Bond investing is simple: when you buy a bond, you are lending money to a company or government. They pay you interest for the loan and then they pay you back. If you would rather not wait, you could sell the bond to someone else - though the price you get might vary. Despite this simplicity, the fixed income world is filled with more jargon than perhaps any other field of investment. The truth is that it isn’t that complex, but it also isn’t risk-free.

Calling bonds risky may sound strange. Over the past few decades, government bonds have produced impressively steady, positive returns - almost matching the returns of global stock markets, but with half the volatility and far fewer crashes. This doesn’t mean that including these bonds in a portfolio will always reduce risk.

To see why, consider what has driven bonds’ stable returns. The global government bond index achieved an annualised return of over 6% over the past 30 years. However, most of this return wasn’t interest; it came from price increases from a stream of willing buyers.

This improvement in prices and consequent decline in yields has gone farther than almost anybody thought it would, but cannot go on forever. Yields have been pushed so low that in Switzerland, Germany or Japan, some are actually negative. At some point, logic dictates that there is simply nowhere for bond prices to go but down. Bonds today may be complementing these low prospective returns with higher levels of risk.

The weighted average time to get your cash flows from an asset (the ‘Macaulay duration’) is used to calculate a useful risk measure - ‘modified duration’. This expresses the sensitivity of a bond’s price to a 1% change in its yield.

As bond yields have fallen over the past three decades, their modified duration has increased. Thirty years ago, investors in the global government bond index expected a 4.7% price decline if yields rose by 1%. Today they expect a 7.8% decline - nearly double the interest rate risk.

This combination of low yields and high duration in government bonds doesn’t offer a good balance of risk and reward - there is plenty of risk, but not much potential reward. As a result, Orbis doesn’t hold government bonds. Even with bonds Orbis likes, it has attempted to protect against rising interest rates by keeping the overall duration of the portfolio lower than that of the benchmark.

But duration, like any respectable supervillain, can be both good and bad. Most people think of it as sensitivity to changes in interest rates. It actually captures sensitivity to changes in a bond’s own required yield. For corporate bonds, this change in yield might have nothing to do with overall interest rates, because the yield on a corporate bond includes a credit spread - additional interest that is required to compensate investors for perceived risk.

If the required spread on a bond goes down because of an improved perception of creditworthiness, its individual required yield might fall, even if interest rates generally are rising. When that happens, you actually want higher duration as that translates to more of a price increase and a larger return.

An example in the portfolio is Sprint, a US wireless carrier. Global Balanced currently holds its 2032 bond. Sprint has a lot of debt, and is considered an underdog compared to larger competitors AT&T and Verizon. Sprint and T-Mobile, the next-largest players, have attempted to merge to improve their competitiveness, but have historically been thwarted. Although Sprint is an underdog, it has significant holdings in wireless spectrum, a scarce, valuable and highly-regulated resource, as well as backing from Masayoshi Son, the successful serial entrepreneur running Japanese communications powerhouse Softbank.
Orbis thinks Sprint is a long way from financial distress. Over the past year, its earnings before interest, tax, depreciation and amortisation covered its interest expense nearly four times over - some comfort that the company can pay its bills. In a distress situation, Orbis is confident that Sprint’s assets could cover its debt. In addition, US regulators (who want to prevent a monopoly in the wireless industry) and Sprint’s Japanese backers would be aligned in wanting a merger. This would allow Sprint’s assets to continue competing and it would likely improve its perceived creditworthiness.

Since Orbis believes that sentiment around Sprint is overly negative, it chose to hold the Sprint bond with the longest possible duration, and thus the greatest leverage to a turnaround.

While the Fund’s overall bond duration is lower than the benchmark, decreasing risk from interest rate hikes, Orbis does not treat bonds as homogeneous. Instead, each bond’s duration is an active decision based on the risk and reward seen in each company and the potential consequences of leverage to a change in yield. Bond duration - like the rest of the portfolio - is based on an active decision, built from the bottom up.

Over the last quarter, there have been no material changes to the allocation of capital to the Orbis funds, nor to the equity, currency and or wider stockmarket exposures to different regions.

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

For something as important and ubiquitous as oil, there sure is a lot of confusion about what its price should be. Predictions range from ‘Tesla will make oil obsolete’ to ‘Underinvestment will send oil back to US$100 per barrel’. While we can see legitimate arguments for less extreme bullish and bearish outcomes, we find it tough to call the direction of the oil price.

However, we believe we can make a decent call on the other half of the profit equation - production costs. Indeed, the more we examine costs, the more it appears that investors’ focus on the oil price is blinding them to how dramatically some companies are driving down costs. This lays open the possibility that, even if oil price bears are right, some oil companies could still do well.

We believe integrated energy company BP fits this bill. This is not because it has been a great company historically. In fact, its historical mediocrity is part of the appeal. The oil majors, with few exceptions, have never been highly efficient. They have had their hands in everything - exploring for crude in far-flung places, operating fleets of tankers, building city-sized refineries and running gas stations. As the biggest players in each segment, they have not had to push their businesses very hard. They grew complacent.

BP’s complacency ended with its 2010 Gulf of Mexico disaster. Then-CEO Tony Hayward disastrously downplayed the incident and he was replaced with Bob Dudley. Dudley recognised that ‘sometimes it takes a near-death experience to radically change a company’, and he immediately set out to recreate BP. In a quirk of timing, this gave BP a head start on the rest of the industry. Four years before the oil price collapse, BP was forced to treat every decision as if the company’s life depended on it. The total cash outlay from the disaster exceeded US$60 billion, but the company survived through US$45 billion of divestments, shrewder investments and an intense focus on improvements in operational efficiency.

That truly one-off expense has passed, but BP’s survival instincts remain. Dudley has driven a lean manufacturing ethos into the production side of the business, with a focus on deploying ‘big win’ big data as well as practical ‘no brainer’ technologies. Big data and predictive analytics are being used for things like taking project screening times from months to minutes. On the more mundane end, 3D printers have been deployed to offshore rigs so they can print replacement parts instead of having to locate a part, ship it and fly it to the rig on a helicopter. BP now includes leading non-energy companies as operating performance comparisons. These efforts are starting to bear fruit in everything from well decline rates to production costs to expected growth rates. BP has reduced its oil price break-even from US$80 in 2014 to US$60 in 2016, with the prospect of this dropping to US$40 in 2018 as a cohort of recently developed basins start producing crude.

Upstream efficiency is not the only thing supporting BP’s potential profitability. The company also has huge downstream energy businesses, including transport, refining, chemicals and retail gas stations. Many of these activities actually see profits improve when the price of oil drops - in refining and chemicals, for instance, the price of crude oil is an input cost.

If BP’s operational performance is anywhere close to their guidance, and energy prices hover at recent levels, the company should generate US$10 billion in free cash flow next year, with more growth from there. Importantly, this comfortably exceeds what BP is expected to pay out in dividends, settling any questions about them having to cut their distributions to shareholders. Quelling those concerns should force the market to reassess the massive spread between BP’s dividend yield and those of other stable yield investments. If the current 7% dividend yield fell to the 4 to 5% level of today’s global telephone utilities, this would make for some terrific share price performance. (Put differently, BP’s price-to-dividend ratio would rise from 15 to >20, suggesting >30% upside.) In the meantime, with equity valuations and bond yields where they are, clipping a 7% coupon seems a good use of our clients’ capital.

Of course, should oil and gas prices move markedly higher, BP will do better than the discussion above implies. But it will not do nearly as well as pure exploration and production companies and feast-or-famine drillers. The fundamentals of those companies are more tightly linked to a bet on the oil price. With BP and fellow integrateds Shell and Woodside Petroleum, we are not making a bold oil price call. We are investing in fundamentally stable companies when they are temporarily thought to be risky.

Over the last quarter, there have been no material changes to the Fund’s allocation of capital to the Orbis funds, nor to its equity, currency and wider stockmarket exposures to different regions. With regards to individual holdings, KB Financial Group, Korea’s largest retail bank, entered the top-ten holdings, replacing Aetna, a US health insurance company. This change was driven by price movements, with KB’s shares performing robustly as the bank’s credit costs have declined while its revenue structure has notably improved.

Adapted from Orbis commentaries contributed by Alec Cutler

Sixty percent equities and forty percent bonds - the ‘60/40’ fund - has become such a standard for ‘moderate risk’ that any other allocation raises eyebrows. The idea behind the 60/40 goes back to the 1950s, when economists like Harry Markowitz and William Sharpe proposed that ‘imperfect correlation’ between equities and bonds meant that combining the two would reduce risk. When equities went down, bonds would go up, so the stocks could provide long-term upside while the bonds protected against a market crash.

That theory remains popular, but the facts have changed. Since the Global Financial Crisis, central banks have tried to prop up growth by printing money and using it to buy bonds from banks. The hope is that banks will use that cash to lend more freely and in doing so support growth. Printing money often fails to spur real economic growth, but it rarely fails to distort asset prices. With central banks buying up bonds, bond prices increase, which lowers yields and forces income-dependent investors into other assets in search of returns. The result is that investors have pushed equity markets up at the same time that bond prices were pushed to record highs. In other words, the financial wizards have broken the historically negative correlation between bonds and equities. They appear to have (at least temporarily) broken the old method of risk protection along with it. Bonds and equities have run up together, and they could crash together.

Consider the Orbis SICAV Global Balanced Fund, which represents 74% of your portfolio. Orbis does not believe that filling 40% of the Fund with overvalued sovereign bonds is an effective way to protect clients from risk today. Looking closer at the equity market, the picture looks even more unlike the past. Stock markets are entering the ninth year of a bull market and look expensive. At the top of an equity market cycle, it is typically the ‘cyclical’ stocks that look overvalued. This time, however, it is ‘defensive’ names that have driven the market upwards.

This makes sense: central banks suppressed the prospective returns on bonds by bidding up their prices, so investors who had previously held bonds were forced into equities. As reluctant equity investors, they went for the most bond-like stocks they could find, at a time when other equity investors lacked confidence in growth. Amid continued uncertainty, cyclicals like banks, industrials, and energy remained cheap. So not only do we have a situation where bond and equity markets have run together - we also have a situation where the market, particularly the US, looks expensive and yet cyclicals look attractive.

As a result, the Fund’s asset allocation may look counterintuitive. Orbis is worried about rich stock market valuations, but most of the Fund is invested in selected equities. Orbis is particularly worried about valuations in the US, but its bottom-up research process has led to overweight positions in selected energy, bank and healthcare shares that should perform well if US growth accelerates. Orbis seeks protection from a downswing in equities, but the Fund has limited fixed income exposure - all of which is also geared to accelerating growth.

With 86.6% of the Fund in selected stocks, it is certainly different from the 60/40 standard. How do we reduce risk? The solution is to employ equity hedging, bringing the Fund’s stock market exposure to 62.6% - not far above the weight of equities in the benchmark, but achieved very differently. As a result of this hedging, part of the Fund is not exposed to either stock markets or to bonds. Instead, this portion should capture the difference in returns between these selected equities and the stock market indices used to hedge.

Through hedging, exposure to the expensive US market has been meaningfully reduced, without eliminating assets that Orbis believes should outperform. This is an uncomfortable position if one anchors on the risks of the past, but in light of Orbis’ evaluation of today’s risks, it makes sense. The Fund has been positioned to offer some protection against the risks Orbis fears most and to perform well regardless of which of a range of possible scenarios plays out.

Over the last quarter, there have been no material changes to the Fund’s allocation of capital to the various Orbis funds, nor to its equity, currency and wider stock market exposures to the different regions. With regards to individual holdings, Aetna and Anthem, both US health insurance companies, entered the top 10 holdings, as Orbis believes that weak sentiment on the healthcare industry, amid regulatory concerns, has left selected high-quality businesses available at a meaningful discount to their intrinsic value. Other changes to the top 10 holdings were minimal and largely driven by price movements among Orbis’ preferred shares.

Orbis Global Balanced currently comprises 74% of the Fund. This Fund aims to balance capital appreciation and income generation with the risk of loss, which naturally promotes securities that offer attractive yields. But yield alone is not reason to purchase a security. Rather, two considerations trump all others: whether a security offers a discount to its intrinsic value, and whether holding it will improve the portfolio's overall balance of risk and return.

This is particularly relevant in today's environment. While Orbis still likes securities with attractive yields, these stocks now offer less potential for capital appreciation and a higher risk of loss than they have for some time, with their rising popularity and valuations. In fact, the relative valuations of high yield shares has peaked just as US bond yields troughed - no accident, as low bond yields have pushed many investors into stable yielding equities in search of income.

Finding many 'lower risk' names rather risky from a valuation standpoint, Orbis sold many of the Orbis Global Balanced Fund's stable yielding holdings in early 2016, hunting for discounts in other areas. Where that led to shares with greater business uncertainty, volatility, or economic sensitivity, Orbis worked to mitigate these risks by selectively hedging stock market exposure and by building greater conviction through continual fundamental research. Often, the best way to protect against downside is to buy what's already down and inexpensive.
At Orbis and Allan Gray, we are not textbook value investors, as we believe discounts to intrinsic value can also arise when the market assigns an average valuation to a company with superior growth prospects. But, if you are looking for shares that trade at a discount to intrinsic value, it's not a bad idea to hunt among shares that trade at low multiples of their equity, earnings or free cash flow. Lately, such value shares have appeared exceptionally attractive.

This follows a period of unusual underperformance for value stocks. Over very long periods, buying stocks that trade at a low multiple of their book value, earnings or cash flow has proven to be a winning strategy. However, in the US and globally, value shares have lagged their growth counterparts since the end of 2006 - the longest value shares have ever gone without notching a new peak in relative performance. That makes it tempting to wonder whether this time is different. Perhaps the value 'anomaly' has been eroded as investors have become aware of it and the poor recent performance is a sign that the value approach is broken.
Or maybe value's underperformance is a sign that the relationship between prices and fundamentals is still really stretched in some parts of the market. Orbis believes that is the more likely explanation and this has resulted in an increase in the holdings of selected bank, energy and health insurer names, as well as one-off 'deep value' opportunities where Orbis believes it has a research-driven edge. As outlined in the Orbis Global Balanced quarterly commentary, Wells Fargo is a recent example.
Wells Fargo, one of the premier US lenders, is a recent example. Reflecting its high quality, it has historically commanded a premium valuation compared to its banking peers. It is unusual for that premium to evaporate - yet it has this year, amidst a highly publicised fake accounts scandal. Orbis believes the controversy is likely short-lived in intensity and that the performance dip presented a unique entry point.

The competition for capital within the portfolio has led to a shift towards more classic value shares and while only time will tell whether this was the right move in the near or medium term, Orbis is confident that following our shared philosophy in a disciplined manner will bear fruit over the long run.

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 wider stock market exposures to different regions. With regards to individual holdings, Sberbank of Russia, US-based Wells Fargo, and multinational oil and gas company, BP, entered the top 10 holdings. Orbis increased position sizes in BP and Wells Fargo, as its conviction in each has strengthened, while Sberbank's strong outperformance has accounted for it re-entering the top.
Adapted from Orbis commentaries contributed by Alec Cutler
For the full commentary please see www.orbisfunds.com