As 2019 draws to a close, we are more excited about the Orbis Global Equity Fund’s positioning and its ability to outperform world markets than we have been for some time. But we recognise that the past two years have been stressful, and our upbeat message may be testing your patience. While the Fund’s net return in US dollars was a healthy 21% this year, it failed to keep up with the blistering 28% pace set by the FTSE World Index and was especially disappointing following the underperformance of 2018.

At times like this, it is natural to look for things that have gone wrong, so let’s start there. Before the outperformance we’ve seen in the last quarter, there were 17 stocks in the Orbis Global Equity Fund that detracted significantly from performance over the relative drawdown period from March 2018 through July 2019. The events that have caused these stocks to lag had no common theme. Out of these 17 major detractors, we continue to hold 11 and have sold out of six. In three cases – NetEase, AbbVie and XPO Logistics – we took the opportunity to increase our exposure. While it is too early to tell whether this was the right decision, these stocks have all recovered significantly from their lows.

But detractors are an inevitable part of investing – at best we will only be right about 60% of the time over the long term. The bigger problem over the past two years has been an unusually short supply of winners to offset the losers. Since inception, our average winner has outperformed by 34%, but over the last two years, it has outperformed by just 12%, while our losers have lagged by about as much as they have historically.

It may not sound particularly insightful to say, but we haven’t been invested in parts of the market which have done well. Among the best-performing areas of the market have been growth stocks, US large caps, and shares exhibiting low volatility. While this has been painful, we believe it is in the best interests of our clients to be disciplined and avoid areas where valuations appear stretched. The most extreme examples can be found amongst the low-volatility shares, many of which are also based in the US. These include household names such as Coca-Cola, Pepsi and Procter & Gamble.

Given the investment environment today where more than US$11 trillion of bonds have negative yields, many asset owners are struggling to find a new safe haven. As they try to find an alternative for their bond exposure, one of the common alternatives they have sought is the stock market. But as reluctant equity investors, they are turning to the equities which are most bond like – very defensive, stable businesses which have a reliable dividend. These low-volatility shares have attracted so much investor demand that their share prices have been pushed to extraordinarily high valuations.

This is a frightening picture for a value-oriented investor. If you go back to basics, there are only three variables that can drive a stock’s long-term return: the dividend yield, future earnings growth, and any change in valuation. With these mature companies, dividend yield – where you can have the most confidence – is paltry at 2%, future growth seems to us unlikely to be as good as it was in the past, and valuations are already well above average – perhaps unsustainably so. While the risk of Coca-Cola or Nestlé going out of business is close to zero, that’s not the same thing as being a “safe” investment. You can still lose a lot of money by paying more for a stock than the underlying business is actually worth.

To end with a specific example, we can compare one of the Orbis Global Equity Fund’s top 10 holdings (Honda Motor) with one of the market’s current favourites (Nestlé). Nestlé’s long-term return on equity has been about twice that of Honda’s, so, it wouldn’t be surprising to note that through much of history, Nestlé has traded at roughly twice the price-to-book value multiple of Honda. What is striking, however, is the recent divergence in valuations. Today, Nestlé trades at eight times the price-to-book multiple of Honda!

Of course, this is just one example, but it is indicative of a broader theme. The Orbis Global Equity Fund’s holdings trade at just 18 times normalised earnings on average versus 28 times for the benchmark, despite having better future growth prospects and a higher dividend yield. There seems to be such an unquenchable thirst for stability and safety at the moment that valuations no longer matter. They still matter to us.

We can’t tell you when the market will come to share our view. But we don’t have to because the long-term fundamentals are on our side. When we compare the areas where we have invested your capital to those that we have steered clear of, we can’t help thinking of a quote by former world chess champion Garry Kasparov: “Losing can persuade you to change what doesn’t need to be changed, and winning can convince you everything is fine even if you are on the brink of disaster.”

With that in mind, we are sticking to our knitting.

Over the quarter, most of the concentrations in the Fund were unchanged. The largest individual purchase was a Mexican beverage company, Fomento Económico Mexicano UBD. There were no significant sales over the quarter. Adapted from commentary contributed by Matthew Spencer, Orbis Investment