Stock Catalysts: Where You Make Your Money💸

As you may recall from chemistry class, a catalyst is something that causes a reaction to occur more quickly. Similarly, a stock catalyst is an event that quickly drives the price of a security either up or down.

Today, we’ll be taking a look at catalysts through the lens of a value investor. Thus, catalysts make the market correct in order to be in-line with our predictions, assuming our assumptions are accurate. To start off, we will cover the Efficient Market Hypothesis (EMH) theory — it’s more interesting than it sounds. After getting a grasp on how catalysts work, we will go into how to identify as well as classify different stock catalysts. At the end, we’ll illustrate the process with an example.

Before reading this article make sure you have read the following investBETA articles or have a good understanding of the following concepts:

• The Stock Market
• Fundamentals
• The Operating Model

Efficient Market Hypothesis Theory

The EMH theory states that it is impossible to outperform the market in the long-term because the prices of traded assets already reflect all publicly available information. The average buyer has just as much information as the average seller, meaning a stock is just as likely to overperform the market as it is to underperform.

As you might expect, this theory is highly disputed and controversial. The four main arguments brought up to dispute EMH theory are the following:

a) Varied Interpretation

Different investors may look at the same information and come to different conclusions.

b) Late Response

The market may take time to reflect new information in the pricing of assets.

c) Emotion and Human Error

The market may over- or under-react to new information simply due to deficiencies in human nature.

d) Market Anomalies

The market may occasionally reflect unusual pricing representing inefficiency that an investor can exploit.

These are the four sources of stock catalysts.

Identification and Classification

If you recall from the operating model article, it was recommended that you try to get your model to reflect the current share price of the model and then see where your assumptions differ. Generally, there should only be one or two assumptions where your view differs from the market. These are the areas where you should be looking for catalysts. If you suspect higher revenue growth in the upcoming fiscal year due to stronger industry growth than the market consensus, then you may look for upcoming quarterly reports or potentially competitor press conferences where they would release next year’s projections. If your assumption is correct, then there would be events that would accelerate the market to correct to your price target. You can learn more about how news and events affect stock prices from a previous article, Evaluating News for Investing.

The reason that it is important to consider the EMH theory and to take catalysts into account is summarized by a quote from the famous British economist, John Maynard Keynes: “The market can remain irrational, longer than you can remain solvent.”

At the end of the day, even if your assumptions are correct and the market is incorrect, it won’t matter if the market maintains its perspective for longer than your investment horizon.

Investment horizon refers to the length of time an investor aims to maintain their portfolio before selling their securities. A long horizon means that you can afford a short-term loss, while a short horizon means that you cannot. The longer your investment horizon, the longer you can sustain, and the further away your catalysts can be. Optimally, however, the catalysts transpire as soon as possible.

There are two types of catalysts: soft catalysts and hard catalysts. Soft catalysts are more general events with only vague timelines and no specific dates (e.g. international market expansion). Hard catalysts are very specific and refer to distinct events (e.g. Q4- 2021 Earnings release). Hard catalysts are easier to work with but many events are hard to predict precisely, thus soft catalysts suffice.

Example

For this example, I built an operating model for the company Aritzia Inc. (ATZ:TSE), a Canadian clothing company. With my operating my model, I used discounted cash flow valuation to determine the company’s intrinsic value, then adjusted my model to aproximate the current share price with both the perpetual growth as well as the exit-multiple method. Here are the assumptions and DCF respectively:

Now, let’s say that I adjust my assumptions to predict a drop in capex/sales to 5% and a sharp decrease in COGS/sales in 2022 because I believe that the viscose material they use to create much of their fabric will be dropping in price. Here are my new drivers, with changed highlighted in yellow:

Taking a look at the DCF model with these new assumptions returns the following:

This gives us a new average implied share price of $23.69, representing a 24% upside. For my assumptions to come to fruition, there are a number of potential catalysts I should be looking out for. Soft catalysts may include things like the decrease in the market commodity price of viscose. On the other hand, Aritizia’s 2022 Q1 earnings would be a hard catalyst. If I have an investment horizon of a few years, I don’t have much to worry about, but if I have a horizon of only a few months, I should look elsewhere to invest my money.

Hopefully this article helped you learn how catalysts work as well as how to identify and classify them. If so, be sure to look over some key takeaways and at some next steps you can take to support us and further your learning!

Key Takeaways

1. The Efficient Market Hypothesis theory states that it is impossible to outperform the market
2. The main disputing arguments are a) varied interpretation, b) late response, c) emotion and human error, and d) market anomalies
3. Look to identify catalysts in your assumption that differ from the market
4. “The market can remain irrational, longer than you can remain solvent.”
5. Long investment horizon = can afford more risk, and vice versa
6. Soft catalysts are vague, hard catalysts are precise

Next Steps

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