One of the most common questions I have heard through my investment career has undoubtedly been: “what’s the catalyst?” I have definitely asked it myself a few times but have tried to abstain in recent years. Most discussions around catalysts are an effort to anticipate what will change the view other investors hold about an asset – a pretty challenging task. We appear to believe that because catalysts seem obvious after the event, they must be predictable beforehand. This is a dangerous assumption.
There are two types of investment thesis – one about something that is already performing well, here a catalyst is unnecessary because we just need to extrapolate; the other is about something that isn’t working right now, and then a catalyst seems to become essential. The desire to identify a catalyst probably stems from our bias toward believing that current trends will persist, coupled with our discomfort at being uncertain – we want to know exactly how and when something will change.
It is worth taking a step back to consider what it is we are typically doing when identifying a catalyst.
There are three elements:
1) Predict an occurrence.
2) Predict how other investors will react to it.
3) Hold other things constant.
There are problems in each of these components – we are poor at making predictions about future events, we aren’t great at forecasting the reaction of other investors, and things are never constant. Other than that, we are all set.
Catalysts are asking us to specify in advance a specific driver of a change in the return profile of an asset or security. This is no easy task.
Although I am generally sceptical about catalyst predictions there are certain instances where it is more reasonable, particularly with micro-level decisions. For example, if an investor were to suggest that a company selling an underperforming unit could be a catalyst for higher returns to shareholders – this would seem specific and defensible (difficult but defensible).
The broader an investment view – I think US equities will start to underperform because X will happen – the more fanciful it seems. It just becomes far too complex. (I have looked back over my twenty-year career and found 476 catalysts identified for Japanese equity outperformance).
As with most things in investment decision making, the obsession with catalysts is, in part, a time horizon issue. If our horizon is appropriately long-term, we don’t need to predict what specific catalyst will change a certain investment’s fortunes, we can wait for the gravitational pull of fundamental factors to take hold (assuming we are right). The shorter our horizon the more sentiment matters – we are explicitly attempting to guess the behaviour of other investors, so we need a view on what might change that. (Short-term investing is hard).
It is safe to assume the success rate for identifying catalysts for potential shifts in the return profile of an investment is pretty low. We need to be right twice – about changing performance and the precise reason it will happen. The first one alone is hard enough.
If we are in the business of specifying catalysts, it would be prudent to keep a record of the judgements that we make through time. We may not like what we find.
At the start of this piece, I said that “catalysts seem obvious after the event”. The critical word here is “seem”. In most cases it is incredibly difficult to confidently specify the exact causes of a change in the performance of an asset even after it has occurred. We can certainly tell a great (and simple) story as to why something has happened, but the truth is almost always more intricate. If we cannot do it with the benefit of hindsight, trying to do it with foresight feels unwise.
Will there be a specific catalyst that alters the return profile of an asset? Maybe. Can we identify it in advance? Probably not. Do we need to? No.
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