Alec Cutler and Rob Perrone, from our offshore partner, Orbis, discuss the real risks the world is facing and the attractive investment opportunities Orbis has found to mitigate these real-world risks for the Orbis Global Balanced Fund. Watch a 27-minute recording of Alec’s presentation at a recent Allan Gray investment update and see a summary of the key takeouts below.
Key takeouts
It is important to understand the impact that these real-world risks are having on the investment environment and the potential opportunities presented. Four risks facing the world at the moment include:
1. A defence deficit
Military expenditure as a percentage of GDP has been slashed since the Berlin Wall fell. Relying on the “peace dividend”, Western countries stopped worrying about Russia and China, and the more hopeful in Europe were looking to tax so-called “social ill” companies, with defence stocks placed in this category. With the peace dividend gone, countries and alliances need to make up for a decades-long investment deficit in defence. That need is being felt most acutely in Europe and Japan, where defence contractors have performed poorly for 20 years, exacerbated recently by investor unease about the social responsibility of investing in those firms. Now, we appear on the cusp of a boomerang-like turn in both fundamentals and sentiment.
On the back of this sentiment, Orbis invested in a diversified basket of defence companies, including BAE Systems, Saab, Rheinmetall, Leonardo Thales and Mitsubishi Heavy Industries. Orbis did not buy these companies because they foresaw events in Ukraine, but rather because they believed rising geopolitical risks were not reflected in their valuations and had been slowly building positions in recent months. Even before the situation in Ukraine, there was a growing realisation that China was becoming more aggressive, and Russia was looking to reassert itself.
2. A hasty transition away from fossil fuels
The hasty transition away from oil and natural gas has led to underinvestment in traditional energy. While the intention is to invest in alternatives, the demand for energy has not reduced as the world transitions, and the war in Ukraine has severely impacted the supply, causing energy prices to skyrocket.
Longer term, the energy shortage may hasten Europe’s desire to increase energy efficiency and transition to renewable power. One of the easiest efficiency wins is to use LED lightbulbs, which should provide a tailwind to Signify, maker of Philips-branded LED bulbs. And investment in renewable energy should support both the wind turbine and electrical grid equipment businesses of Siemens Energy.
The pressure to transition away from natural gas has had an unintended consequence of putting major pressure on food supply, as natural gas is a primary input to fertiliser (see point 3). ESG goals are critical, but responsible investors need to take a broader view.
3. A global food shortage
Food prices were already rising before the war and have soared since, with wheat and cooking oil prices more than doubling due to global shortages. Producers in regions outside of the warzone are under pressure to maximise crop yields, and the demand for fertiliser has increased. The primary nutrients in fertiliser are nitrogen (from natural gas), phosphorous and potassium (from potash). Gas and potash shortages have led fertiliser prices to double. Along with lost acreage in Russia and China, food scarcity has increased. The need to maximise crop yields has never been more important, and Orbis believes agricultural chemical companies like Bayer and Nufarm are well placed to benefit from increased demand for their products.
4. An energy crisis
As the world divides, it is becoming obvious that the US must lead the way in providing Europe with energy security – Europe and the US have already signed an agreement to increase transatlantic liquefied natural gas (LNG) shipments. The most obvious beneficiaries are responsible Western companies that can contribute to the energy security effort. Much of that LNG will be handled by Shell, one of the world’s largest LNG producers and traders. Forty percent of gas consumed in the US flows through the pipelines of Kinder Morgan, which also owns stakes in LNG export terminals.
The case for active management
Amid heightened volatility, the case for active, contrarian investing has rarely looked more necessary. Valuation gaps within markets remain wide, creating ample opportunities for us as bottom-up investors. Holdings in the four areas above represent over a third of the Orbis Global Balanced Fund, and the shares in the Fund currently trade at a 35% discount to world stock markets on a price-to-earnings and price-to-free-cash-flow basis. By being attuned to real-world risks, we believe there are opportunities for active investors to generate attractive real returns.