Orbis does not invest in "the market". Instead, they focus entirely on finding the most compelling individual opportunities on offer. There's no better way to understand those opportunities than to take a closer look under the hood. In this article, contributed by members of the Orbis investment team and woven together by John Christy, you can see the rationale behind a broad sample of the Orbis Global Equity Fund's current holdings. We hope you'll enjoy hearing it straight from the team and come away confident about the positioning of the Fund.
The FTSE World Index rose 24% in 2017, keeping the current bull market alive for a ninth year. While this has been glorious for global equity investors - and it is gratifying that the Orbis Global Equity Fund has performed even better - future stock market returns hardly look appealing at current valuations. However, the world looks different to a bottom-up stock-picker.
From a global perspective, few parts of the market have offered abundant bargains in recent years. Financial services is one exception. Over the past two decades, the sector has rarely traded at this big a discount to the global index. Of course, many of these shares are cheap for good reason, so our job is to find the needles in the haystack - the asymmetric opportunities in which potential return significantly exceeds risk. We believe we have identified a handful of financial-related companies that meet that definition, and they come in different shapes and sizes.
KB Financial Group, Korea's largest bank, and American International Group, a global insurer, are both reasonable quality businesses on firmer footing than they were in the past. We expect profitability to improve at both companies over our investment horizon, which should allow them to grow their per-share book value by 10-15% p.a. Yet today, each trades for less than its book value.
Our job is to find the needles in the haystack - the asymmetric opportunities in which potential return significantly exceeds risk.
Sberbank, the dominant retail bank in Russia, offers the kind of investment credentials that have become all too rare these days. How often does one find a dominant, competitively advantaged market leader with 20%+ return-on-equity trading at only seven times earnings? What puts investors off, of course, is the unquantifiable "Russia risk". While we accept this deserves consideration and comes with some short-term volatility, we believe the current discount is too severe given our long-term investment horizon.
A less traditional financial business is PayPal, the payments technology leader. As a newer business model, it is the hardest of the group to value. The stock looks expensive at first glance because the company's profits are perennially weighed down by heavy marketing and product development expenses, but we regard these as investments that should produce benefits well beyond the short term. PayPal's true economic value creation, in our view, is considerably higher than what's captured by headline earnings in any given reporting period.
Along with greater online transaction activity, cybersecurity breaches are also becoming more common. Their cost to global economic activity is already comparable to narcotics, piracy, and car crashes. Companies have rushed to plug gaps in their security, but despite a surplus of options there is a scarcity of firms that can provide unified, high-quality expertise. We believe Symantec is an attractive exception.
Founded in 1982 by artificial intelligence researchers, Symantec grew into one of the world's largest cybersecurity firms. The company sells software to consumers under the Norton brand, and to enterprises under a variety of product lines. Despite its initial leadership in security, over the past decade, Symantec lost its focus, its product competitiveness, its growth, four CEOs, and its premium valuation. Today, at 15 times adjusted earnings, or a free cash flow yield to equity of 8%, Symantec trades at a notable discount to the US market, and at a substantial discount to its technology peers.
What do we see differently? First, we believe the new CEO, Greg Clark, has refocused the company on security by transitioning it to stickier subscription pricing and refreshing Symantec's product range, the broadest in the industry. While the path may be uneven, we believe this will translate into growth as customers consolidate vendors, selecting those that can offer a true "platform" at a competitive price. Over the long term, Symantec should benefit from the adoption of cloud computing as cybersecurity transitions away from the "firewalled fortress" model of the past to a decentralised model that requires broad, integrated coverage.
In our view, Symantec is simply not the ex-growth legacy business of a few years ago, but the stock's current valuation doesn't yet reflect what we see as the positive changes to the business.
At the opposite end of the technology spectrum, the Fund holds shares of two UK-based tobacco companies: British American Tobacco and Imperial Brands. Tobacco shares have underperformed over the last six months, in part due to the US regulator exploring whether to reduce the nicotine in cigarettes to very low levels. That could happen - but the evidence so far suggests it would hurt smokers, who seem to respond by smoking more cigarettes to get their usual nicotine hit. We therefore expect the current regulatory stance to remain in place. If that be the case, the future for tobacco companies could look a lot like the past.
Over the long term, tobacco companies have steadily grown earnings per share by about 7% p.a., and for decades, this growth has coincided with declines in smoking rates as regulators strive to improve public health. The reason is that tobacco companies have been able to raise prices by more than enough to offset continuing declines in smoking volumes. This playbook will stop working eventually - at a certain point, price hikes will bite. But that point hasn't come yet. It is no guarantee of future success, but over time, this pattern has allowed the tobacco sector to quietly outperform world markets by roughly 6% p.a. for 50 years.
These shares represent some of the ideas that our investment professionals find most compelling on a bottom-up basis.
In 2017, Japan has quietly outperformed other world stock markets (in US$ terms). But all Japanese shares have not benefited equally; Japan is home to some of the widest valuation dispersions of any region. The Fund currently holds a cluster of value shares in Japan, including of trading company Mitsubishi and oil and gas producer INPEX.
Mitsubishi is a diversified industrial conglomerate dealing in everything from coking coal to salmon to convenience stores. Over its history, the company has almost always been profitable, delivering steady growth in shareholders' equity. But as businesses with similar returns on equity have risen to trade at 3, 4, or even 5 times their book value, Mitsubishi's valuation has languished at about 1.0 times - a multiple we regard as too low given the company's fundamentals and improvements in capital allocation. We are prepared to take a long-term perspective to see if the market agrees with us.
INPEX is uniquely idiosyncratic among the world's oil and gas producers. Other producers may worry about their ability to grow without spending more than their cash flow; INPEX is all but certain to grow its production rapidly over the next few years, while greatly improving its free cash generation. This is because of Ichthys, a massive liquefied natural gas project off the coast of Australia. Many years in the making, Ichthys will start producing gas (and cash) in 2018. The project will take time to ramp up, and it is an open question how management will allocate these cash flows. But despite the start-up of Ichthys, the stock's valuation has not risen over the past four years - INPEX trades at just 0.7 times the value of its tangible net assets.
Outside of Japan, holdings elsewhere in Asia constitute the most noticeable concentration in the Fund. Much of that exposure is to Chinese shares. But this exposure is a result of our stock selections, not a driver of them. The Fund's weight in China is almost entirely in just a handful of internet-related shares, including of NetEase and JD.com.
The Fund has held NetEase for nearly 10 years. During that time, we have always regarded the company as a first-rate online game developer. Propelled by its industry-leading research and development, NetEase has grown earnings by over 25% p.a. in the past decade.
NetEase continues to have a promising games pipeline, and it also has two attractive e-commerce businesses: Kaola and Yanxuan. Kaola offers easy access to foreign goods (Australian nappies, for example, are very popular with Chinese parents). Yanxuan provides a simple range of quality products at low prices. In addition, NetEase operates China's largest email service, with nearly a billion registered users, as well as one of China's largest online music services. With these units adding to the ongoing potential of the games franchise, we believe NetEase continues to offer above-average growth, but lingering fears of competitive pressures have left its valuation at undemanding levels.
JD.com is China's second largest e-commerce company after Alibaba. While the companies are fierce competitors, they have different strategies. Of the two, JD.com has focused more on building its own infrastructure - everything from warehouses to delivery scooters - so that it can efficiently sell goods itself. This Amazon-like model is initially more expensive than facilitating third-party sellers, but ultimately provides a better customer experience. Over the long term, we believe JD.com's future is brighter than its current valuation suggests.
The Fund's positioning
Overall, the stocks discussed account for roughly 1/4 of the Fund and less than 2% of the World Index. Individually, these shares represent some of the ideas that our investment professionals find most compelling on a bottom-up basis.
As always, our own money is invested alongside yours, and we hope you’ll share our enthusiasm for the Fund's positioning.