2020 has proven to be a year of many firsts, for all the wrong reasons, resulting in much uncertainty. Presenting to clients via Zoom webinar, Alec Cutler, from our offshore partner Orbis, examined the global environment amid COVID-19, touching on some of the exciting opportunities that are emerging. He also gave a sobering assessment of the Orbis SICAV Global Balanced Fund’s performance.
Orbis investment update: Summary
We’ve seen many things this year that we’ve never seen before. Global stock markets have never sold off this sharply. Unemployment has never risen this quickly. Central banks have never printed this much money. Oil futures have never traded at negative prices. In short, it is an environment of extreme uncertainty. As contrarians, we embrace that. While unsettling, such periods often create the best long-term investment opportunities.
Key stances disappoint
Coming into the crash, the Orbis SICAV Global Balanced Fund (the Fund) had three key stances: away from long-term government bonds, away from the US stock market in favour of other regions, and away from popular momentum shares in favour of cyclical shares. Each stance was driven by the opportunity set. At the beginning of the year, global government bonds yielded just 1%, the US traded at a 30% premium to stock markets elsewhere, and valuation spreads within equities were at their widest levels since the global financial crisis. Then government bond yields fell to 0.6%, the US stock market’s premium over other markets expanded to 45%, and the valuation gap between growth and value shares widened from a decade high to an all-time high.
Three out of three of the Fund’s key stances have made us look stupid, and the relative return experience has been awful. But as analysts, we can see that the key drivers of that performance have been expensive assets getting more expensive and cheap assets getting cheaper.
Looking back at performance is sobering. Looking ahead leaves us fired up about the opportunity for relative returns from here: On a scale of 1 to 10, today looks like a 10. That’s true right across the portfolio. When performance is rough, we tend to talk about the stocks that have hurt, and that can make it seem like the whole portfolio is racy. It isn’t. We own a wide range of businesses, and the bulk of the portfolio is in defensive companies, firms with net cash on their balance sheets, and resilient cyclicals.
We have spent much of our time in recent weeks stress testing these businesses, particularly the cyclicals. Our aim is not to own businesses that can merely muddle through; rather we look for businesses that can survive the crisis and emerge stronger over the long term. If an industry is enduring a painful period, but a company is financially stronger than its peers, the industry pain should actually improve the strong company’s long-term competitive position.
Looking for the best opportunities
The automakers BMW and Honda are great examples. Today is clearly a tough time to be selling cars. Fortunately, BMW and Honda are much stronger than many of their peers. Each has >US$10bn of net cash on its balance sheet, while most of their competitors are indebted — some with junk credit ratings. To test their resilience, we ran a worst-case scenario where Honda and BMW don’t sell any cars for the rest of the year. In that scenario, their balance sheets a year from now would look like their competitors’ do today, so you can only imagine the sort of pain their competitors would face. With BMW and Honda trading at around 0.6 times book value, we think their share prices are completely untethered from their long-term prospects.
Other resilient cyclicals include the integrated oil majors BP and Royal Dutch Shell. Plummeting oil prices are unhelpful, but the integrated majors are more diversified than pure oil producers. Their extensive networks of service stations put them among the world’s larger retailers. Both businesses have retained their investment-grade status, retain attractive access to credit markets, and have significant flexibility in their capital spending.
More importantly, they can continue to generate free cash flow even with oil prices at the current futures strip, putting them in a position to benefit as higher-cost and financially weaker competitors suffer. At current oil prices, most US shale producers can barely cover their cash production costs, let alone generate free cash flow. When prices are too low for producers to make money, they cut supply, which restores balance and allows prices to rise. The cure for low prices is low prices, and BP and Shell should be among the survivors who reap the benefits over the long-term.
Finally, consider US Health Insurers Anthem and UnitedHealth Group. Both shares fell more than 30% during the first quarter of the year as investors became concerned that insurance claims would skyrocket due to coronavirus-related costs. However, this is likely to be more than offset by the deferral of elective procedure costs. Both companies have since reported solid earnings and maintained their guidance for 2020. Net-net, we think the impact on this year’s earnings — let alone their long-term fundamentals — is negligible, so the price moves created a great opportunity to buy.
During the most recent quarter we have rotated capital from stocks that have held up well into areas that have been extremely weak. We have looked to take advantage of opportunities to add to or buy quality franchises that are now available at much lower prices. Examples include US broadband operator Comcast, media giant Disney, and Chinese e-commerce leader Alibaba. The result is that the portfolio holds a higher-quality collection of businesses than it did at the beginning of the year — and it is also much, much cheaper.
Over the past few years, investors have become far more worried about risks related to economic activity and idiosyncratic risks, like lawsuits, regulation, or politics, than they have been about paying too much to buy things that feel comfortable. This has caused investors to throw caution to the wind and pay more and more for securities that they believe carry none of these risks. Conversely, as investors focused on fundamental bottom-up research, we’ve become increasingly worried about valuation risk, peaked by comments like “valuation doesn’t matter”, and “we only own winners”. We try not to allow worries to cloud our decision-making and take what the market is giving us on the cheap. The crisis has delayed the reckoning for overpriced parts of the market, but this too shall pass, and at some point the gravity of valuation will kick in. It always has.