Last December, we wrote that 2018 was a disappointing year. 2019 was as well, for different reasons. Experiencing either year in isolation would be uncomfortable, but to experience them back-to-back has been tougher still. Over the past two years, the Orbis Global Balanced Strategy has returned -6.1% net of fees against a 12.5% rise in the benchmark 60/40 Index in US dollars. Challenging periods are testing to endure, but they are often the times when we find the most exciting opportunities. The current stretch of underperformance is no different.

We see the current period of underperformance as split into two distinct parts.

Broadly, 2018 was characterised by company-specific issues leading to sharp underperformance for multiple holdings, set against a market backdrop where cash was the only major asset class to deliver a positive return and assets perceived to be stable ruled the day. In some cases, we leaned into the weakness to add to high-conviction positions, but in others, such as PG&E and Alta Mesa, our thesis was broken, and we sold.

In 2019, some of the positions that were most painful in 2018 went on to contribute positively to performance, including Celgene, XPO, Credit Suisse, and Bayer. While it is pleasing to see the green shoots of a change in sentiment for these companies, their performance was not enough to help Global Balanced keep pace with the strong returns of stock and bond markets this year. In US dollars, the Fund returned 11% after fees, trailing the 19% return of the 60/40 index.

The benchmark has been driven by stock markets, and in particular, the US market. This has been a headwind to relative returns, as we have had difficulty finding stock investments in the US that are as attractive as what’s available elsewhere. Since January 2018, the US has set multiple new records, while the rest of the world has stayed mired in a hidden bear market. Yet this year, the US has once again led the world, rising 29% against an 18% rise for stocks everywhere else. That return has come almost entirely from the US valuation premium increasing, not outsized earnings growth.

Compared to its benchmark, Global Balanced has also suffered from its zero weight in long-term government bonds. The JPM Global Government Bond Index started the year with a yield to maturity of 1.6%. The Index also carried a duration of eight years, suggesting an 8% price decline if yields were to rise just 1%. Compensation of 1.6% for 8% (or worse) downside potential struck us as simply uninvestable, so Global Balanced held no long-term government bonds.

Ultimately, we will live or die by our security selection, and as we’d always expect, that was the biggest driver of the Strategy’s relative returns in 2019. Several of our major detractors this year have been energy-related, including large holdings BP and Royal Dutch Shell. Many investors seem to dismiss the energy sector out of hand, yet dismissing the sector generally as a punt on the oil price risks overlooking serious fundamental improvements in these businesses. Energy producers’ success should not be measured by the price of oil, but by the revenues they produce minus the cost of producing them.

Both BP and Shell generated more free cashflow in 2018, with an average oil price of $72/bbl, than they did in 2014, when oil fetched $99/bbl. With 6.5% dividend yields and modest growth, we believe the companies can generate a long-term return of 10-12% per annum, without any improvement in the price of oil, and without a re-rating by the market. And with European oil majors trading near record low valuations relative to world markets, and 6.5% dividend yields overly generous relative to bonds, the scope for a re-rating is sizeable.

Global Balanced’s energy holdings are one chunk of a larger exposure to value shares in the portfolio. As we wrote in March, valuation spreads have widened consistently in recent years, and now appear to be extreme. However, as always, we are not dogmatically attached to deep value shares. We are happy to buy high-quality, fast-growing businesses when they are available at attractive valuations.

When we look at the equity holdings in the portfolio in aggregate, they now trade at an even larger discount to world stock markets than they did nine months ago. If the past is any guide, this bodes well for future long-term performance. We remain confident that our approach can deliver on the Strategy’s mandate over the long term, and we thank you for your trust, confidence, and patience.

In the past quarter, there were no significant purchases. The largest sale was a 2020 US treasury note. The Fund’s asset allocation remained largely unchanged, with a small rotation from fixed income to equities.

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