Episode 6: In Search of Catalysts

• Disclosures (0:00 – 0:30)
• Host introduction (0:35 – 0:47)
• Episode introduction (0:49-1:17)
• Introduction of the episode’s guest: Dustin Haygood (1:20 – 1:56)
• Diversity of thought and experience on the investment team (1:56 – 2:48)
• What is a catalyst? (2:49 – 4:33)
• Where catalysts fit in the investment process (4:37 – 5:24)
• What are and are not catalysts (5:25 – 7:17)
• Financial engineering (7:27 – 8:34)
• Samples of catalysts in action (8:38 – 10:32)
• Industry specific nuances (10:39 – 11:15)
• Corporate Transformations (11:16 – 11:46)
• How does the team assess catalysts after buying a business? (11:49 – 12:53)
• Conclusion (12:55 – 13:24)

Alex Warren: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, Aristotle Atlantic Partners, and Aristotle Pacific Capital, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor, registered under the Investment Advisors Act of 1940, as amended.

Welcome to the Power of Patience, Aristotle’s podcast, where we share our views on topics actively explored by our investment teams and across the organization. I’m Alex Warren, Product Specialist at Aristotle, and I’ll be your host today. Coming up on today’s episode, we’ll be speaking with Dustin Haygood, Client Portfolio Manager at Aristotle Capital Management. If you enjoy this podcast, please like and share it on LinkedIn to help spread the word.

Today on the show we’ll discuss catalysts and how they fit into the Aristotle Capital Management investment process, examples of what does and does not constitute a catalyst, and nuances to identifying catalyst in the research process. Without further ado, let’s get started. Dustin, thank you so much for joining me today. To lead off the discussion, can you introduce yourself and provide a brief overview of your role at Aristotle Capital Management?

Dustin Haygood: It’s a pleasure to be on the podcast, Alex and hi, everyone, tuning in. My name is Dustin Haygood and I’m a member of Aristotle Capital Management’s investment team and I’m based here at our headquarters in Los Angeles. I graduated from the University of Chicago’s MBA program a few years ago and I joined Aristotle after grad school. That is a very typical path for our analysts. Prior to business school, I spent a number of years in Washington DC. I worked in politics and one thing that I’ve really admired about our investment team is that we’ve created a very diverse group of individuals.

I’m the only one on the team with a political background and we’re probably lucky for that, but we have others on the team with degrees in engineering, history, and statistics. There are people in their thirties up to their sixties. We have people that have grown up or lived all over the world. There are more than five languages spoken on the team, more than five passports held, and that’s all intentional. If we want to understand businesses from a global perspective, it’s incredibly important to have a variety of backgrounds both professionally and personally. It’s really been great to have joined such a unique team.

Alex Warren: Absolutely. Thank you, Dustin. Now, you recently wrote a paper titled In Search of Catalysts where you noted catalysts are often found at the very intersection of potential becoming reality and where additional runway lies to further improve the business. Can you touch on what a catalyst is?

Dustin Haygood: We want to invest in businesses that are high quality and attractively valued, but those two factors are not enough. The company also needs to have catalysts. Catalyst, it’s a common term you hear thrown around in the industry, but it means something distinctive to us at Aristotle Capital. We define a catalyst as an action or an event that’s both currently underway and within management’s control that we believe will fundamentally improve the business, move a company closer to meeting its potential, and over the long term drive the company’s stock price towards our estimates of intrinsic value. Catalysts, they’re not short-lived events such as a presentation date or an earnings call. They are company-specific improvements that we think will take place over the next three to five years.

Said differently. If you were an owner of a local business, what are the three to five things you would do to make that business better? Those are catalysts. If it’s a local sandwich shop, maybe that means installing a drive-through, so there’s higher throughput, which would increase revenue. Maybe it’s adding beverage flavors to the soda fountain, which will drive more soda sales and increase profitability, since soda is a higher-margin product than food. Maybe it’s the creation of a rewards program to incentivize more repeat customers. These could all be catalysts for us and the publicly traded companies we invest.

Alex Warren: That makes sense. And it sounds like there are a lot of boxes that need to be checked. Now, where do catalysts fit in the investment process and how important are they?

Dustin Haygood: Catalysts are incredibly important, Alex. They are a necessary factor for us to invest. We have three criteria that are all equally important. A business needs to be high quality and needs to be attractively valued and they have to have compelling catalysts. It’s like a three-legged stool. They all need to be present. None of them are superior or inferior in terms of priority. When quality valuation and catalysts line up, we’ll invest. When one of them isn’t present, we’ll wait and continue to study the business and if one of them weakens in a company we own, we’ll step aside and sell that business. It’s a very disciplined process.

Alex Warren: Now, let’s dive in a bit deeper. Would you be able to provide some examples of what are and are not catalysts?

Dustin Haygood: Catalysts, they come in many forms. It could be a company increasing its market share. It could be the restructuring of a business. It could be the divestiture of an unprofitable or underperforming division. It could be a mixed shift towards selling higher margin products or services which would improve profitability, and it could even be something like a newly installed management team that’s brought with it a different go-to-market strategy that might even hurt earnings in the short term but will improve the business over the long term. That means it could be an investment into something. For those out there that are homeowners, we all know that living through remodeling a kitchen or a bathroom, it’s very expensive in the short term. It’s painful, it could take a long time, but when you go to sell that house five years from now, it will add value to it. That would be a catalyst.

To extend the home ownership example, a catalyst would not be property prices going up further from where we are today. Property prices going up broadly, that’s something that might be true, but it wouldn’t tell us which house to buy. Again, these are company specific improvements, not macro, not things like a change in interest rates or a change in commodity prices. We are trying to understand the individual companies, the companies that are doing the heavy lifting and the tough work, that are in control of forging their path forward, their path towards improvement. And if our analysis of improving business prospects is accurate, we lower the probability of falling into a value trap. And that’s because we believe, over the long term, stock prices eventually follow fundamentals.

Alex Warren: I like your home ownership analogy. As someone who’s remodeled their master bathroom, I like to think that the pain and the time that it took will eventually pay off. Let’s switch gears now. Financial engineering has been prevalent in the US markets for the last decade. Would share buybacks or spinoffs be considered catalysts?

Dustin Haygood: Yes. Capital allocation, it’s a critical element to investing and managing a business. And changes in capital allocation, they can be catalysts. There are some businesses that have proven they are the exception and they’re actually able to add value through acquisitions. This could be a catalyst. And it really also depends on the type of company. Companies that are in more consolidated or mature industries, perhaps something like a grocery chain as an example, if they increase their free cash flow generation, we would rather see them return more capital to shareholders through share buybacks or dividends, while there are other businesses out there that are earlier on in their lifecycle and they’re able to deploy capital at a 40 or 50% return. For those types of businesses that are also run by great management teams, we want to see them instead use that capital to reinvest in their business.

Alex Warren: That makes sense. Different approaches for different businesses. Now, can you provide specific examples of catalysts in action?

Dustin Haygood: The most recent purchase across our global, international and value equity strategies is the French tire company, Michelin. Almost everyone is familiar with their mascot, the Michelin man, and it’s a market leader in the industry with about a 15% share of global tire sales. It’s a high quality company that we believe is on the path toward further improvement driven by the catalyst we identified for the business. These catalysts include the mixed shift toward selling a higher proportion of larger diameter tires. These are tires that are 19 or 20 inches on cars, and sold at higher margins and it’s more profitable. They also have a very high loyalty rate amongst Michelin customers. If a car is stocked with 20 inch Michelin tires new, there’s about a 90% chance another set of Michelins is put on the car when they wear out. That means stickier customers and higher recurring revenues.

In 2015, about 25% of Michelin sales were large diameter tires, and today it’s over 40%. We believe this mix shift towards larger diameter tires should increase Michelin’s profitability. It’s something that’s already taking place today. It’s something we can track and we think it will continue. And in addition, when you look at the ongoing adoption and rollout of electric vehicles, EVs, they are heavier than cars with internal combustion engines because of their larger batteries and they have higher torque. That means EVs burn through tires much faster. And because of Michelin’s market leadership, history of product innovation, and expertise in large diameter tires, it makes them uniquely positioned to benefit from the shift towards electric vehicles that are fitted with large diameter tires.

Alex Warren: That’s a fascinating example, and that 90% loyalty figure that you provided is just staggering. Are there catalysts that are more prevalent in specific industries?

Dustin Haygood: Sometimes in the industrials or even material sectors, there are companies that have grown with acquisitions, so simplifying things through streamlining their manufacturing footprint or getting back to focusing on their core competencies, can provide efficiencies and cost savings. That could be a catalyst. In the technology sector, there are companies that have switched from licensing their software to a subscription based model that provides predictable recurring revenues and higher normalized margins. Also, corporate transformations such as M&A and spinoffs, they’ve provided opportunities for us. We have owned several spinoffs that were inside larger businesses. Those spinoffs can often benefit from being independently run, being in charge of their capital allocation decisions, no longer being undermanaged, or having an executive team that was under incentivized. That could help drive better innovation and business structures, which can be a catalyst.

Alex Warren: That makes sense. They’re able to control their own destinies. Now, this has been a great conversation and we have time for one final question. What if a company executes on its catalyst or the catalysts aren’t working? How does the team approach assessing catalysts after buying a business?

Dustin Haygood: We continuously monitor catalysts, just like a business owner is continuously monitoring their business. We come to work every day trying to understand how the companies we own are propelling their businesses forward. That work allows us to see how management teams are developing or improving on their strategies. And the best ones, they are creating new catalysts during our course of ownership. That’s allowed us to own some companies for eight, nine, sometimes 10 plus years as they find new and often interesting ways to improve. While some other companies, they may execute on catalysts more quickly and that’s fine as well, but that’s really the fun part of the job, doing deep research, learning more about a company’s value chain, better understanding how these businesses are changing, and that’s what everyone on our team is so passionate about.

Alex Warren: A passion for the business. I like it. Now, that brings us to the end of this episode. Thank you so much, Dustin, for joining us today. We hope you’ve enjoyed it and learned more about Aristotle. Thank you for listening to the Power of Patience. To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed the show, please rate and review us on Spotify and Apple Podcast. And on behalf of Aristotle, this is Alex Warren, and thank you for listening.

For additional disclosures please refer to www.aristotlecap.com.