performing or problematic divisions.

• Separating businesses with legal issues or poor reputations.

• Isolating operations with volatile financial results.

• Simplifying complex financial structures.

The goal is often to create separate parts with a combined market value greater than the present whole.

What makes spinoffs particularly attractive is what happens after distribution. Most shareholders receiving spinoff shares sell quickly without analysis. Klarman explains why:

Several factors drive this selling pressure:

• Institutional investors often find the spinoff too small for their portfolios.

• Index funds must sell if the spinoff isn't in their assigned index.

• Many shareholders prefer to sell rather than learn about a new business.

• Wall Street analysts rarely follow spinoffs initially.

This creates a temporary supply-demand imbalance that pushes prices below intrinsic value, creating opportunity for patient investors.

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