Catalyst Value Fund
US > Small-Cap > Growth
Dec 10, 2009
52 Week HL
20.55 - $16.29
Sep 27, 2012
Q: Would you provide some background information on the company and its funds?
A : The Catalyst Funds and Catalyst Capital Advisors LLC, their investment advisor, were formed in early 2006 by Jerry Szilagyi and I. Our first fund, the Catalyst Value Fund, was launched on July 31, 2006. Jerry Szilagyi is the CEO of the investment advisor and I am the Senior Portfolio Manager for the fund.
We currently offer three funds, the Catalyst Value Fund, Catalyst High Income Fund and Catalyst Total Return Income Fund. Currently, the Value Fund has assets under management of $23 million, the High Income Fund has $50 million and the Total Return Income fund has $7 million in assets.
Q: What does the word “catalyst” signify in your fund?
A : The word “catalyst” implies an agent that speeds significant change or action. A “catalyst” is also very descriptive of what we are looking for in our investment style – value investments in companies. We would like to see that such companies not only show a tremendous amount of value relative to their forward earnings expectations but also that there is some catalyst to unlock that value somewhere in the relatively near-term.
Q: What core beliefs guide your investment philosophy?
A : Our investment philosophy is based on buying the best companies while they are trading at a discount to fair value. We define the best companies as those that generate the highest profits on their invested capital. We seek to buy these companies when their stock prices are low relative to the earnings they produce and our estimate of their intrinsic value. Essentially, we do our best to find undervalued securities that offer the greatest opportunity for capital appreciation.
As value investors, we view stocks and bonds as pieces of a business, not pieces of paper. Over the long term, we believe that stock prices reflect the true worth or intrinsic value of the underlying business, but over the short term stock prices can move significantly above or below the business value. We are only interested in investing in superior businesses when we are confident that they are selling at prices in the market significantly below our estimate of their intrinsic value. A portfolio of excellent companies trading at a significant discount to their underlying business values should offer downside protection as well as substantial upside potential.
The basic philosophy is that we’re essentially looking for small-cap companies that are trading at a discount.
Q: How does your investment philosophy translate into an investment strategy?
A : The fund invests in companies with the potential to earn high returns on invested capital while still generating a strong earnings yield relative to their current stock price. We invest primarily in common stocks of domestic issuers. The fund considers companies of any market capitalization but is focused on smaller capitalization stocks.
Q: Would you describe your research process?
A : The investment process utilizes a quantitative methodology to screen stocks based on our strategy coupled with a qualitative review for portfolio construction. The quantitative model ranks stocks using a combined formula of return on invested capital and earnings yield. We then analyze the results to ensure the selected stocks meet our investment guidelines. The portfolio is then constructed by selecting the highest ranked stocks that we believe are likely to continue to generate a similar return on invested capital in the future.
Our research process starts with a quantitative ranking of all U.S. traded companies above $50 million in market cap. First we rank all companies from highest to lowest by earnings yield, which is their cash earnings relative to their current stock price. This gives us an indicator of how cheap a company is trading relative to their earnings.
The second analysis is to rank all the companies based on their return on invested capital. This tells us how efficient the companies are at using their capital to generate cash profits.
We then combine each company’s rank score based on return on investment capital with their rank score based on earnings yield. We create or add value for investors by combining return on invested capital with earnings yield. Thus, we get a combined ratio based on those two scores that identify companies that on average are very cheap but at the same time, they are much more effective with managing their company’s assets.
After running all companies through those two models, we look at the top 100 companies on that screen. And then we do fundamental analysis on those 100 companies and try to find the companies that are being ranked highly by the model but at the same time truly fit into the ideals of our investment strategy.
We like to have a decent idea about management, but we don’t really want to become too attached to it. Our belief is the reality of a company’s financial health really comes out on their earnings statement and the balance sheet. And, we prefer to trust in looking at those numbers because they’re more objective rather than the projections of management.
We want companies that can generate free cash flow yield not only in the past but in the present as well as the future. Then what we try to do is go down from that 100 companies to essentially about 30 companies that we believe fit the model for good reasons where we believe that not only are they cheap but they’re also outstanding companies. This gives us the opportunity to outperform since we're essentially developing a portfolio of the best companies at the cheapest possible prices on a relative basis.
Q: Could you give a few historical examples to better illustrate your research process?
A : A good example of a company we’re invested in is Ebix, Inc., which is an international provider of software and e-commerce solutions to the insurance industry. The current CEO is Robin Raina and he just completely revolutionized the company. He basically shut down any operations that weren’t effective, moved the entire company from Chicago to Atlanta, and built one of the best enterprise software companies in the business.
He built software for insurance marketplaces, where a carrier will do a transaction with an agent and through the exchange software that they use set up a platform for the carrier, where agents can directly interact with them and complete a purchase. And they do that at a very low cost relative to the value of the service or relative to completing the transaction in a way outside of an exchange.
The other benefit of this service is it’s inexpensive. Another strategic advantage is that there’s very high switching cost, so once they have revenue its very consistent revenue, recurring and the business is growing.
The company’s net income growth is 34% a year and 20% growth in sales over the past couple of years. They’ve done a lot of very accretive acquisitions, built earnings sequentially over the past ten years, and have a 40% net income margin.
The company has a much higher net income margin, has much faster earnings growth, the business is much less economically sensitive, it grew rapidly even through the downturn, and the CEO is now turning very shareholder friendly.
Another good example of a company that we are invested in would be Jackson Hewitt Tax Service Inc. This is the second largest tax preparation service in the United States. The company provides computerized preparation of federal, state and local individual income tax returns in the United States through a nationwide network of franchised and company-owned offices operating under the brand name Jackson Hewitt Tax Service.
The tax preparation business has a lot of desirable qualities. Firstly, it is not capital intensive and it’s easy to set up franchises. And they get to collect royalties without really putting up much capital. Another advantage is they can grow their revenues without putting up much capital expenditures. Another nice aspect is, this business generates a lot of cash available for shareholders. It’s one of those types of inevitable businesses where everybody needs to do their taxes and the tax code is pretty complex but each year people need to do it.
The company has high return on invested capital and earnings yield and they have a nice consumer brand, which enables them to leverage off of that.
Another example would be Questcor Pharmaceuticals, Inc. They have a product called Acthar. It’s an injectable treatment for inflammatory disorders, specifically for multiple sclerosis and it also looks into the treatment of infantile spasms. The company is almost unbelievably profitable based upon how high they’ve been able to mark up their product. Their earnings yield is in excess of 20% and they have very little competition in terms of their core product.
The nice part of that business is its small-cap and that’s always an advantage. They have very high pricing on the Acthar and outstanding operating margins and they are trading at low multiples. Insurance companies are willing to reimburse up to 90% in spite of their high price. And we have a nice situation where we have the niche product that’s serving the niche market and trading at a very low valuation and there is room to grow that product to treat other things as well.
So, it’s a nice situation where the earnings yield is in excess of 20% and whenever the earnings yield is that high and some potential for growth there is scope for good returns.
Q: What is your sell discipline?
A : The portfolio is monitored to ensure that the holdings continue to meet our investment standards. Stocks are sold if they no longer meet our criteria. This usually occurs if the stock price appreciates to where it trades at a fair market value or higher or if earnings deteriorate.
We subsequently remove a stock from the portfolio when we believe it is unlikely that the stock can continue to generate a similar return on invested capital in the future.
Q: How do you do your portfolio construction?
A : First of all, we have a relatively concentrated portfolio. We generally keep it between 30 and 40 names with about 20 core positions that make up the majority of assets under management.
In regards to how we size positions, a lot of it is based on looking at the moat around the business, and risk award in a situation, and then trying to make a judgment call based upon the combination of those two things.
The most important thing that we look for before investing in the stock of a company is that there is some differentiating quality that enables the company to generate earnings stream, more like an annuity or growing annuity or even a bumpy annuity.
And, then the second aspect is just looking at the risk award. Meaning, there is an outstanding risk award in the company where we can take minimal risk and still have the potential for generating substantial capital gains going forward.
We try to look at companies side by side and look at those two characteristics and see how we can minimize our risk by investing in companies that both have those moats and have a capital structure that doesn’t make us question whether or not we are likely to be the owners of that earnings stream going forward. So, we want to ensure that we are looking at the business in its totality rather than just relying purely on metrics.
Q: What kind of risks do you perceive in the portfolio and how do you manage them?
A : We look at all types of risks. But first off, the risk we are most concerned with is company-specific risk - anything where the company itself is at risk or their business model is at risk, that’s our first priority. We want to minimize company-specific risk and capital structure risk unless there is an outstanding return relative to that risk.
The second factor we look at is the overall valuations and how our companies are positioned relative to the market as a whole. We want to make sure we own companies that are dramatically better than the market as a whole while trading at a cheaper valuation.
The third thing that we’ll look at is market risk as a whole including macro-economic factors. And, typically, we do not want to be making that a priority in our business in terms of how we look at things. But events in the past year have proven that just looking at company-specific risk isn't enough.
Q: Do you consider cash to be an investable asset?
A : We agree that cash is not an investment for the most part but our belief is that, in general, if we are finding great companies at great valuations, it is much better to be in those companies than cash unless we think there is some enormous systemic event that would make such a thesis invalid. We had one of those systemic events in the fall of last year and we were heavily in cash for a short time as a defensive measure.
While we do hold cash at any given point, in general, it would be more in the area of 5% so that we can be able to make decisions as opportunities come up rather than an ideology that we believe in having a substantial position in cash.