The issues of bushfires have quickly been overtaken by virus alerts globally. This reinforces the fact that you cannot know what lies ahead and, perhaps more importantly, you cannot know which events will matter when it comes to investing – to attempt to do so is a fool’s folly. Assessing valuation then buying assets for much less than they are worth is your best weapon.

Watch the Allan Gray and Orbis Investment Forum webinar recorded on 25 March 2020, to see Allan Gray Managing Director and Chief Investment Officer, Simon Mawhinney, together with Orbis’ Investment Director, Charles Dalziell, cover the outlooks for their respective portfolios. They also look at how these times of surprise and uncertainty can throw up great opportunities for contrarian investors.

CPD points are available to advisers who watch the video, but not for reading the transcript. Watch the webinar now, or read the transcript below:

Transcript:

Simon Mawhinney:

Good afternoon everyone and thank you for making the time to participate in this webcast. My presentation is going to cover off on three broad areas. Firstly, our performance in brief and then secondly how unpredictable the world is and always has been. As well as the apparent premium that people are prepared to pay for predictability even though it’s seldom the case.

 

But first onto our performance, and I’ll go through each of the three funds that we have. Firstly, the equity fund. Starting from the left to the right, you can see the difference from our long-term performance since inception to the very short-term performance we’ve had. And our modest outperformance over a longer term period has been reduced by the more recent underperformance over the last year or so. As I go through this presentation, I think the reasons for that underperformance become more apparent, and it has everything to do with the premium that investors are prepared to pay for apparent predictable earning streams.

 

The balanced fund has an inception far more recent, and this essentially has launched at a time when the equity funds of the underlying strategies have performed poorly. And so its performance hasn’t been that good in the back or in the wake of a very strong investment market. So its performance has lagged the benchmark. And then the stable fund has had very good performance over the longer term and shorter term, and that’s emblematic of a very strong investment market. Importantly, all of these numbers are up until the end of February and so would look a little bit different if they were run today.

 

If you had asked investors, experts, economists, what they thought would happen in 2019 it’s interesting what responses you would get. And this is a survey that actually took place at the end of 2018 where experts were asked what they thought would happen to the reserve bank of Australia’s cash rate as well as what investment returns are likely to be in 2019. The outcomes are quite illuminating. In 2018, 73% of people, survey respondents felt that interest rates would stay on hold, 18% cut and 9% hike. And then with the same for equity markets, we had 58% of respondents suggest that investment markets would be bearish in 2019, with 42% saying the opposite.

 

This next chart shows you exactly what has happened. You can see almost every single asset class’s done extraordinarily well, despite most of the respondents being quite negatively disposed towards equity and other asset class returns in 2019. And not only were they wrong with respect to the asset class returns, they were very wrong with respect to interest rates with the Reserve Bank dropping interest rates from 1.3%, or 1.25% to 0.75% and now even further more recently.

 

So investors got it very wrong in 2018 with respect to 2019’s earnings, and that’s on the back of what didn’t really feel like a very comfortable year last year. We had US/Iranian tensions, we had the rise of the Corona virus, and of course all of these numbers are up until February and so that was very well understood by that stage. We had a lot of negative bond yields, which is somewhat emblematic of economies struggling. And so not a lot of good news out there. Yet investment markets did spectacularly well.

 

So if you fast forward to the end of 2019 and look at that same survey, it’s interesting to see what these people said. You can see that 58% of respondents were quite bullish about the stock market’s prospects going into 2020 and the remaining 42% quite bearish. And of course this is where we are as of yesterday with almost every single asset class falling quite significantly. So the message here really is that we have always lived in unpredictable times. It has always been very difficult to forecast the future and experts are very seldom accurate in their predictions.

 

This apparent predictability that people continue to find solace in is probably best demonstrated by two companies, two hypothetical companies, company A and company B. Company A is a reasonably defensive company or seemingly so, which starts in year one earning $10 a share, or for the entire company $10. And then grows its earnings gradually over the next 10 years to a level where the combined earnings over that 10-year period is $126.

 

Company B is a cyclically impacted company with quite a volatile earnings stream. You can see in year one its earnings where low, year four high, and in year five it made losses. But the combined or aggregate earnings over the 10-year period is also $126. For consecutive 10 year periods which mirror this 10-year period and absent the time value of money, which is not a crazy assumption in today’s interest rate environment, these two companies are worth exactly the same amount of money. As companies are valued at the present value of their future earnings streams, these earnings are identical. Yet in today’s stock market, there is a massive premium attached to the stable earner, Company A in this case, and a very significant discount attached to the more volatile cyclical earner, Company B.

 

This has manifested itself in the stock market, a widening gap between the performance of cyclical shares and the performance of defensive shares. And that has only gotten wider and wider as the coronavirus has unfolded, but even prior to that, momentum has driven very significant performance in the more stable companies. The cyclical companies are banks, materials, and energy mainly and the defensive of companies have been healthcare, REITs, infrastructure, utilities, basically everything that’s not cyclical.

 

That gap is almost as wide as we’ve ever seen. In fact, it is as wide as we’ve ever seen and we think it presents great opportunity. It’s also one of the reasons why our performance hasn’t been very good. Going back to the first slide, which showed the last year’s performance for the equity fund lagging quite significantly behind our benchmark because this is not something we’ve been exposed to, the cyclical companies, in the last one or two months, they’ve been an exposure that we’ve shifted into over the last two or three years.

 

If you were to break it down, healthcare on the defensives has been one of the best performers and it’s graphed here. And then in terms of the worst performers, energy, materials and more recently the banks, who are the most cyclically exposed companies. I thought it might be helpful, and certainly to help understand how we think about these companies, if we compare one of the largest constituents of the healthcare index, CSL, to some of the constituents of the more cyclically exposed companies. And so what we’ve done is we’ve tried to compare CSL to a combined ANZ Bank and National Australia Bank. And you can see that CSL’s market capitalisation as of yesterday was $130 billion and that’s on the bar chart on the far left.

 

When we had first decided to do this, it was quite a neat outcome that CSL’s market capitalisation was the same as the combined market capitalisation of ANZ and NAB. But subsequent to first thinking about this, ANZ and NAB have fallen significantly in price such that CSL’s market capitalisation is now almost $50 billion above NAB and ANZ’s combined market capitalisation. And to put that into perspective, a lot of that is on the back of concerns around the Corona virus and what that might do to the economy, recessions, and loan loss provisions and loan write-offs by the banks. That $50 billion equates to roughly 3% of the combined ANZ and NAB’s loan book, which is quite a significant impairment were it to take place.

 

For the rest of this slide, I think it’s best to assume that NAB and ANZ are proxy for CSL and compare what you get from buying each of the two. In CSL’s case you get almost $4 billion of earnings next year and in ANZ and NAB’s case, assuming consensus was unchanged for both companies, you get a little over $12 billion in earnings. And so for companies that used to be priced similarly, you get three and a half times the amount of earnings from ANZ and NAB as you do from CSL. And of course now you pay $50 billion less for the privilege of three and a half times more earnings.

 

And so I guess the first question is why on earth would people do this? And the answer of course is the relative growth rates and the earning streams. In CSL’s case, its earnings are forecast to grow at 10% per annum for the immediate future, if not long term. Whereas NAB and ANZ have already gone through a reasonably significant period of growth since the early 1990’s and they’re forecast to grow slightly less than nominal GDP if you take the broker consensus forecast numbers, which is a bit below 3% per annum. And so CSL is obviously grown its earnings much faster than NAB and ANZ combined are.

 

Notwithstanding that, it would take almost 20 years for CSL’s earnings to catch up with the combined ANZ and NAB’s at those forecast growth rates being 10% for CSL and a little less than 3% for the banks. Over that same period, CSL would have had roughly $240 billion of earnings and the combined banks $350 billion. Given the current market capitalisations of the two, the banks would have repaid in earnings roughly four times your current investment in 20 years’ time and CSL would have earned more than its current market cap, but would have paid much less than it given that most of its earnings are retained in order to achieve those high growth rates.

 

If these growth rates were sustainable, it would be reasonable to invest in CSL before ANZ and NAB, but I think the stock market and many investors may overstate the likelihood that CSL will be able to continue to grow at levels as it has in the past. And to demonstrate that we want you to show how difficult it was and how few companies had managed to achieve these growth rates that shareholders are paying handsomely for today. There are only three companies in Australia that have managed to grow their earnings at more than 10% per annum for 20 years. CSL is one of them. The other two are Macquarie and Computershare.

 

For the earnings of CSL to equate to the earnings of the combined banks in 20 years’ time, we need CSL to be able to grow its earnings at this rate for a further 20 years. In other words, 40 years in total, and these are very big numbers that we’re talking about and these laws of large numbers make growth of that magnitude incredibly difficult to sustain. And if you go back and look at other companies around the world that have grown their earnings extremely well over, we’ve used a 15-year period just to help with data, and then gone on to continue to grow their earnings at a similar rate in future, it’s very unlikely that that level of growth continues.

 

We’ve done a sample of companies here and you can see only 21 companies or 17% of companies that manage to grow their earnings at more than 10% per annum for 15 years, go on to grow their earnings at 10% per annum for the next 15 years. It is a very, very difficult thing to do and it doesn’t take away from how successful CSL has been as a company. All it does is demonstrate the amount of blue sky and optimism that is currently priced into CSL share price and the pessimism which is factored into ANZ and NAB’s at the moment. And it’s for this reason that our portfolio is more disposed to investing in an ANZ and a NAB than a CSL. Whilst we do own ANZ and NAB, this is a more representative of the type of companies we’ve been building, the focus on the fundamentals. Our refusal to rely on seemingly unsustainable growth rates and trying to come up with assumptions which are manageable and replicable based on historical outcomes.

 

So just to summarise, it’s very hard to predict macro-economic trends and market catalysts. Valuation gaps have continued to widen, as illustrated by the CSL and the banks, and amidst this uncertainty that we are currently living through, Allan Gray remains steadfast in its focus on fundamental value and continues to employ its capital along those lines. Thank you.

 

Julian Morrison:

Thanks very much Simon. People often talk about the market as though it’s one thing. That really highlighted some of the essential disparity between different parts of the market. And also I think, some of the difficulties of extrapolating limitless growth for companies. Simon, I’ll bring you back in later to address some questions if I could. For now, I’d like to introduce Charlie Dalziell, who is investment director for Orbis. And Charlie’s going to take us through the global equity view and also some specifics on the Orbis global equity fund. So Charlie, thank you for joining us too and over to you now.

 

Charles Dalziell:

Thanks Julian. So good afternoon ladies and gentlemen and thanks for dialling in. As Julian said, today I’d like to just take you through our recent performance numbers. But then spend a majority of the presentation talking about the current crisis and how we’ve positioned the portfolio to deal with it and how well positioned our portfolio is to deal with it. And finally I’ll take you through a couple of stock ideas that we think you might find interesting in the current environment.

 

All of the themes we talked about in the last forum are certainly relevant. The dispersions between value and growth stocks remain extraordinarily wide and we’ve obviously suffered as that gap has gotten wider, but the portfolio is extraordinarily cheap today. It’s no exaggeration to say that it’s as cheap as it’s been in 30 years. Our investment team is extremely excited about the medium to long-term outlook regardless of the current crisis that we’re going through. If history is any guide, this is not the time to panic. This is in fact the time to be embracing these sorts of opportunities, if you have a medium to long-term outlook.

 

So look, “a watched pot never boils” is an expression I’ve come to appreciate as an investor over 25 years. I often joke that my best investment performance came when I went on holidays, when I stopped looking at the market and stop worrying about the daily gyrations of markets. We at Orbis feel a little bit like Garfield here. We know that the latent alpha within the portfolio is primed, it’s cooking and it’s just ready to pop. And as time goes on, our conviction only gets stronger that there is very good value in the portfolio today, but it can be an agonising wait. So the risk we think today is, however, that we do get distracted by the current pandemic or you get distracted by the current pandemic and when you briefly look away, the opportunity will disappear pretty quickly. So our performance numbers isn’t a great story and as you know, we went through one of our biggest relative drawdowns in the last two years. And that really hasn’t recovered since our last investment forum.

 

We’ve tracked roughly in line with our benchmarks since our last investment forum, which is a nice change from what we’d experienced prior to that, but it’s clearly still had an effect on our medium to long-term numbers. Our performance since inception has still being exceptional, but our medium-term numbers certainly need a fair bit of catch up from these levels. Since the markets peaked around February 20, these numbers are to Friday of last week, you can see that our portfolios tracked roughly in line with the market. Which is obviously disappointing because normally in a downmarket Orbis has historically performed better, and that is primarily because the stocks we own tend to be cheap already.

 

But the market has been pretty indiscriminate across all sectors, so it hasn’t mattered whether you’ve been a value manager, a growth manager, a minimum volatility manager or high momentum manager, you’ve seen some pretty decent price moves within your portfolio. And if you look across the world, it’s been pretty consistent as well. Whether you’ve been in the US, whether you’ve been in developed markets outside of the US or emerging markets, you have seen a pretty similar level of sell-off over this time. The worst sector has obviously been energy and banks, but even technology stocks haven’t been spared. And that suggests to us that there has been a fair degree of forced selling within this market and a real ‘throw the baby out with the bath water’ type mentality as investors have panicked out of stocks today.

 

So in terms of the current crisis, I think what needs to be understood is no one really knows how long or severe this pandemic will be. Containment measures could be in place for longer than expected. If you listen to Scott Morrison, he’s saying six months. If you listen to Donald Trump, he’s saying less than three weeks. So it is a very uncertain environment. What is quite clear though is that containment measures need to be enforced strongly, they need to go hard and they need to go early to minimise the damage done to global economies from here. Having said that, I think a global recession is looking inevitable, but policy response from central banks and government has obviously been very strong. A $2 trillion package coming out of the US, a trillion-dollar package coming out of Europe, and obviously central banks resorting back to very low or zero interest rates and quantitative easing measures.

 

Should we be worried about a recession? We think a recession is very well and truly priced into the stocks we own today. So we think if you’re prepared to look beyond the current pandemic and look beyond the current economic downturn, we think value stocks generally come out of recessions much better than safe stocks and growth stocks initially. So we think there’s a very good opportunity for us to add significant value as the enormous amount of fiscal and monetary stimulus that comes through potentially drives a recovery sometime down the track.

 

What are we at Orbis doing? Well, as usual, we’re taking a long-term view and that’s important because it prevents us from making knee jerk reactions at a time of maximum fear. We are very much sticking to the kind of stocks we know very well. So we’re not being lured into positions where we are seduced by low valuations, but we don’t really know what sort of risks we’re walking into. So we have a very big bench of stocks that we know well that we would like to buy at the right price. And we’re really spending a lot of time sifting through those companies today looking for hidden gems that can fit into the portfolio.

 

We’re stress testing all our vulnerable holdings from a financial and a business perspective. And to give you a bit of colour around that, we recently stress tested our holding in BMW and another company, which was a European airline. And we really threw the book at it, we really assumed that BMW would have to shut down all its operations, sell no cars, earn no income, pay all its employees, which will cost them around about a billion euros a month. And what we found when we applied that stress test was that BMW could comfortably survive that sort of situation for at least 18 months given current cash levels.

 

When we applied that same stress test to the airline, we found the airline could only survive for one quarter. So although both stocks looked incredibly cheap, three times earnings, they’d fallen between 40 and 60% each off already cheap levels, we were far more inclined to lean into our holding in BMW and ignore the potential opportunity in the airline. BMW today trades at just a small premium to its net cash backing, which is extraordinary. And if you think of it another way, if you exclude their financing business, which has been an amazing business for 40 years, but if you exclude their financing business, the market cap today implies a negative $5 billion value for the car business.

 

So if somebody came to you today and said, “We’ll give you BMW’s car business for free, plus we’ll give you $5 billion to go along with it also for free,” what would you think? It really is an extraordinary situation we’re seeing in cyclical companies, but even ones that have strong balance sheets. The markets focus on balance sheets hasn’t been there for the best part of 10 years because the government’s just been bailing poorly capitalised companies out for such a long period of time. And even in this sell-off, well capitalised companies like BMW just haven’t been rewarded. So for us that is really a wonderful opportunity.

 

I should say though that not all our portfolio fits into that type of category. In fact, we have a number of holdings that the business will actually do better in this environment. Our largest holding in the portfolio is a company called NetEase. It’s an online computer gaming company in China and when you’ve got a billion people in lockdown, video games is one of the few you can do, one of the few entertainments you can enjoy. And NetEase is potentially a beneficiary of that.

 

So if you look at our trading since the 20th of February, you can see that we’ve sold some of our high quality and stable names like S&P Global. We’ve trimmed our AbbVie for this position, although that is still a top 10 position. We’ve sold out of Bristol Myers Squibb, and these are good quality companies that have performed well leading up to the sell-off and then held up reasonably well during the sell-off. And we’ve rotated that money into three new positions

Some defensive names that you can see there that are very well capitalised companies that got sold down by as much as the market, if not more than the market, despite having very little risk in their operations from the current pandemic. So again, it’s that ‘throw the baby out with the bath water’ type mentality that the markets had, has enabled us to pick up some very good quality names and good stable shares at a time when they’ve been sold off. We’ve also added to some of their cyclical names like BMW, but only the ones that we’ve done this stress testing on and have the balance sheets to cope with some business disruption.

 

If you look down our top 10 holdings, it really hasn’t changed much over the year and that’s because our conviction within this portfolio is so high. It’s very hard to get a new idea into the portfolio because the return hurdles are just so high to achieve that. To give you some example, in 2019, our analysts analysed 440 companies over that year, of which just 54 were recommended to policy group meetings and out of those 54, only six were bought to meaningful positions within the portfolio. So we really love what we own today and it’s very hard to get new ideas in. That’s not to say that turnover won’t increase as we experience greater volatility, it probably will because stocks move up and stocks move down and opportunities arise on a daily basis.

 

If you look down that top 10, we think seven of those companies have businesses that won’t be significantly affected by what’s happening with the global pandemic and that’s primarily because they’re in Chinese online computer gaming, they’re in US healthcare, and they’re in sectors like gold mining. The other three, as I mentioned, are cyclical companies, but we do think they have the strength of business and the strength of balance sheets to withstand any sort of business disruption. If you look at the portfolio characteristics of the fund, you can see why we’re so excited for our normalised price earnings ratio is just eight times. And eight times is cheap in any economic environment, not just in a recession or during a global pandemic. It is extraordinarily cheap across all economic cycles.

 

And you’ll notice that it’s now half the price of the MSCI world index. And when I talk about latent alpha, when you look at the other characteristics of the portfolio, return on equity of 20% which is actually better than the market average, revenue growth over the last decade has been stronger than the market averages, dividend yields higher, net equity, the balance sheets are stronger and our companies aren’t earning top of the cycle profits, whereas the market on average is earning above mid cycle earnings. So when you look at those characteristics, there’s really no reason why our portfolio can’t trade to market averages. And if it does, that implies a 100% alpha relative to the market.

 

If you look at our key overweights, you can see that we’ve got 29% of the portfolio in emerging markets. 11% of that is in China and our sector overweights include US pharmaceutical and healthcare and autos. What I’ll do now is just take you through a couple of stock ideas. I’ll have to go through them quite quickly because I’m running out of time. But the US healthcare sector is a fascinating sector as a concerned investor because it’s very complicated and it’s very political. So the managed care organisations of which we own two, Anthem and United Healthcare, administer health benefits on behalf of sponsors, namely employers, both large and small and state governments and federal governments. And their job is to find the best healthcare providers for those beneficiaries and then negotiate the best prices for them.

 

This is a business with enormous moats because it requires huge scale, both national scale for buying cheap drugs or getting good prices on drugs, and local scale for getting the best prices from local providers. And medical management capability is extremely important for managing costs and because suppliers and customers are so fragmented, it is an incredibly complex business to manage. It’s also a great place to be because healthcare expenditure in the US has grown much faster than gross domestic product for a long period of time. And you can see here as a percentage of GDP since 1970, healthcare has grown at a reasonable percentage of overall GDP. On the right hand side, you can see that the MCOs penetration within government business has risen rapidly, particularly in the last decade. And that is because managed care organisations are so much better at managing this than governments are.

 

Anthem has been a wonderful stock for a best part of 20 years and I’ve shown you here, the revenue growth and the profit growth in the blue line and the cash flow per share growth in the orange line. And you can see it’s been a wonderful compounder of value for a long period of time. So why has it underperformed since the beginning of 2019? Well, a big part of it has been due to the popularity of Bernie Sanders. And Bernie Sanders has been running on a political platform where he’s promised to reform the healthcare industry and bring in a single payer system into the US similar to what we have in Australia with Medicare. Our research and assessment was that the chances of Bernie being successfully able to do that were extremely remote. But now that Bernie is not the preferred candidate for the Democratic nomination, it’s pretty clear that it’s almost zero.

 

To put it in perspective, five presidents have come to office since the Second World War with a single payer agenda and none of those presidents have managed to succeed. So we definitely think the MCOs are here for the long term. The last time Anthem experienced this sort of political stress was back in 2011 when Barack Obama was pushing Obamacare and you can see here Anthem underperformed the market by 40% over the 13 months from June 2011 to July 2012, at which time the Supreme Court stepped in and struck down large parts of Obamacare on the grounds that they’re unconstitutional.

 

Over the next three years, it was a glorious time to be an investor in these managed care organisations. They outperformed the market by over 100% once that political risk had had been extinguished. Today, Anthem is on 8.7 times normalised earnings for a company that has got a net cash balance sheet and has been able to grow profits at 11% per annum for a decade. It is really quite extraordinary how extreme the fear around the stock has become, particularly when you look at it relative to the US market, which is on 17 times earnings but has only grown profits of 5% per annum over a decade.

 

Emerging markets are another area where we’re finding plenty of value and this chart just shows you the relative performance of emerging markets and developing markets over almost 100 years, and you can see the cycles have been remarkably consistent. Turning points have been preceded by a period of consolidation that normally lasts a couple of years and we’ve highlighted them in the circles. But emerging markets have now underperformed developed markets by eight years, primarily because investors have been concerned about a slowdown in China. And more recently there’s been noise around trade wars and obviously riots in Hong Kong, but we think we’re finding from a bottom up perspective, fantastic value in emerging markets today.

 

Part of the reason is this chart. Pricing earnings ratio expansion has been massive in developed markets, but it has been negligible over the last 10 years within emerging markets. Emerging market companies on average also have much stronger balance sheets than their developed market counterparts, 25% less debt on average. So, within emerging markets we’ve been finding great opportunities particularly in the technology space, we’ve owned NetEase, we own Naspers, we own Taiwan Semiconductor, we’ve owned Autohome. We’ve also owned some very contrarian cheap ideas as well, such as Vale and Sberbank of Russia, which are classically contrarian, very cheap companies. But what I’d like to talk to you today is just a little bit about NetEase.

 

NetEase is a fantastically run business. It’s the second largest online computer gaming company in China. And I’m not talking about gambling, I’m talking about games that people play on their computers. They’ve been a wonderful developer of their own games for a long period of time and we’ve been an investor in this company for well over a decade. On top of the gaming business they also have some venture investments in online music streaming business and an online education business, as well as an eCommerce joint venture.

 

NetEase has been a fantastic stock for a lot of the time that we’ve owned it. The share price is shown here on the blue line and the earnings per share are shown on the yellow line. And what you’ll notice is, the share price is only ever tracked in line with profits, which is why we’ve owned it for such a long period of time. The stock’s never really gotten that expensive. It’s never really traded much above 15 times earnings, which is extraordinary because an equivalent US company will trade on twice that multiple. You’ll notice that earnings took a dip in 2018 and that was due to the Gaming Regulator in China closing their approvals of new games. And part of what they were thinking was, they wanted the gaming companies to take more social responsibility for reducing addiction to young players and their exposure to violence within these games.

 

We always saw this as a short-term problem and the stock fell quite significantly and it enabled us to rebuild position in NetEase having almost sold out of the company by the beginning of 2018. The regulator reopened approval for games at the end of 2018 and since then NetEase has been become one of our strongest contributors to the portfolio, or our single strongest contributor to the portfolio after having been one of our biggest detractors just a year ago.

 

Despite its good performance, we still see good upside from NetEase from here. In 2019 NetEase earned about $1.9 billion from its gaming business. We think by 2023 on fairly conservative assumptions, it can earn about $3.2 billion out of its gaming business. The venture businesses that I talked about, the streaming and the education businesses, lost $400 million a year in 2019 but we think the revenue growth within those businesses is so strong, those losses will disappear over the next four years.

 

We think from where the company’s valued today at about $40 billion, if we apply fairly conservative assumptions to the gaming business, 15 times earnings for the gaming business, we get a valuation of about 47 billion cash on balance sheet will grow as retained earnings from profits. Add to that pile of cash will grow from 7.4 to 13.4 billion. And then we also think the losses from the venture businesses will disappear and that will give it potentially some Blue Sky valuation that you can see there in the yellow. But with just the gaming and the cash, we think there’s 50% upside from here with additional upside if the market starts to give them some value for the Blue Sky.

 

In summary, we think uncertainty creates great opportunities. We think this is a wonderful time to be buying into value today. Our portfolio hasn’t been cheaper in 30 years and the investment team is very excited about the medium to long-term outlook. And with that I’ll hand back to Jules. I think we’ve got some questions to answer.

Julian Morrison:

Charlie, thanks very much. I think you managed to fit a lot into about 20 minutes there, so thanks very much for that. Lots of food for thought and hopefully that’s prompted some more questions. I can see them still coming through now, so certainly it has. I’ve got a list of those we received until about five minutes ago and they still seem to be coming through so I’ll flip between these. So, this is probably to both of you but Simon, I’ll hand this to you first. We entered this period from an all-time high in the market, I think you could say the US market or the Australian market, whichever market. And now markets have fallen a lot, so how attractive are stocks now in terms of the opportunity set versus before that recent fall? How does this compare to say the depths of the GFC?

Simon Mawhinney:

Thanks Julian. Some companies look ludicrously cheap to us. Charlie mentioned in his presentation some indiscriminate selling, sometimes disregard for balance sheet strength. And so two companies might be similarly exposed, one with a lot of debt and the other one with very little but both companies have fallen similarly hard. And so there’s quite a few of those opportunities out there. It’s always the case that the market in aggregate is not as cheap as the cheapest part of the market and so there’s a huge opportunity to do significantly better than the stock market. Notwithstanding that the broader stock market has quite a lot of very expensive heavyweights in them, like CSL. Even in aggregate, the stock market doesn’t look extraordinarily expensive, but it’s definitely not a global financial crisis levels in aggregate. Yet there are opportunities within that which we think exceed the attractiveness of the financial crisis level.

 

Julian Morrison:

Sure. So, it’s fair to say you’ve been taking the opportunity of some of those to this point?

 

Simon Mawhinney:

Yes, we have and further supporting some of the companies that we already have investments in that haven’t done well through this process. This is the first time in over 10 years that some of the REITs have started to look interesting and there’s a number of companies that have very strong balance sheets that have been sold off quite significantly and we’ve been adding to it.

 

Julian Morrison:

On that note, Charlie I’ll get to you in one second but there’s a question that’s just come through and I see that. What is the reason for property funds underperforming over the last month compared to the overall market? That may or may not be something that you can answer in terms of the last month, but is there any key reasons they can be?

 

Simon Mawhinney:

These companies started for the most part at premiums to book value and so you were paying more than the current valuation of the properties for these companies, and those properties were valued based on then rentals and cap rates. And there is a strong view that rents are going to fall from here and so, of course the valuations of those properties will most likely fall as well. And then added to that is, the fact that the company’s debt however modest doesn’t fall at all. And so you could have valuations of the company portfolio fall 30 or so percent, the debt doesn’t change and suddenly the gearing levels are much higher. Occupancy becomes a really big issue at times like this and so, as we’ve been saying for a number of years, REITs are not safe havens during economic turmoil, occupancy falls, rents fall and so do share prices and so I think that’s the large reason why these companies are falling.

 

Julian Morrison:

Thanks Simon. Charlie to direct one to you, one has come through asking whether you have an insight about China and other Asian countries starting to get back to normal recently in sort of way.

 

Charles Dalziell:

Interestingly, China’s been the best performing market in the downturn and China being at the epicentre of the whole crisis, is I suppose illuminating in a way. That’s up until last Friday, whether or not that remains the case is difficult to say. But we are seeing Wuhan for example, which was the first city to go into lockdown coming out of lockdown. They went into a very extreme level of lockdown and when you read about it, it looks like they’re more going to our level of lockdown where people can actually leave their homes and go to the shop rather than just remain safely locked away in their apartments for a couple of months.

 

Certainly, the statistics that you’re seeing out of China are worth following. I know they haven’t had a new case recorded for a couple of days now. So when they talk about the flattening of the curve, those are the sorts of things you want to see. Obviously, Australia is a long way from not recording a new case, but keeping an eye on countries like Italy, Japan, Korea, and seeing how they’re fairing from an infection level and from a recovery level is very interesting. And then seeing how potentially this whole thing can play out in other economies could be quite illuminating and interesting.

 

Julian Morrison:

Thanks Charlie. We had a couple of questions both on risk. One is a bit broader and more general than the other more specific. So I’ll maybe start with the broader question, Simon for you. How do you view risk and how do you deal with it? What are the biggest risks for investors today in you view?

 

Simon Mawhinney:

Debt is one of the biggest areas or sources of risk today. Balance sheet strength is one of the largest determinants of risk from here I think. And we’ve been looking at it through a similar lens that Charlie described for Orbis. It’s reasonably easy from company financial statements to account what the cost basis of companies are and we’ve been stress testing balance sheet strengths using one to six month and twelve month periods of lockdown without any revenue and what that might do to the balance sheet.

 

Those companies that will be able to sustain that are obviously less risky from a financial leverage perspective and those that aren’t are more risky. And then of course it’s the price you pay, it’s not to say that you can’t invest in a more risky company, it’s that those companies need to be extraordinarily cheap relative to the less risky company. So, that’s one of the biggest lenses that we look through risk at the moment and it seems to be the source of the largest amount of risk at the moment is debt.

 

Julian Morrison:

Moving on to the more specific question Charlie, this came through, how do you view the risk versus opportunity in autos? You mentioned BMW, have you bought more? How does it compare to other autos?

 

Charles Dalziell:

So, obviously balance sheet strengths are a big one, and BMW and Honda are the two biggest auto holdings. Honda has a third of its market cap, if not more, today sitting in cash and obviously BMW is trading pretty close to cash backing, so both those companies are extraordinary well capitalised. From a business perspective, we like Honda because of the motorcycle business. We don’t think it’s got much concern around disruption, but from electric vehicle type disruption effect not from a global pandemic disruption perspective. There is obvious concern around manufacturing shutdown at Honda. But in terms of our other automotive holdings, we also own Toyota, which is the biggest car company in the world and, a similar situation, with a very strong balance sheet and in a very strong hybrid market share that will serve them well once the economies go back to normal or once activity goes back to normal, lockdowns finish up and the activity goes back to normal.

 

Julian Morrison:

Thanks Charlie. This one seems to be quite a lengthy question so I’m going to break it into two. Where do we see the global markets heading with regards to the US election, if we can comment on that? Charlie that will be you. The change in shift to electric vehicle production and the impact this will have on oil timeline and seasonality? And low interest rates? So, I will break that into two… If you have any comments Charlie regarding the US election and the low interest rate environment, anything you’d like to comment on there with regard to the outlook for markets?

 

Charles Dalziell:

The US is throwing the kitchen sink at the economy today in terms of trying to limit the economic fallout from the current pandemic. So Donald Trump is in an election year, he can’t stand the thought of the stock market being down. He wants to get it up as fast as he possibly can. Whether he can or not, it’s completely out of his hands. He’s just one voice in one of many. So, it’s impossible to say what the outlook is for the US market for the remainder of 2020.

 

Julian Morrison:

Thank you Charlie. The other part of that question related to electric vehicle production and the impact on oil, I guess energy. Simon, there’s also another question, or a couple of questions relating to the energy sector. One talks about the Russia-Saudi spat, breakevens and the theory that some countries are trying to bankrupt the US shell producers, the impact on those. A question as to whether this might be positive over the long term for the stocks we own or not? Another question actually on that, have we added more to holdings like Woodside Petroleum on recent weakness or other energy stops? And so maybe we could break that up into a few pieces rather than altogether. So have we added to the energy exposure?

 

Simon Mawhinney:

Modestly, yes. And companies like Woodside and Origin seem to have much stronger balance sheets than some of the others. We’ve also added to second derivative beneficiaries of what could come if oil prices improve and that would be WorleyParsons. So yes, we have added, but it’s been modest at this stage. The EV production numbers, we see those continuing and increasing. But I think demand from EV’s or substitution towards EV’s, the demand destruction is a small part of the negative oil thesis and there’s much larger factors involved mainly on the supply side at this stage and more recently virus related on the demand side.

 

So, whether or not the Saudis and Russia are trying to bankrupt the US shell producers, I’m not in a good position to comment on other than to say that current oil prices will definitely bankrupt huge sways of US oil production. Most companies have already announced 20 to 40% capex cuts, expectations for production to be lower and by our estimates about five to six million barrels per day of North American oil production are loss making, and that’s of a total of around 12. And in the context of the world’s 100 million barrels per day of consumption, that’s around 5%, which is quite significant. So everyone’s focusing on the demand side at this stage, but there will be a supplier response. We think it will be huge and we fully expect bankruptcies to follow and all the more reason to invest in a company with a very strong balance sheet that may benefit through the cycle deploying capital in a counter cyclical fashion.

 

Julian Morrison:

So if that thesis mentioned here were to play out it might well be a positive thing.

 

Simon Mawhinney:

It most likely would be positive if that does play out, yes.

 

Julian Morrison:

Thanks Simon. Charlie One for you, as a contrarian investor one might expect you to be researching opportunities in the eye of the storm, such as the hated airline, hospitality and gaming sectors. As the pandemic has got worse and implications are now even far reaching, what’s your view there? Are you still looking at those things? I think you touched on that a little bit.

 

Charles Dalziell:

Initially when the whole coronavirus thing started, I think we very much underestimated how much of an issue it was going to be. We couldn’t have imagined the situation we’re in today when it first came out. So we saw opportunities to go and have a hard look at some of the cruise companies, and some of the airlines. We had a very small existing position in a casino as well. But as the pandemic’s gotten worse, our enthusiasm for those airline stocks and cruise ship operators has significantly waned. Particularly when we went into those stress tests, as I discussed. We did see a different casino operator, that we switched our other casino operator out of, and into a new casino operator. So we think there are potential opportunities in that space for the sort of companies that have the right balance sheets. But a majority of those tourism and leisure companies just don’t have that liquidity and financial capability in place.

 

Julian Morrison:

Okay, Simon, a similar question for you. This comes from the view that we are a contrarian investor, I guess. We don’t own many retailers apparently in the portfolio. Why is that? With everyone talking about retail being under pressure, is there contrary view not to buy? Is retail truly dead? And then another question was, are there any sectors where you had no exposure previously, and now you see value? So maybe you can touch on the retail side, and then more broadly sectors which weren’t attractive before, which now are.

 

Simon Mawhinney:

We have owned some retailers. I guess you can split the retailers into two categories. There’s the consumer staples, the Coles and Woolworths of the world. And we’ve owned Coles, although we have very recently sold it entirely. And then the discretionary retailers, the Harvey Normans, the JB Hi-Fi’s, super retail groups of the world. We haven’t got those in the portfolio, you’re right. We had felt that for the most part, they weren’t cheap enough prior to this outbreak. But some of those are looking reasonable. It’s just that they may have reasonably large rental and cost-based imposts and so they’re not as insulated from a reasonably long economic downturn as one might think. But they are beginning to look attractive and in some cases we have, and certainly in one case, we have started to add small position in that retailer.

 

I think the one area where we had no exposure whatsoever is the REITs, that’s before the outbreak. And now we look at it and think actually there are few REITs that are beginning to look attractive. And we’ve done quite a lot of work and dusted a few old files on the REITs. Some of our investors who’ve been with us for some time may recall, during the financial crisis or in the aftermath of the financial crisis, we took REITs in our portfolio up to 25% to 30% of the total portfolio. And there’s a lot about this, which is emblematic of the financial crisis.

 

And then the other thing we were very significantly underweight in and remain underweight in is the banks. I did mention ANZ and NAB in my presentation. We do own those two companies, but our overall banking exposures has been very low. And that’s one area where we would consider increasing quite significantly.

 

Julian Morrison:

Okay, thank you. And Charlie, I’m going a bit more broadly now on that question. I had a specific question on Indian banks. Are they looking particularly cheap? There’s been a big pull back in valuations apparently, is that view of the Orbis team? And then outside of that very specific area, more broadly, that the markets and areas that you think are most attractive?

 

Charles Dalziell:

Yeah we have owned one Indian bank and there hasn’t been a lot of discussions about Indian banks more recently, but that’s definitely an area where we have some expertise. And I think we’ve definitely got one Indian bank, if not more, on our bench. So there’s no doubt the team will be doing some work on that.

 

Julian Morrison:

And other companies in India?

 

Charles Dalziell:

Not that I’ve heard of, not that I’m aware of today.

 

Julian Morrison:

I think you’ve probably covered, especially in the presentation, the areas that look particularly cheap. So we’re going to move on to another question. There’s a few questions to turn to you Simon, with regards to the banks. One was, how do you feel about debt levels that the banks have in terms of leverage to people in businesses? And it relates to the last credit crunch being because of a debt binge. Are we at high levels now? And then there was another question asking, I think with regard to NAB and ANZ’s earnings, is the market suggesting that their earnings will decline over the next 10 years plus, rather than keep pace with GDP?

 

Simon Mawhinney:

Yeah, okay. So all banks around the world are leverage beasts. They are in the business of borrowing huge amounts of money and lending similarly large amounts of money. And in the case of the Australian banks, out of every hundred dollars that they lend, only five or so dollars is truly funded by equity. So they are extraordinarily geared. It’s more like $7, but it doesn’t take away from the level of gearing. Australian households are quite indebted, but serviceability should be quite strong, absent unemployment, which is almost a certain outcome of this downturn.

 

But equally this is the cheapest you’ve been able to buy banks at any time since the 1990s and a lot of what you describe or the question that describes this may happen in terms of loan defaults, et cetera, has at least to some degree been priced into the bank share prices today. They trade at discounts to the NTA. And it’s quite likely we will have an elevated level of loan impairments.

 

So yes, there are some very serious risks which the banks may face, but they are priced for at least some, if not more, than those risks unfolding. And then the second thing is, the banks have entered this period the most capitalised and least indebted they’ve ever been in the past 30 years. And so I think that they’re probably better placed than most to weather the storm.

 

Julian Morrison:

Okay. I’m sorry to come straight back to you, Simon. There’s a couple of questions. Charlie already talked about airlines from a global perspective. There’s a couple of questions specific to Australia. Is that something to be looked at, of interest to Qantas and other Australian based airlines?

 

Simon Mawhinney:

Well, we’re not interested in Virgin, but Qantas we have looked at and are currently looking at. And they’ve made an announcement today that they’ve increased their funding facilities by entering into some secure debt over some of the aircraft that they own. It’s quite clear that Qantas will have a very large cash drag and it’s obviously trying to make some changes to its fixed cost base, employee costs and the like. It’s very unclear how that’ll all pan out. Air New Zealand has received a rescue package from the government, which I think offers a lot of safety in terms of the long term viability of the airline, but doesn’t necessarily be ended up being a good thing for shareholders and that’s something we’re quite conscious of. Qantas will not fail, but that is not the same as Qantas will be a good investment for equity holders.

There are other companies in the travel sector, Flight Centre and Webjet, both of which are currently in trading holds and both of which seem like they will be recapitalised, that we are looking at, that we don’t own currently. But all of these opportunities are ones that we are pursuing and assessing on a case by case basis.

 

Julian Morrison:

Thank you, Simon. I’m going to have to go to you again, because I had two questions on similar subjects. We’ve been in the media for two companies, G8 and oOh!media, both of those apparently. Can you comment on those and their positions?

 

Simon Mawhinney:

Yeah, so oOh!media is 0.2% of our fund. It’s a very small company or small investment for us, or for you our investors, all of us, yet we own about five and a half percent of that company’s issued capital. They’re also in a trading halt. They seem to be well capitalised, but they have decided that they would like to raise equity or it appears they may have decided they would like to raise equity. And so, to the extent they do, we’ll assess any raising on its merits. But that’s very small from our perspective and there’s no hint that the underlying business or our initial equity investment is impaired. It’s been a very recent investment for us.

 

And then G8 is the other one which represents 0.5% of the portfolio. So quite small. But again, we are more than a 5% holder of the company’s issued shares. And so we’ve had to disclose a regulatory filing to that effect. Again, we think that they’re well capitalised, they’re trading normally. And their big issue and the concern is occupancy of childcare centres as parents pull their children out of the childcare centres. And yes, we acknowledge that’s a risk. It’s just not clear how long this will last for and therefore what the impact on their earnings will be. But we think that the company’s current share price supports a potentially extended low or no occupancy level for G8.

 

Julian Morrison:

Sure. Thank you, Simon. A question on gold. Why do you think gold has underperformed during this period of turmoil? Any thoughts on that? Maybe, Charlie, over to you first and then, Simon, back to you?

 

Charles Dalziell:

Well, I think I just alluded to it in my presentation in that selling’s been indiscriminate. Whether you’ve got strong balance sheets or whether you’re a gold mining company, people have been wanting to sell you down. And I think it’s a little bit to do with as markets have moved so rapidly, people have had to look for liquid opportunities to sell out of. They’ve had to look for liquidity in a difficult environment. And the gold stocks just haven’t been spared in that sell off.

 

Julian Morrison:

Simon, any thoughts to add to that?

 

Simon Mawhinney:

I think I agree. The reality is, I don’t know. I have been incredibly surprised at how weak the gold miners have been through this period. Charlie showed Newcrest as one of their top 10 stocks. It is our top stock by some margin and its performance has been disappointing, notwithstanding the recent strength. But this ‘throwing the baby out with the bath water’ expression I think is apt and it’s very difficult to make an assessment of these things over a particularly short period of time, like three or four weeks. We need to see this run its full course and see how these companies do. But certainly relative to the current gold price, Newcrest in both of our cases seems to be extraordinarily cheap and has a very long reserve life. It has next to no gearing and so there’s very little risk that it won’t come out the other side of this tunnel every bit as strong as it went in.

 

Julian Morrison:

A specific question, Simon, on Metcash. It says you’ve been a long term holder of this stock. Are you still positive on the position?

 

Simon Mawhinney:

Yes, I am positive on the position. It’s been a big beneficiary during this crisis. I mentioned earlier that we had sold all of our Coles holding and Metcash has done phenomenally well for us, and it should be no surprise that we’ve also already significantly trimmed our holding in Metcash too. Having said that, I think the company is very cheap. It’s around a $3.3 billion enterprise value company and should generate around $300 million in pre-tax-free cash flow, which is certainly not the cheapest company we own. But it is by far in away one of the more stable companies we own. And it’s an example of a stable earner that doesn’t attract an incredibly high price multiple as the likes of Woolworths, Coles, CSL, ResMed’s, Cochlear. I think I’ll stop there. So yeah, we’re still very attracted to it.

 

Julian Morrison:

I think maybe we can close up now but to summarise, there’s great disparity in the market. I think we’ve gone from an all-time high in various markets to historical low points, that’s not been seen for quite a long period of time. Some stocks may have gone, as I think you alluded to Simon, from a euphoria to slight anxiety. And others have gone from fear to despondency. And there’s a big difference between those things and it’s our job to try and take advantage of those, both globally and in Australia. But we’ll bring to the close the updates.

 

Thank you all very much for joining us. And for your time and for your questions. If you did ask a question, and there were more outstanding so sorry if we didn’t get to them, we will follow up with you. And feel free to contact your relationship manager or our client services team. Contact us at any time. And otherwise, thank you very much to Simon and Charlie for your time. I know you’ve had to change the presentations from day to day or even hour to hour as things have moved on into this, so thanks very much for doing that.

 

And to all of you, keep well, and we look forward to speaking again soon. Thank you.