The money bubble
US$14.8 trillion of bonds globally trade at negative yields. We mentioned that in June, but we didn’t explain what it means or who would buy a negative-yielding bond. Understanding this story is worthwhile – because the current state of bond markets makes little practical sense and affects the rest of the investing world. In our view, the biggest driver of the bubble in bonds has not been profit-focused buyers, but organisations who have other motives for buying bonds:
1. Central banks, for whom pushing yields down is the whole point.
2. Banks, who have been cajoled by regulators and pushed by central banks to hold government bonds.
3. Life insurers and pension funds, who need bonds for timing reasons, and who have also been “incentivised” by regulators to hold government bonds.
4. Passive mutual funds, who indiscriminately buy negative-yielding bonds in their index because they don’t have a choice.
5. Long-term pessimists, who have extremely bearish views about the long-term outlook for stocks.
6. Short-term speculators, who hope to flip bonds to someone else at a higher price, even if the bonds aren’t worth holding long term.

Rather than go into detail about the motivation of each of the bond buyers, we’d like to elaborate on the last two as their motivations are particularly interesting.

Long-term pessimists
While we think buying negative yielding bonds is nuts, we have spent some time thinking about what you would need to believe to find government bonds attractive today.

One possibility is that these investors are very pessimistic on the long-term prospects for the global economy. If the world enters a protracted recession, interest rates and inflation could stay depressed for a long time and in such an environment, losing a little bit of money on a government bond might be preferable to losing more money in stocks or corporate bonds.
We find it hard to be that pessimistic. The world has gone through wrenching periods before, yet companies have been able to recover and earn profits. It’s also not enough to think that inflation and interest rates will stay low. If yields remain at their current low levels, government bonds will return a measly 0.8% per annum (the yield to maturity on the JPM Global Government Bond Index). From here, getting a good return would require yields to go even more negative. It’s possible, but we’re not prepared to bet on it.

Today, the JPM Global Government Bond Index has a duration of 8.6 years, suggesting 8.6% downside for every one percentage point rise in yields. Even if you’re extremely bearish on stocks and credit, long-term sovereigns aren’t the only place to hide. You can just hold cash instead, without the interest rate risk.

Short-term speculators
The trouble with cash is that it offers good downside protection, but no potential for price upside. Government bonds do offer that upside potential. If a fund manager merely believes that the stock market environment will get scarier before it gets better, they might buy those unattractive bonds with a plan to sell them later at a higher price to a buyer that’s panicking for safety.

That’s fair enough as a bet, but it’s not how we operate. Buying an overpriced asset in the hope that it will get even more expensive is not investment; it’s speculation.

Better alternatives
Both of these groups would have produced good returns in government bonds over the past year, while we have avoided them. We would encourage the thus far successful pessimists and speculators to look at two areas that we find carry much better risk-reward prospects. Nearly 10% of the Orbis SICAV Global Balanced Fund is in gold and gold producers, and much of the equity portion is in higher-yielding and out-of-favour shares.

If you like bonds because you believe real (inflation-adjusted) yields will decline, you’ll love gold, which performs very well when real yields fall. Added to this, gold has a strongly negative correlation with stocks in stock market crashes, and the capacity to do very well if inflation returns.

The other opportunities we find attractive are higher-yielding contrarian stocks. If central banks continue to do everything they can to prevent a recession, leading growth, inflation, and yields to stay low, eventually yield-hunters should come to appreciate the high-yielding stocks we own. Consider BP, with a well-covered dividend yield of 6.2%. BP can borrow out to 2031 for just 0.6% per annum! The bond market is suggesting that these companies will have absolutely no trouble paying their bills for years and decades to come.

Opportunities like these leave us enthusiastic about our approach of building the Fund from the bottom up, sourcing opportunities across asset classes. Rather than being “stuck” holding risky, negative-yielding government bonds, we can invest in attractive securities which offer good prospective returns in a wider range of environments.

Adapted from an Orbis commentary contributed by Alec Cutler, Orbis Investment Management Limited, Bermuda

For the full commentary please see www.orbis.com

The performance of the Orbis SICAV Global Balanced Fund over the last year has been poor. These results have also dragged down the Fund’s longer-term performance numbers, which are now far below the standards we set for ourselves.

We appreciate how uncomfortable these periods are. It is challenging to hear the market shouting that you are wrong, even when the fundamental evidence says you are right. But maintaining our discipline in the face of this discomfort is at the core of our job, and we believe it is the very reason we can add value over the long term.

As we would always expect, the recent performance was driven chiefly by our security selection, not by our stances towards different asset classes. This is by design. We aim to deliver maximum exposure to our security selection skill, while maintaining a risk profile consistent with the Fund’s mandate. In 2018, we had our fair share of losers, had few big winners, and suffered as dislocations between prices and fundamentals widened for many of our favourite (and least favourite) securities.

The underperformance in 2019 has been a different story. In our view, the trends that have hurt returns are clearly cases of market prices moving ever further away from fundamentals. This leaves us more enthusiastic about the relative return potential of the portfolio. This divergence is clear in fixed income, where a record near-$13 trillion of bonds globally now trade at negative yields. It’s also clear in the substantial outperformance of financial assets (like stocks and bonds) over hard assets (like commodities). It makes sense that central bank money printing would push up stock and bond prices, but not compared to commodities. Central banks can’t print gold and oil.

The most significant trends year to date have occurred within equities. Some might remember what came to be called the TMT (Tech, Media, Telecom) bubble of the late 1990s. The narrowness of the current market is beginning to bear some striking similarities to this period. In 1999, the very largest stocks were driving the market higher to the exclusion of all else. The same is happening now, both globally and in the US.

The headline indices are dominated by the largest shares, and they’re doing fine. The top 50 shares in the US set new record highs last January, again in October, and again this April. But if we look instead at an equal weighted index of global stocks, we see that the average stock remains mired 18 months into a bear market that started on 26 January 2018. Well, so what? Maybe these trends are justified by fundamentals. But they aren’t. Once again, non-fundamental drivers appear to have taken the steering wheel. In the current environment, it’s clear that, as ever, investors don’t take the same degree of comfort from all quality companies. Good businesses with hard-to-see risks trade at great company prices, and good businesses with easy-to-see risks trade at bad company prices.

For example, consider our discussion of Coca-Cola last quarter. To recap: the company’s revenues and earnings have failed to grow, it is paying out every cent it earns to support the dividend, and it is piling on ever more debt. Those are big fundamental risks, but they aren’t obvious, and they will never be on the front page of a newspaper. Google, on the other hand, has an obvious, front-page-friendly risk: tech regulation.

Today, in the collective wisdom of investors, 0% growth Coke merits a valuation of 32 times earnings, while Google, which has grown revenues and earnings by over 15% per annum, merits a valuation of 24 times (ex-cash) earnings. To us, that looks nutty! And yet Coke has been, by far, the more comfortable company to own over the last three months. But it doesn’t for one second make us think we should sell Google and buy Coke.

At a high level, that is one of the dominant patterns in the portfolio today. We own what we think are some very high-quality businesses that the market has excessively punished for having obvious risks - and we don’t own what we think are the stretched businesses trading at silly prices. Shares of underappreciated but fundamentally strong businesses currently represent over a third of the Orbis SICAV Global Balanced Fund. That leaves us increasingly enthusiastic about what we own and new opportunities the market is coughing up. We believe that the divergence among securities is extreme and at irrational levels. Unfortunately, irrationality doesn’t correct on any set schedule, and we humbly appreciate your patience while we wait this out.

In the past quarter, the biggest addition was to German car manufacturer, BMW. The largest sale was a specialty financial services company bond. The Fund’s asset allocation remained unchanged over the quarter.

Adapted from an Orbis commentary by Alec Cutler, Orbis Investment Management Limited, Bermuda.

For the full commentary please see www.orbis.com

Over very long periods, buying cheap ''value'' stocks has been a winning strategy. That sounds intuitive, but people aren’t stupid. Cheap stocks are often cheap for a reason - maybe they grow less quickly, or earn worse profits, or carry more risk than other businesses.

But investors often take differences between companies too far. They get excited about a fast-growing company and start to believe it will maintain its exceptional growth forever. If the story is exciting enough, the company might look like a good investment at any price. Investors can get too pessimistic about other companies, thinking today’s struggles will last forever. If the story is scary enough, the company might look uninvestable at any price. That is a mistake, and the reason that value investing works over the long term. At a low enough price, almost any asset can be a good investment, and at a high enough price, any asset can be a bad one. Exceptional growth often fades, and tough periods often pass. Yet investors have made these mistakes consistently enough that blindly buying all the cheap stocks in the market has historically outperformed by quite a bit.

To be clear, that is not what we do. We conduct in-depth company research, aiming to buy businesses at a discount to their intrinsic value. Sometimes this is a company whose superior growth potential is underappreciated, and other times it can be an average company where an external and temporary issue has depressed its share price, like a cork held under water. Our focus on fundamentals, however, does lend a pattern to our performance. Our approach tends to produce better results when cheap stocks are getting less cheap, and has a tougher time of it when expensive stocks are getting more expensive.
In the decade since the trough of the financial crisis, we have seen more of the latter: expensive stocks getting more expensive. The spread between the valuations of cheap and expensive shares has gotten much wider.

By definition, value stocks are always cheaper than the expensive stocks in the market, but sometimes they are just a bit cheaper, and sometimes they are much cheaper. Hunting for ideas among value stocks is much more rewarding when valuation spreads are wide, as they are today. Thus you should not be surprised that the Fund’s equity holdings have increasingly tilted toward shares trading at low multiples of their normalised earnings, or low valuations relative to their history. We’ve been adding to what’s currently unwanted, untouchable, and cheap, relying on our fundamental research to fight human nature and buy when others think we’re foolish.

While leaning into those shares, and selling what have become appreciated ''winners'', has been painful from a performance standpoint, we are equally excited by what we’re able to buy, at the prices we’re able to buy them for. To explain this enthusiasm, we need to take a step back. Sometimes, the expensive stocks in the market are called ''growth stocks'', but it’s important to understand how those buckets are defined. In discussions about value and growth, growth stocks are conventionally defined by their high valuations - paying no attention at all to the companies’ actual growth. ''Antivalue'' would be a more accurate term. Likewise, just because a stock is cheaper doesn’t mean it is a worse business. This is what we spend much of our research time exploring. By researching many ideas, we can sometimes find stocks that are cheaper than the average stock and have better growth, profitability, and balance sheets than the average company. When we find and build conviction in these, we invest.

In aggregate, the equity holdings in the Orbis SICAV Global Balanced Fund are cheaper than the wider market as a multiple of their book value, sales, trailing and normalised earnings, free cash flow, and dividends. But as a reminder that low valuations don’t entail poor growth or quality, those same holdings, in aggregate, have historically delivered better returns on equity, grown book value and revenues more quickly, and currently have stronger balance sheets than the average stock in the index. Though many of them have been painful to hold over the past several months, we believe the portfolio today is simply more attractive for it when compared to the equity component of its benchmark. A number of the portfolio’s top holdings tick more than one of these boxes, including large holdings BP, Shell, AbbVie, Taiwan Semiconductor Manufacturing Company, and Bayer. We can’t know when expensive stocks will stop getting more expensive, but when the time comes for cheap stocks to get less cheap, we think shares like these should be at the front of the line.

We’ve observed before that investors appear to be overpaying for perceived stability and predictability. An example is Coca-Cola. The company’s revenues and profits today are lower than they were in 2010, and its net debt per share has doubled. Yet you’d never know that from looking at the share price - today it trades at 30 times trailing earnings. Rather than overpaying for slowing, increasingly leveraged ''safe'' shares, we’d prefer to underpay for good businesses when investor expectations are nice and low.

We can’t predict when expensive stocks will stop getting more expensive, or when our performance will turn, but we are determined to stick to our discipline. We remain convinced that buying quality on the cheap and passing on what’s highly valued by others remains a winning formula over the long term.

In the past quarter, the most significant addition was to underappreciated defensive, British American Tobacco. The largest sale was of Bristol-Myers Squibb, a pharmaceutical company, to moderate the position following its announced acquisition of Celgene, which is also held in the Fund.

2018 was a disappointing year, particularly as the Orbis SICAV Global Balanced Fund underperformed in a down market. To understand the year as we do, it’s important to revisit some of the changes we discussed early last year.

It may feel like a lifetime ago, but the beginning of 2018 was a time of enthusiasm in the investing world. By February, valuations were telling us that investors were insufficiently fearful, so we took the opportunity to reduce our positions in financials and some industrial cyclicals.

This rotation reduced the Fund’s net stock market exposure from 67% at the beginning of last year to 56% at the end of March. Through much of the year, we continued this shift, and from January, our exposure to shares in cyclical sectors decreased by as much as 19 percentage points before buying our most beaten up stocks at the end of the year. From a risk management perspective, this rotation was sensible, which makes it all the more frustrating that the Fund has underperformed as the market has fallen. The reason is simple: our favoured securities have simply not performed as we hoped.

With the capital from the cyclicals we sold, we bought or added to positions in underappreciated defensive shares, selected corporate bonds, gold, and shortterm US Treasuries. Of these, only the short-term Treasuries have performed well this year. Indeed, cash was the only major asset class to deliver a positive return in 2018. Even ‘safe haven’ gold declined, and our selected corporate bonds are also down, though we remain confident that their issuers’ cash flows and assets can cover what they owe us.

But the biggest driver of the poor return, by far, was the performance of our underappreciated defensive equities, including Pacific Gas & Electric (PG&E) and our long-term holdings in diversified oil majors BP and Royal Dutch Shell.

PG&E was the standout disaster investment, leading to a permanent loss of roughly 2% of the portfolio’s value and single-handedly accounting for a fifth of the underperformance.

We built the position in PG&E when it traded at a more than 30% discount to its utility peers due to concerns around the 2017 California wildfires. We believed the market was pricing in too high a chance of a worst-case scenario. In November, less than three months on from newly legislated protections for PG&E, that worst-case scenario came when the ‘once in a century’ Camp Fire broke out in California. The resulting potential liability could overwhelm PG&E’s financial capacity and it may now make sense for the company to voluntarily file for bankruptcy. This possibility led us to significantly reduce our assessment of the company’s intrinsic value, as well as its position in the Orbis Global Balanced Fund.

Even leaving PG&E aside, the dramatic underperformance of our fundamentally stable businesses has been the biggest disappointment of the year. In our view, our contrarian defensives offer better fundamental prospects, more sustainable dividend payouts, and lower valuations than the ''approved'' defensives in the market - yet ours have lagged. This sometimes happens with our approach. When markets are scary, investors don’t buy contrarian names, they buy things that make them feel comfortable in the moment - regardless of the relationship between price and intrinsic value. This leaves us frustrated about performance, but no less enthusiastic about the prospects for the opportunities we like. Shell is an excellent example here, as is fellow integrated major BP. In our opinion, the valuations on these shares look increasingly attractive.

The shares are down because the oil price is down, though for reasons that should prove short-lived. We have no idea where volatile spot oil prices will go, but longer-term prices have barely budged over the past four years, three-year Brent oil futures have consistently been between US$55 and US$65 a barrel. At those levels, both Shell and BP can do very well for their shareholders.

While the companies’ share price performance could continue to belie their relatively stable fundamentals, what matters to a business owner is free cash flow, and we believe BP and Shell can each grow theirs over the next four years. In the meantime, each company offers a dividend yield of 6%, which is higher than their historical averages and roughly quadruple the yield on long-term global government bonds.

As we look around the portfolio, we see a familiar pattern - companies we regard as having above-average fundamentals, trading at a discount to the wider market. At times over the past year, shares like Taiwan Semiconductor Manufacturing Company, AbbVie, and NetEase have been painful to own. But we are delighted to own them today.

Over the past quarter, the biggest addition was Bristol-Myers Squibb, a pharmaceutical company, whilst the largest sales were of Apache, an exploration and production company, and aerospace parts maker Arconic. The Fund’s exposure to the US stock market declined slightly, roughly offset by an increase in its exposure to shares in Asia ex-Japan. During the quarter, the underweight to the US dollar also narrowed slightly.

Adapted from Orbis commentary contributed by Alec Cutler