Over multiple decades, the traditional value approach of buying cheap stocks has worked well. Over the last decade, it hasn’t, leading an increasingly large chorus to proclaim that value investing is dead. While we aren’t textbook value investors, this debate is not academic for us, as the value philosophy and our fundamental, long-term, and contrarian philosophy are intellectual cousins. Value investing has taken knocks before and recovered – can it do so once again?

Our answer is an emphatic yes. It will work in future for the same reason that it has worked well in the past – at its core, its efficacy is driven by thousands of years of basic human nature, specifically the urge to run with winners and from losers. In markets, investors habitually expect the winners to forever thrive and the losers to forever struggle, and they price the companies accordingly.

For value opportunities to emerge, investors first have to overestimate the differences between companies. Widening expectations are essential to value investing. That does not make periods of widening expectations any more comfortable, however. In the 80 years from 1926 to 2006, value shares experienced seven periods of 20%+ underperformance vs expensive shares. The good news? Every one of those periods was followed by significantly betterthan- average outperformance for value.

Yet this long historical perspective hasn’t stopped investors from claiming that this time is different, whether because of technological change, falling interest rates, changing valuation metrics, or even the very awareness of value investing.

Today, valuation spreads globally are unusually wide. On a price-earnings basis, they have only been wider around the Japan bubble in 1990, the tech bubble in 2000, and at the trough of the global financial crisis. We are flexible, however. Although valuation spreads are wide, not all of our favourite ideas are trading at depressed multiples. In the US and emerging markets, we have found more opportunities that offer underappreciated growth potential at a reasonable price. In Europe and Japan, however, it’s a different story – many of the most compelling ideas we’ve found there trade at very low valuations.

European value: BMW
Trading at 0.8 times book value and just six times depressed 2018 earnings, BMW is trading at an all-time low valuation due to concerns about the global auto industry.

Globally, the push for battery electric vehicles (BEVs) is a headwind to automakers’ profits. Customer demand, however, is not yet high enough to allow manufacturers to sell BEVs at prices that generate sustainable profits. Whilst this is challenging over the short term, over the medium term, we think it’s more likely that consumers, rather than manufacturers, will pay the cost of reducing emissions via higher prices.

BMW’s premium brand has helped it earn roughly 15% return on equity and grow its book value whilst paying out a third of earnings as dividends. We believe a re-rating to just 1.1 times book value, coupled with modest growth and a wellcovered 5.5% dividend yield, could drive very attractive returns for BMW shares over our investment horizon.

Japanese value: Mitsubishi, Sumitomo and Mitsui & Co.
General trading companies are best thought of as industrial conglomerates. Their subsidiaries deal in vastly diverse businesses and in effect, their fundamentals unsurprisingly tend to track those of the Japanese economy as a whole.

In 2013, however, the market was concerned about the companies’ resource businesses, leading the stocks to trade at a discount to their book value. We bought positions in Mitsubishi and Sumitomo for the Orbis Global Equity Fund in 2013, adding Mitsui later. Our thesis was that their assets would generate reasonable, sustainable profits, and that improvement in capital allocation could drive a re-rating and attractive returns for shareholders.

On the asset side, there have been hiccups. Amid the commodity crash from 2014 to 2016, the companies took write downs, leading to Sumitomo’s first annual loss in 15 years, and Mitsubishi’s and Mitsui’s first losses in over 40 years. Since then, however, the companies’ biggest commodity segments have recovered. The companies have also become better at allocating that cash flow by investing more carefully in new projects, paying down debt, and making higher payouts to shareholders.

Yet that improvement has not been rewarded with appropriately higher valuations. Today, all three companies trade at a discount to their book value and just seven times earnings, with dividend yields above 4%, despite earning higher returns on equity than the broader Japanese market.

Focusing on intrinsic value
In today’s market environment, valuation spreads look unusually wide, and we have uncovered a number of attractive value shares, particularly in Europe and Japan. With opportunities like these on offer, we believe time will prove that today’s reports of the death of value investing were – once again – greatly exaggerated.

Adapted from an Orbis commentary contributed by Michael Heap and Brett Moshal, Orbis Portfolio Management (Europe) LLP, London

For the full commentary please see www.orbis.com

Contrarian investing is a strange profession. When things are going well, you can look like a magician - earning extraordinary returns while others flounder. At other times, you can follow precisely the same process and look hopelessly out of touch. We have spent an embarrassingly large amount of time in the latter camp of late.

In truth there is very little alchemy to our approach, in either the positive or negative direction. The fluctuations in relative performance mask what is ultimately a rather solitary endeavour: studying financial statements and waiting patiently to purchase shares of good businesses at a discount. The challenge at times like this, as expressed so eloquently by Rudyard Kipling in his most famous poem, is to ''meet with triumph and disaster, and treat those two impostors just the same.''

Markets tend to do the opposite. Share prices, driven by fickle human emotions of greed and fear, are far more volatile than the fortunes of the real companies they represent. Exploiting these emotional extremes is what enables the contrarian investor - with a focus on intrinsic value and a willingness to be different - to earn superior long-term returns.

Unfortunately, we don’t get all our investment decisions right. We recognise that we have tested your patience and lost the authority simply to say ''trust us.'' But if you can allow us a bit of enthusiasm, we believe the value inherent in the portfolio increasingly tells an exciting story.

Our definition of a bargain lies in the ''sweet spot'' between price and quality - an above-average company trading at discount price. In the market environment of the last few years - characterised by insatiable appetite for perceived ''safety'' - we have found such opportunities to be rare. Instead, the above-average companies have been expensive, while many of the discounted ones have been cheap for good reason.

Encouragingly, the stocks held in the Fund today are significantly cheaper than the World Index and they are fundamentally better businesses. Honda Motor is an example. At current prices, Honda’s valuation is trading below levels last seen during the global financial crisis. But what about self-driving cars, the trade war, ride-sharing and electric cars? While the risks facing Honda are pertinent, our assessment is that they may ultimately prove to be overblown over our investment horizon. Instead of seeking to predict the future with certainty, our approach is to assess the full range of possible outcomes, and to compare that with the expectations embedded in Honda’s current share price.

The results are illuminating. At only 0.7 times tangible book value, Honda’s shares are trading at less than half their long-term historical average rating, and are embedding a significant destruction of value that we believe is wholly inconsistent with the company’s four-decade history of consistent profitability. It is true to say that the transition to electrified vehicles will be a challenge for all car makers, but it’s sobering to recall that - even some 15 years after Elon Musk founded Tesla - electric cars still only made up two out of every 100 cars sold globally last year. As for all the hype around ride-sharing, it’s easy to forget that the most common form of shared vehicles have been around for decades (we used to just call them ''taxis.'')

At $45 billion, Honda’s current market price seems to ignore its most attractive asset. Honda is the world’s largest motorcycle manufacturer with a dominant (75%+) share in emerging markets such as Thailand, Vietnam, Indonesia and Brazil. Giving due credit for this gem of a business, one almost gets Honda’s car manufacturing business (with its $100 billion of revenues) for free. Such are the opportunities that become available when investors focus relentlessly on predictability.

Looking more broadly at the current portfolio, we see similar mispricings for many other high-quality businesses. For example, there are three China-related shares - NetEase, Autohome, and Naspers (Tencent) that stand out as highly profitable, cash-rich entrepreneurial businesses with above-average growth prospects. Together these comprise 18% of the Fund and more than half of the Fund’s emerging markets exposure. Clients have often asked how we get comfortable with this positioning, particularly amid a raging trade war and protests in the streets of Hong Kong. Our answer is that being ''comfortable'' isn’t our goal - delivering superior risk-adjusted returns is - and the two things don’t always go together.

That’s not to say all of our stock selections will turn out to be great investments. But it is fair to say that the individuals managing your capital - and our own - are feeling significantly more excited about the portfolio today than we have been for some time. We remain humbled by your persistence and determined to earn your trust and confidence. Over the quarter, most of the concentrations in the portfolio were unchanged. The largest individual purchase was a German car manufacturer, BMW, and the largest sale was a US biotechnology company, Celgene.

Adapted from an Orbis commentary by Ben Preston, Orbis Portfolio Management (Europe) LLP, London.

For the full commentary please see www.orbis.com

The Orbis Global Equity Fund aims to deliver higher returns than world markets, but that is not its whole mandate. Crucially, it also aims to deliver those higher returns without taking on a greater risk of a permanent loss of capital.

Risk is likely front of mind given our recent performance. Periods of underperformance are painful, but in them, our job is to remain disciplined. The underperformance year-to-date has been driven chiefly by three shares: logistics firm XPO Logistics, drug developer AbbVie, and Chinese internet firm NetEase. Our thesis for each company is unchanged, and the Orbis Funds’ stake in these companies has increased over the quarter. We view these situations as disagreements with the market, not permanent losses of capital. The latter is the risk we aim to assess and manage.

Risk assessment and management begins at the stock level. More things can happen than will happen, so our forecasts consider a range of probable paths for a company’s intrinsic value. We do this for every stock, yet we recognise that combining these independent ideas could produce unintended consequences at the portfolio level. With that in mind, it is important to take a step back and ensure we are comfortable with the portfolio’s positioning and confident that the risks taken are adequately balanced with the potential upside.

To inform this broader perspective on the portfolio, our Quantitative and Risk team works closely with our investment decision makers. In its analysis, the team has two main jobs: 1) to monitor and assess the risks in the portfolios and 2) to find and highlight attractive dislocations in the opportunity set. Using proprietary tools, the team applies objective analysis to challenge our equity analysts’ bottom-up views.

One exposure sticks out. The portfolio is overweight stocks that have higher-thanaverage economic sensitivity. That exposure can increase the portfolio’s volatility, yet we’re comfortable with that exposure because it helps us reduce the portfolio’s valuation risk, which is the risk of losing money by paying too high a price for an asset.

In our view, the riskiest thing an investor can do is overpay for an asset, so when we look at an exposure, our question is always, "What do we get paid for taking this exposure, and what do we have to pay to avoid it?" For stocks like XPO and BMW that behave cyclically, we find that risk is more than compensated for by low valuations that look attractive over our long-term investment horizon.

The other side of that question is also interesting. What do we have to pay to avoid cyclical exposure? Today, stocks perceived to be defensive are trading at lofty levels that we believe are disconnected from the companies’ underlying fundamentals. You have to pay a steep price to avoid cyclicality. This presents valuation risk, which we are not comfortable taking.

Valuation risk is interesting because as valuation risk gets lower, a stock’s return potential becomes more compelling. This gets into the second main job of the Quantitative and Risk team: to find and highlight attractive areas in the opportunity set. At present, the dislocation between low- and high-multiple shares is particularly interesting. ''Value stocks'' and ''growth stocks'', here defined as shares that are cheap (value) or expensive (growth / anti-value) on a price-to-book basis, deliver their returns in different ways. To see this, we can break their returns into parts: growth in fundamentals, change in valuation, and dividend yield.

Value has historically outperformed growth, and the biggest driver has been changes in valuation. Value shares have done well, by starting off cheap and becoming less cheap when the market realises things are not all that bad. For value investors, valuation risk is low.
For the growth style, most of the return comes from growth in fundamentals. However, the market often overpays for this growth, leading to a price de-rating when fundamentals disappoint. For growth investors, valuation risk is high. Contrarian investing spans the two styles. We are comfortable holding fastgrowing stocks if we feel the market’s valuation is not capturing the company’s future growth potential.

Historically, value has beaten growth, but since June 2007, the market cycle has been difficult for value stocks. While the style’s underperformance has not been as sharp as in some past periods, this is now by some distance the longest ever drought for value shares. A few headwinds have contributed to this underperformance, the most significant being the starting valuations of value stocks. Having outperformed during the run-up, value stocks were not especially cheap going into the global financial crisis (GFC). As a result, the potential for a post-crash re-rating was lower. In fact, value stocks have actually de-rated from June 2007 to today, a stark contrast with their historical performance, while growth shares have de-rated much less than they have over the longer term.

By definition, value stocks are always cheaper than growth stocks, but sometimes they are only slightly cheaper, and sometimes they are vastly cheaper. Today we see the latter, on a global basis and within individual sectors in the US. Interestingly, this widening gap has been driven almost entirely by expensive stocks getting more expensive, rather than cheap stocks getting cheaper. This also confirms what we’re seeing on a bottom-up basis. Our most attractive ideas in the US have not been stocks with the very lowest valuation multiples, but high-quality businesses, such as AbbVie and Celgene, that are trading at undemanding valuations.

Perhaps valuations for the most expensive stocks are justified given their aboveaverage profitability, but that profitability looks stretched, - it has never been higher. Many of the richest stocks seem priced for perfection, leaving plenty of room for disappointment and substantial valuation risk. We are happy to avoid them.

Yet what comes next is difficult to predict. In the most substantial bubbles of the past, valuations looked stretched for months or years before the peak. So, while we are unusually enthusiastic about the relative return potential of the Fund, the path of future returns is highly uncertain. If things get more stretched, the path could be painful, as more investors capitulate. But the very difficulty of remaining patient is precisely what makes patience so rewarding over the long term.

Over the quarter, most of the concentrations in the Fund remained unchanged. The concentration in UK Consumer Staples has increased driven in part by adding to British American Tobacco and Imperial Brands. The largest individual purchase was in a specialty financial services company.

The last year was brutal. It offered more than its share of pain and was deeply disappointing. The Orbis Global Equity Fund lost about 20% of its value in 2018 - more than twice that of the broader decline in global equities. About 60% of our stock selections underperformed, consistent with similar bouts in the past. Emotionally, however, it felt more like 100%. Our craft is to acknowledge and set aside those emotions to capitalise on the advantage this emotional control offers. It’s the actions we take now and in these situations that will compound to make the greatest difference.

Successful long-term investing is not about avoiding these uncomfortable times, but rather about having the courage to embrace the rewards that they can offer. Nothing illustrates this better than our recent experience with XPO Logistics. When we last wrote about the company in the first quarter of 2018, it was the Fund’s largest position and trading at about US$100 per share. The company, one of the largest transportation and logistics companies in the world, had a productive start to the year and was the top contributor to the Fund’s performance for the nine months ended 30 September. As recently as October, XPO shares traded at nearly US$115 before hitting an intra-day low of US$41 in mid-December. Much of this seemed to be fuelled by a combination of concerns about the global economy as well as a sharp rise in risk aversion.

The most visible part of the rout was a sensational 70-page ‘sell’ report from a short seller on 13 December. The previous day, the more substantive development was XPO’s reduction of its 2019 guidance for operating cash flow (or EBITDA) from 15% to 18% year-over-year growth to a lower 12% to 15% range, given softness they cited in Europe. What followed over the next several days was a period of intense primary research, thesis interrogation and reflection.

XPO’s stock has demonstrated huge price volatility at times and has not been a stock for the faint of heart. But what really matters to us is intrinsic value. Is the company worth massively less than our own internal estimates and 50% of what it was a few months ago? In our view, the answer is ‘no’. None of the principal claims in the short seller’s report hold up relative to our primary research, and we calculate little impairment to XPO’s intrinsic value.

To use a technical term, we believe the opportunity to own XPO at current prices is ‘juicy’. In XPO, we pay about a 40% discount to the S&P 500, yet we get what we regard as a world-class business that plays in a large, growing addressable market; owns scarce supply chain assets; earns high incremental returns on capital and is a prime beneficiary of the secular boom in e-commerce. We expect XPO to organically grow its free cash flow at a mid-teens rate annually over our investment horizon, with acquisitions as an incremental kicker. We have taken advantage of the recent sell-off to begin rebuilding the Fund’s position and have now bought back nearly the entire amount that we trimmed earlier in the year. And XPO, for its part, has also used the opportunity to authorise a US$1 billion buy-back of its own shares - equivalent to 15% of shares outstanding.

While we believe the hurt experienced in XPO will prove rewarding in time, in other cases the sell-offs have just plain hurt. Another key detractor in 2018 was Pacific Gas & Electric (PG&E), which collapsed by more than 50% in early November as the worst wildfires in the history of California raged. We built our PG&E position to a bit over 2% of the Fund after state legislation was passed this summer that authorised a process to fund wildfire claims from 2017 as well as future claims. The legislation had a quirky loophole and did not address claims that might occur in 2018. We recognised this as a risk at the time, albeit a low probability one. Sadly, that risk was realised and it appears the fires could result in liabilities of more than US$10 billion. At this point, the prospect of bankruptcy is real. It was our judgement that the odds of further downside was meaningful relative to the potential upside, so we exited the position in November.

What’s striking in each of these examples is how swiftly and almost irrationally the shares were punished. The insatiable appetite for perceived ‘safety’ has been quite punitive for the types of shares that we currently own, but we believe these market conditions represent opportunity for those who can take a more patient view.

The same can be said of investing with Orbis. Some of our most rewarding decisions have come at trying times for our clients. Our Global Equity Strategy has lagged the MSCI World Index by more than 10% multiple times in its nearly 30-year history. But here is the silver lining - all prior drawdowns proved rewarding for those who could endure the discomfort and look to the horizon.

Today we find ourselves at another painful juncture. Stepping back and looking at the portfolio, a number of companies are trading at fat discounts to our intrinsic value estimates - and some of these discounts look extreme. While we would not count on a quick rebound, we can say that a large portion of what we own is squarely in the ‘juicy’ bucket and in those cases, we have either already added capital or are eagerly waiting to add more.

Over the quarter, most of the concentrations in the Fund were unchanged. One exception is our exposure to UK Consumer Staples, which is a new key concentration in the Fund. This was driven in part by adding to Imperial Brands, a multinational tobacco company. The largest individual purchase was Naspers.

Adapted from an Orbis commentary by Adam Karr