So you think stock markets are inefficient and are there to be beaten?

Unfortunately it's not quite that simple.


You’ve looked at different investment styles and decided that value is the way to achieve the greatest returns or alpha. Unfortunately it’s not quite as simple as buying cheap- looking companies, sitting back and waiting for the returns, however. In a follow-up to the article in last year’s Annual Report “Five commandments for value investors”, Port- folio Manager Ole Søeberg talks about the common hazards that can trip up an active manager pursuing a value-based philosophy and what can be done to avoid them.
Pitfall 1: Beware the value trap
Value traps occur when thehidden value that investors think they can see in a company fails to materialise. The effects can be very damag-
ing – either skewering shareholders quickly or inflicting a slow and painful death. An example of the former from the SKAGEN Vekst portfolio is the now restructured Sevan Marine, a Norwegian manufacturer and operator of offshore installations, which generated a loss of NOK 96m for the fund.
These financial mirages come in many guises and, by definition, can appear from out of nowhere. As Søeberg explains: “Very few investors asked firms about their debt covenants in 2005-2007 but in 2008 banks reduced their credit lines and many com- panies with seemingly cheap valuations suddenly became a lot cheaper as default risk increased, often in a very short space of time.”
Although the threat may originate from a wide variety of sources, some causes are
common and there is usually a human ele- ment at play. “In most cases value traps are due to poor management, low return on company assets or default risk. While these three components clearly interact, the peo- ple running the business are the most obvi- ous single reason for value traps,” explains Søeberg.
So what can be done to avoid them? Søe- berg believes it is important to look across a company’s business model and capital structure: “Combining information on finan- cial solidity from the corporate bond market with our own assessment of valuation in the stock market can provide clues warning of potential value traps.”
Unfortunately the rating agencies seldom shed any light on the quality of company management per se. When assessing poten-tial investments SKAGEN therefore adopts a healthy suspicion of company executives, often preferring the relative safety of Annual Reports checked by auditors rather than the glossy equity story found in many presenta- tions to gauge whether management does what it says it will do.
Pitfall 2: The perils of the P/E ratio
The Price/Earnings ratio is one
of the most popular valuation measures in use, partly thanks to its simplic- ity. But buying a stock just because it has a low P/E is no guarantee of a good return. The low P/E could be a result of low growth prospects or (temporarily) low tax charges and could mask high levels of debt and earn- ings manipulation. According to Søeberg: “Following Worldcom and Enron, cash flow statements and analysis of off-balance sheet commitments have become more important; if they’re not in harmony with the income statement and balance sheet one needs to
be very alert.”
One solution is to use a variety of differ-
ent valuation tools and to be particularly vigilant during periods of expansion. “When a business doesn’t generate enough cash from internal sources to fund its growth one needs to be very cautious; Enterprise Value/ EBITDA or Enterprise Value/EBIT can provide some indication of the leverage-adjusted valuation but net cash earnings are a far bet- ter measurement for checking the health and performance of a company,” says Søeberg
Pitfall 3: Selling too soon
Unfortunately not all invest- ments are like the long-held SKAGEN investments, Olav
Thon or Great Wall Motor, which can be bought, held and continually deliver good growth while remaining attractively valued. Most investments have to be sold at some stage and selling winners too soon – or the disposition effect as it is called in behav- ioural finance – is a psychological phenom- enon. Søeberg likens it to expensive Eiswein: “The grapes are only harvested very late in the year, after frost has set in, and the risk is that if you leave them too long they become
worthless. So selling before they reach their highest possible value has to be balanced against the risk of leaving it too late.”
Like many investors, SKAGEN has some- times been guilty of failing to suppress an itchy trigger finger and has done consider- able work internally to address this. Com- pany price targets are discussed and revised regularly in response to new information. When the sell decision is made – either because the target price is realised, the company develops unexpectedly or we find better investments elsewhere – holdings are typically reduced gradually to minimise any opportunity cost.
Søeberg explains: “In SKAGEN we are very focused on business evaluation i.e. earnings growth and volatility, key business drivers and balance sheet items. A quarterly review of business performance gives a good idea of direction, speed and potential trou- bles ahead. Our fundamental valuation work is ongoing and usually the key deciding fac- tor for both buying and selling a business.”
Pitfall 4: Overpaying
A good business can become too expensive, and one must avoid the temptation of pay-
ing too much for a company. This is a risk for all shareholders but particularly for value investors, given that they tend to be more sensitive to capital preservation, and it is especially acute for those who, unlike SKAGEN, focus on relative, rather than abso- lute value.
To mitigate this risk and identify potential bubbles forming, it is important to look at valuations relative to historic averages, as well as other companies or sectors. A current example is in emerging markets where con- sumer staples companies currently trade at an average P/E of 21x, which is much higher than the historic average of around 14x. The portfolio managers are understandably cautious. Even more important is to under- stand the intrinsic value of a company and the possibilities on the downside as well as the upside. As Søeberg explains: “Avoid unrewarded risk and only take risks that you fully understand; even the best insurance underwriters occasionally make mistakes,
but on average they make a lot of money because they understand the risk.”
Pitfall 5: Mental hazards
The final danger comes from within and requires having the courage to trust your analysis
and instincts. You need to be prepared to stick your neck out and go against the market as well as face potential criticism from colleagues and clients. That said, this doesn’t mean having blind faith in a com- pany and it’s equally important to be able to admit when you’re wrong. “If your assump- tions for a revaluation of the company do not materialise i.e. operating cash flow does not improve as expected, then get out,” elabo- rates Søeberg.
Of course, many of these pitfalls are inter- linked and side-stepping one may land you in another. In trying to navigate as smooth a path as possible, Søeberg offers the fol- lowing summary: “Ideally at SKAGEN we’re looking for net cash generators with mod- est debt and a sustainable business model which consistently create value year after year. Then it’s mainly a question of identify- ing good entry points.”
Put like that it sounds easy but of course it’s much harder to do it than to explain it. Being able to do it consistently is the real art – the art of common sense.