In recent quarters, Orbis has observed a dislocation emerge between the shares of ‘stable’ or ‘defensive’ businesses in areas such as healthcare and consumer staples, and more cyclical companies with a greater degree of future earnings uncertainty. Orbis has found more compelling investments in the more cyclical areas such a financials, basic materials, emerging markets and autos.

Orbis did however find value in classic defensive companies, such as household names Procter & Gamble, Coca-Cola, McDonald’s, electric utility Southern Company, wireless infrastructure provider Crown Castle International and telecom provider Verizon Communications and Imperial Brands. The key difference is that they bought those shares long before they were as fashionable as they are today. Make no mistake: these are excellent businesses, but at a high enough price, ‘safe’ investments can actually be dangerous. Orbis has felt this way generally about most bonds for some time and now feels the same about many so-called bond proxies.

Few areas of the market today are more shunned by investors prizing stability than banks. Until earlier this year, Orbis identified relatively few undervalued shares within the sector, consisting of a few high-quality banks such as JPMorgan Chase and special situations like Sberbank and Korea’s KB Financial Group. That changed in the second quarter of this year, as Orbis began to find more attractively priced banking shares.

Banks have been disliked by investors for very good reasons. Bank investors enjoyed excellent returns from the late 1990s to the mid-2000s amid a steadily declining interest rate environment that facilitated fat spreads between their lending rates and the cost of funds along with a combination of greater risk taking and more permissive regulation. But those gains, and more, were all wiped out once the music stopped.

And it still isn’t playing. The post-crisis era has been painful for bankers and shareholders alike, with a constant flow of investigations, massive fines and punitive regulation. This has crushed both bank profitability and bankers’ morale. No longer pillars of their communities, bankers have become better known in the vernacular as ‘banksters’ - a play on the gangsters of 1930s America. Making matters much worse, central bank experiments such as Quantitative Easing, Reverse Twist, Negative Interest Rate Policy and others have served to crush net interest margins - the lifeblood of traditional lending.

In the meantime, many bank management teams, most of them new, have been working hard to improve their businesses. Despite significant headwinds, many banks have stabilised profitability by simplifying their structures, cutting lower-returning businesses and locations, and generally cutting fat. Orbis has found an increasing number of banks whose share prices are failing to give them proper credit for the improvements they have made. These include the aforementioned JPMorgan Chase, Sberbank and KB Financial Group, as well as Citigroup and Goldman Sachs in the US and Europe’s ING Groep, Erste Group Bank and Bank of Ireland.

Orbis hopes that the market will come to share its view that not all banks are on the path of steady decline and some are in fact strengthening businesses that may in time be able to afford to pay investors a healthy income - at a time when low-to-zero bond yields - make investment income generation a rare commodity. Then again, at that point Orbis may well be shifting out of banks and into unloved consumer staples shares and bond proxies.

Over the last quarter, the portfolio moderately increased its capital allocation to the Orbis Global Equity Fund in order to increase the net equity exposure, which was offset by a reduced allocation to the Orbis Optimal funds. There have been no meaningful changes to the portfolio’s currency or wider stock market exposures to different regions. With regards to individual holdings, US-based XPO Logistics and SPDR Gold Trust, an exchangetraded fund which aims to track the value of gold bullion, entered the top ten holdings, replacing Newcrest Mining and Barrick Gold. Exposure to Newcrest Mining and Barrick Gold was reduced as their strong performance in the first half of 2016 caused the discount to intrinsic value to narrow.

Adapted from Orbis commentaries contributed by Alec Cutler
For the full commentary please see www.orbisfunds.com

Within the Orbis Global Balanced Fund, rather than trying to meet specified ‘bond’ and ‘equity’ quotas, Orbis considers what each individual security will contribute to the risk-reward profile of the Fund. This means that a stable, high-dividend-yielding equity may well beat out a riskier corporate bond, or a low- or negative- yielding government bond, for a position in the Fund. Likewise a high-yield bond might beat out a stock with a similar expected return but higher market risk or a less certain payout timeline.

In applying that asset class-agnostic approach, Orbis looks at companies holistically. For a bondholder, the crucial questions are ‘will this company be able to pay me back on time, and if not, are its assets sufficiently valuable to cover what I am owed?’ Any event that permanently impairs the value of bonds would likely cause its equity to be worthless, since bondholders outrank equity holders in bankruptcy. So at the end of the day, the same information - the intrinsic value of a company - determines the value of that company’s debt as well as its equity.

US-based XPO Logistics, one of the world’s largest transportation and logistics providers, is an example of this holistic analysis at work. Orbis knows XPO well, having covered it for over four years and met with senior management frequently, as well as its customers and competitors. As Orbis developed conviction in the ability of XPO’s management to successfully execute their strategy, it concluded that the stock trades at a sizeable discount to the underlying business’s long-term intrinsic value. However, Orbis also identified an attractive opportunity to invest across its capital structure, and purchased the company’s 2019 and 2022 bonds as well.

Up to mid-2015, the market viewed XPO as an asset-light logistics business, since it mainly arranged contract logistics and provided brokerage with third parties, rather than directly engaging in bulk transport. Then, in September, XPO bought Con-Way, a trucking business - complete with a fleet of actual trucks - and the market suddenly began valuing XPO as if all of its businesses were ‘asset heavy’ and therefore less attractive. Orbis believed that was unjustified, and that the deal was actually a positive one that was likely to deliver sizeable synergies and improve XPO’s overall value, providing an entry point to buy its equity.

At the same time, the large debt load resulting from XPO’s purchase of Con-Way led the market to downgrade its view of the company’s credit risk, which was already perceived as vulnerable given it had not generated free cash flow since 2010. This sent XPO’s bond prices down, as the market demanded an even higher yield on money loaned to the company. However, Orbis believes XPO’s cash generation is likely to improve significantly in future years as its trucking business (including Con-Way) increasingly contributes to free cash flow. That cash may be deployed or paid out to the benefit of shareholders or used to reduce debt, including by calling bonds at a premium, which could provide even more upside for bondholders.

There are diversification benefits to holding both the equity and the bond. In their February results call, XPO’s management announced a lower share price target for executive bonuses, and an intention to reduce its debt ratios over time. Equity investors disliked the news, and the shares fell, but bond investors approved of the reduced incentive for management risk-taking, as well as the intention to strengthen the balance sheet over time.

By owning both securities, the Fund retains exposure to the greater upside of the equity, but with a potentially less volatile ride and healthy coupon payments as it stands to be seen if the market recognises the value Orbis has identified in XPO.

Over the last quarter, the portfolio established a modest capital allocation to the Orbis Global Equity Fund in order to increase the net equity exposure, which was offset by a reduced allocation to the Orbis Optimal Funds. There have been no meaningful changes to the portfolio’s currency or wider stockmarket exposures to different regions. With regards to individual holdings, Royal Dutch Shell and Newcrest Mining entered the top ten holdings, replacing XPO Logistics and Carnival plc. These changes were mainly driven by price movements, as shares in Carnival and XPO underperformed in the quarter, while shares in Newcrest Mining have outperformed amidst rising gold prices, and we have incrementally increased exposure to Royal Dutch Shell as conviction that its shares offer attractive relative value has increased.

Orbis commentary written by Ashley Lynn
For the full commentary please see www.orbisfunds.com

The value investing style is out of favor, so it may not come as a surprise that Orbis is increasingly finding attractive investment opportunities in shares that fit in that box. As stable businesses displaying traditional 'growth' characteristics, particularly in developed markets, have outperformed and trended to increasingly elevated valuations, the opportunities for investors willing to look elsewhere are enticing.

That said, many 'deep value' stocks carry considerable risks that have prevented Orbis from gaining adequate conviction in them. With central banks taking unprecedented actions, like driving government bonds to negative or near-zero yields, any macroeconomic bear case for a stock is now hard to convincingly disprove.

Orbis has therefore been moving very gradually in the accumulation of value exposure. An example is the Fund's activity in energy names. While valuations have languished across the industry, recent adds have been in the undervalued names whose businesses are more enduring, like Royal Dutch Shell, BP, and best-in-class European oil services provider Technip. However, a commodity share's intrinsic value is ultimately determined by a single variable-the commodity price-that is outside the control of management and inherently unpredictable. Given this uncertainty, Orbis has constrained its aggregate position size.

Elsewhere, Orbis has identified unique 'deep value' opportunities-names that have for one reason or another been left for dead. A good example is glass bottle maker Owens Illinois (OI) an 'old tech' economic cyclical, and the largest player in the increasingly concentrated global glass container industry. OI's market share grew a little more with its acquisition of competitor Vitro, but its debt load did too, triggering ratings downgrades and spooking investors as high yield bonds swooned at the start of the year.

As is the case with many global commodity manufacturers, the glass bottle industry is currently in oversupply, with the predictable depressing effect on pricing and margins. But bottle making is a bit different by virtue of the fact that glass furnaces wear out, and need to be rebuilt. Combined with a prospectively oligopolistic industry structure, this expensive undertaking can help catalyse a relatively quick supply correction-which would in turn boost glass prices.

Orbis believes OI has two things going for it-shrinking industry capacity and a cheap valuation that ascribes minimal value to the potential for improved free cash flow, as it repurchases debt.

Times are tough for OI and they could get tougher, but Orbis believes the company's share price adequately reflects the macroeconomic risks it faces. Yet, given the unpredictability of negative macro scenarios, OI has been capped at a relatively small position, despite its upside potential.

Orbis' bottom-up research process has identified ever-increasing discounts to its assessment of intrinsic value in other cyclical or deep value laggards, including Rolls-Royce, US manufacturer Alcoa, Japanese carmaker Mitsubishi, US semiconductor company QUALCOMM, and Korea's KB Financial.

Funding for this lean toward deep value has come from the last bits of well-liked growth stalwarts like Alphabet (Google) and Facebook, and from well-appreciated, high-quality positions like US wireless infrastructure provider Crown Castle. These shares have done well, but their good performance has narrowed their discounts to intrinsic value, and Orbis believes other opportunities now offer a better balance of risk and reward for a balanced fund mandate.

2015 was a turbulent year for global markets. Orbis ended the year with high conviction in its approach and its portfolios, notwithstanding a disappointing year of performance. In particular, the flexibility Orbis retains in balancing risk and return empowers its analysts to take advantage of a range of attractive opportunities across different parts of the market.

Orbis continues to believe that an environment where government bond yields are paltry makes bonds broadly unattractive relative to other investment options. Orbis has instead been drawn to three broad types of opportunities: unpopular shares in traditionally 'stable' parts of the market, traditionally stable shares in unpopular parts of the market and riskier shares combined with stock market hedging. An example of the first type of opportunity is Merck, the market's least-loved global pharmaceutical, despite its excellent drug pipeline. The market fears uncertainty around upcoming test results - but that uncertainty is unavoidable when investing in firms with ambitious research and development efforts, and thus Orbis ensures it is appropriately accounted for in share prices.

For the second opportunity type, emerging markets are the best illustration. Broad market valuations in emerging markets appear very cheap, and are at their lowest levels in nearly a decade relative to developed markets. In selected emerging markets, the gap between the most and least expensive shares is especially wide, providing a rich hunting ground for bottom-up investors. Orbis' bottom-up research has identified a number of attractive individual shares in the region, including South Korean multinational electronics company Samsung Electronics, Korea's KB Financial Group and China's second-largest e-commerce player JD.com, in addition to NetEase, a Chinese internet company and the Fund's biggest performance contributor.

Weak sentiment across emerging markets in the past several months has opened up opportunities to purchase shares that would likely have been unaffordable otherwise. A great example is Korean utility KEPCO. Wide pessimism increased just as KEPCO has been emerging from a period of unfavourable regulatory behaviour, which pressured its fundamentals. Orbis took advantage of the widespread sentiment drag to increase its position in KEPCO.

Selected developed market shares with perceived or fundamental exposure to emerging markets have also become available at attractive prices. Two examples are UK-listed BP, one of the world's largest integrated oil companies, and Carnival, a cruise line operator. Energy-related companies have broadly suffered losses over the past year, but an additional weight on sentiment for BP has been its 20% exposure to Rosneft, Russia's largest oil company. While investors have scorned all things Russian until very recently, Rosneft has huge and high-quality reserves, and investing in this through the 7.7%-yielding BP bond allows Orbis, via the Orbis Global Balanced Fund, to access the upside with less of the currency and political risks associated with Russia-listed shares.

Carnival does not have pronounced emerging markets exposure, but the market is concerned that a slowdown in Chinese economic growth could spell trouble for multinationals that look to it as an ever-expanding revenue stream. However, slowing GDP growth should not change the fact that China's population is rapidly getting both wealthier and older, and older people with disposable incomes are a key customer group for cruise lines.

Though it is frustrating to see high-conviction investments underperform, Orbis is excited about the value in the portfolio. By continuing to apply our shared fundamental, long-term and contrarian philosophy with a flexible approach to risk management, Orbis is confident that it can deliver over the long term.

Over the last quarter, there have been no material changes to the portfolio's allocation of capital to the Orbis funds, nor to its equity, currency and or wider stock market exposures to different regions. With regards to individual holdings, US-based XPO Logistics, a logistics and transportation services provider, and JD.com entered the top 10 holdings. Orbis initiated both positions in the third quarter and incrementally purchased more shares as its conviction in each strengthened. Orbis took advantage of share price weakness to increase its investment size in Qualcomm, a US-based company which manufactures chips for use in smartphones.