The challenge for value investors is that it is based on static valuation metrics which often fail to take into account the fact that companies are constantly growing and changing. For a long-term investor with a three to five year horizon, these changes often have a significant effect on a company’s fundamental value.
The key to long-term success lies in a combination of buying companies cheaply and being aware of what will influence them over time. With this in mind, what are the five central success criteria for an active, value-based equity investor like SKAGEN?
First commandment: Avoid losses
If you wish to earn money, a good starting point is to avoid losing it. From the perspective of a long-term value investor, it is important to differentiate between temporary and permanent loss of capital.
A temporary loss occurs when a stock falls in price even though there has been no change in the company’s intrinsic value whereas a permanent loss happens when a company’s fundamental value changes because the future potential to earn money weakens.
Historically, there have been two main causes of permanent loss for value-based investors. The first, and most important, is debt. Companies that take on a lot of leverage in order to earn money should be treated with scepticism because debt reduces the operational margin of safety and manoeuvrability. A poor business year, regardless of whether it is due to a weak real economy or other unforeseen circumstances, can easily result in a company being forced to raise new capital, or in the worst case going into liquidation. Both outcomes cause irreparable damage to shareholders.
A more silent predator is creative destruction; the inherent capitalist process whereby new and expensive products are replaced by better and/or cheaper ones, which causes a company’s competitive advantage and profit to erode over time. As consumers, we continuously get cheaper and better mobile phones and televisions while non-competitive manufacturers perish. To illustrate this, of the 30 original constituents in the US Dow Jones Index only two still exist in their original form; capitalism is a capitalist’s worst enemy.
Second commandment: Growth is our friend, when it is cheap
There is often an artificial divide between growth and value stocks. The fundamental value of a company is a function of future cash flow. The size of the cash flow is tied to the expected growth in earnings. As growth is a component in the valuation of a company, the two are inseparable – both in practice and in theory.
History tells us that many investors are willing to pay an irrationally high price for expectations of future high growth. That is why we always treat expectations of future growth with a healthy dose of caution. Our willingness to pay for growth is dependent on the price of the company, and to what extent we can be sure that the future earnings growth can be estimated.
Despite our inherent scepticism, over time we have seen that growth in companies’ earnings has been one of the most important drivers for returns in some of SKAGEN’s biggest and best investments.
Third commandment: Return on equity is a long-term investor’s best friend
From a value investor’s perspective, the twin brother of growth is the return a company achieves on its equity. Growth requires capital, and the return on this determines to what extent growth creates or destroys value. It is difficult for a company to create value for owners – both with and without growth, if it cannot demonstrate solid return on equity. That is why in the long run it is almost impossible to attain a higher return on stocks than the return a company attains on its own equity.
Fourth commandment: Good management is key
The ability and willingness of management to create value is often decisive in whether a company’s intrinsic value is realised or is left to rust. Naturally we appreciate managers who take care of shareholders’ money in the best possible way by being focused on and good at operational management. Competent, financially-oriented managers, who share value creation with shareholders by means of dividends, share buybacks and structural financial measures are also desirable.
We will not necessarily rule out investing in a company if its management has a poor history, or continues to struggle with a frayed reputation. If we can see management changes on the horizon, which could act as a trigger for the share price, we may take an interest. This is also true if the intrinsic value is of such high quality that even catastrophic management would be hard pushed to destroy it.
Fifth commandment: Dividends – yes please
Most empirical data shows that in the long-run companies’ dividends account for around 50 percent of investor returns from the stock market so choosing companies that provide a solid income stream takes us halfway to our goal of beating the market.
As the benefit of dividends is more apparent over the long term than the short term, they are often undervalued by short-term investors, which goes part of the way to explaining why studies show that stocks with high dividends yield higher returns than stocks with low or no dividends over time.
Beyond purely financial benefits, a robust, deep-rooted dividend policy is often a good indication of a company’s long-term health and of management’s willingness to create shareholder value. Moreover, studies show that dividends are a far better tool for rewarding shareholders than share repurchase programs. This is due to the fact that on the whole companies are not good at investing in their own shares.