Orbis Global Equity Fund Webcast Summary

Allan Gray recently hosted a webcast, where Dr Graeme Shaw, Director of Orbis Investments and Allan Gray Analyst, outlined how independent thinking has led to finding value in global markets. Orbis is Allan Gray’s sister company and Allan Gray Australia distributes the Orbis Global Equity Fund to financial advisers. You can read the excerpt from the webcast below, or please click here to watch the webcast in full.

The investment environment we face today

Today, stock markets are generally high. The MSCI World index has returned more than 200% p.a. since the lows of the global financial crisis 10 years ago.

When stocks get to these sorts of levels it is typical for investors to look for protection. Government bonds have been one of the classic hiding places for bearish investors. But when we look at bonds today we don’t find them attractive for two reasons.

First, while yields have risen a little, they remain at historically low levels. Even if you pick the higher yielding countries, like Australia and the US, you are still earning about 3% on a 10-year government bond. Locking your money away with the government at 3% for 10 years does not make a lot of sense, since returns net of taxes and inflation are likely to be close to zero, even in a benign inflationary environment.

While bonds might protect you in the short term, they are priced for disappointment in the long term. If you are going to use them to protect against a potential market decline, you better be confident about your market timing.  And let’s face it – if we were all good at market timing we would be trading futures from a private island somewhere in the pacific.

The second reason to be wary of bonds is that bonds are riskier than people think. The academics seem to think that risk should be measured using volatility, but in reality risk is better measured by the size of extreme declines rather than the regular bumps in the road.

Table one shows the five largest declines in real wealth for both stocks and bonds using annual data. When you look at the size of these large declines experienced in the last 100 years or so you find that while stocks are clearly riskier than bonds, the difference may not be as big as you would expect when you only look at volatility.

For the US you can see that while stocks have lost investors 40-60% in real terms, bonds have still lost 20-40%.  In Australia, stocks have lost roughly 30-40% while bonds have lost around 20%.

The big stock market losses come when valuations are high and the big losses in the bond market come when inflation spikes above bond yields. History teaches two simple lessons if you want to avoid big losses.

Table one: the five largest declines in real wealth for stocks and bonds using annual data

Source: Elroy Dimson, Paul Marsh and Mike Staunton using data from the DMS database

 

How to avoid big losses

Firstly, if you want to avoid big losses don’t buy stocks when valuations are high. Secondly, don’t buy bonds when yields are low versus potential inflation. We have already shown that stock valuations are high and that yields are low. While forecasting inflation is a game you’re likely to lose, we would note that currently there are more long-term inflationary pressures than there are deflationary ones, which include:

  • The large amount of money printing by the world’s major central banks
  • High income inequality and the fact that a sizable portion of the US workforce has not had a real wage increase in the last 20 years.
  • The fact that the deflationary impact China has had on the world has mostly run its course
  • The population is aging and hence there are fewer workers servicing a larger nonworking population
  • The Trump effect, which includes tax cuts, budget deficits and trade tariffs.
  • Finally I would add that we have become used to moderate inflation and investors have a habit of becoming complacent when things have been the same for a long time.

On the other side of the scale, we have the potential deflationary impact of Artificial Intelligence and robots, and perhaps also India if it can follow China’s development pathway.

It is hard to know which of these factors will dominate, but as I noted before, there appears to be more inflationary than deflationary forces.

The problem with getting defensive

Apart from bonds, the other classic hiding place for bearish investors tends to be defensive shares. Usually this works well, as in a late-stage bull market defensive shares have often lagged and tend to be cheap, so they are both cheap and economically stable.

Unfortunately this has not been the case in this bull market. Defensive shares have actually outperformed the market, driven by investors seeking refuge from low bond yields.

If this all seems a bit depressing, the good news is that if you look a bit deeper you can still find shares with reasonable valuations. While this produces a somewhat eclectic mix of shares, this is likely to be better than investing in an overvalued index portfolio.

Where Orbis is investing

While we pick our investments for stock-specific reasons, we have noticed two clusters of value: stocks in emerging markets, and in selected cyclical stocks.

Curiously, the market is currently forcing investors to choose between expensive defensives, or stocks that are much cheaper but also more economically sensitive.

We know that in the long term it is better to go for cheap; the data supporting the outperformance of stocks that are good value, or contrarian, is compelling. But it is natural to wonder which will be more important if there is a bear market: cheapness or economic sensitivity?

How do emerging markets perform in bear markets?

The London School of Economics has developed an Emerging Market index stretching back more than 100 years. We can examine how emerging market stocks have performed in a global bear market and Table two shows the five biggest bear markets we have had in developed markets over the past 100 years. You can see that emerging markets have only underperformed in one of these – 2008.

Table two: performance of emerging markets in bear markets

Source: Credit Suisse Global Investment Returns Yearbook 2014, Elroy Dimson, Paul Marsh and Mike Staunton using data from the DMS database, MSCI Barra and S&P/IFCG. Orbis calculation.

We shouldn’t look at every bear market, rather we only want to look at periods that are similar to today: where emerging markets underperformed significantly and then there was a global bear market. Well there have been three of these events as indicated by the red negative sign in the middle column and you see that emerging markets did not underperform in any of these.

This suggests that while emerging markets are commonly thought to be more economically sensitive, history suggests they can outperform in a global bear market if they are cheap to start with.

The choice we face – bear markets and cyclicals

Unfortunately we cannot do the same analysis for cyclicals, because we have not been able to find a cyclicals index that goes back 100 years. We can, however, still get a feel for the impact of being overweight cyclicals in a bear market from our own experience.

It is interesting to look at how Orbis has performed in the three bear markets we have experienced. The first bear market was in 1990, the second was in 2000 and the third was the GFC in 2008. In all three bear markets Orbis was overweight cyclical stocks and underweight defensive stocks. And in all three bear markets the global strategy outperformed the MSCI World Index.

From this we conclude that when you are faced with the choice between cheap, and defensive but expensive, you should go with cheap. 

To illustrate the sort of value we can find currently we discuss two stocks in the webcast: a cyclical company, Honda, and an emerging market company, Naspers. These stocks have recently become large positions in the portfolio and therefore provide a feel for the sort of opportunities the market is offering right now. You can learn about why we hold these stocks by watching the full webcast.

Key takeaways

  • Firstly, if you invest in either government bonds or stock market indices, it’s worth noting that valuations have reached levels where historically unpleasant outcomes are more prevalent than is normally the case
  • Secondly, the Orbis Global Equity Fund doesn’t hold 99% of the stocks in the MSCI World Index, which means that our portfolio looks very different to the Index. It is these differences that have led to our strong outperformance over the long term.

 

Click here to watch the webcast in full.