The Orbis Global Equity Fund (the Fund) lagged the MSCI and FTSE World Indices in 2015, extending a period of underperformance that began in early 2014. As frustrating as these periods may be, they are not inconsistent with superior long-term returns. Graeme Forster and John Christy, from our offshore partner Orbis, explain.
The path of the Orbis Global Equity Strategy’s cumulative relative performance since inception is shown in Graph 1. In order to isolate the performance of our investment decisions, the returns are shown before fees. It is clear that performance does not come in a straight line and Global has underperformed meaningfully during many periods over its history. Some of these have been deep but short, with performance recovering quickly, while others were shallow but uncomfortably long. The one thing they all share in common is the temptation to conclude that something is ‘broken’.
So where do we stand today?
Is this just one of those ‘normal’ periods of underperformance, or is it symptomatic of a deeper flaw in our investment approach? While we can’t predict when performance will improve, we have been here before, and we remain confident that our investment philosophy works over the long term. Part of the reason for this overall assessment is the fact that we quite often see similar performance patterns at the individual stock level.
NetEase: discipline rewarded
As an illustration, consider the Chinese online gaming company NetEase, currently the portfolio’s largest holding. After strong performance over the past 12 months, NetEase now ranks among the top 10 contributors to relative performance in the Fund’s 26-year history. While it is obvious today that NetEase has been one of our best stock selections, it wasn’t always apparent that it would add value. Indeed, as shown in Graph 2, NetEase detracted from the Fund’s performance relative to the FTSE World Index from its initial purchase in August 2008 through early 2013 – a period of more than four years!
As the NetEase example shows, we can never know how long it will take for the stock market to share our view, if at all. Even when we correctly identify a mispriced stock, it can still produce disappointing returns for many years. Likewise, there will be instances when our analysis is wrong, yet the stock still goes on to perform well anyhow. In other words, we will experience our share of good and bad luck, all of which will contribute to the volatility of the Fund’s short-term performance. In the case of NetEase, we spent years getting to know the company and developing the conviction necessary not only to stay the course but to build a larger position.
We continue to find NetEase attractive today. The business is highly cash generative and managed by an entrepreneurial founder, William Ding, who has a strong record of creating shareholder value. With a loyal customer base and the industry’s largest research and development capability, we believe NetEase is positioned to deliver nearly 20% per annum earnings growth from both new and existing games as well as other businesses such as China’s largest email service. NetEase should also continue to benefit from a tailwind of greater internet penetration in China, which at 45% is still low relative to levels in developed markets. While there is no guarantee that the positive potential we see will translate into higher share prices, we are pleased that NetEase remains a part of the Fund.
WITHSTANDING PERIODS OF UNCOMFORTABLE PERFORMANCE IS AN ESSENTIAL PART OF SUCCESSFUL INVESTING
Finding value in China’s JD.com
Another beneficiary of increased Chinese internet penetration is JD.com — which we added earlier this year amid pessimism about Chinese shares. JD is the second largest e-commerce player in China and the country’s largest retailer. While the stock market is concerned about the company’s earnings visibility, we believe this is perfectly normal for a nascent e-commerce player and the investments that JD is making in its logistics and infrastructure network are a critical competitive edge. Trading at less than 0.5 times gross merchandise value, its valuation is well below levels that have proven to be extraordinary long-term buying opportunities for other rapidly growing retailers in the past such as Amazon and Walmart.
US holdings: QUALCOMM and Motorola
Within developed markets, the Fund is positioned in selected shares that we believe will be able to deliver superior returns over the long term, despite generally elevated valuations. Examples here include QUALCOMM and Motorola Solutions, the Fund’s two largest US holdings, which together account for 10% of the portfolio. At a time when valuations in the US look extended after a six-year rally following the global financial crisis, we are excited to be able to identify shares in which our investment thesis is highly company-specific, as is the case with both of these positions.
QUALCOMM develops and owns technology used in cellular communications, and is also a leading maker of semiconductors used in mobile phones and other electronic devices. The company collects royalties from manufacturers on nearly every 3G/4G handset sold globally. Over the past year, QUALCOMM has lagged world stock markets by 30% as the company has been hit with a confluence of negative events in both its semiconductor and licensing businesses. We believe, however, that these difficulties will prove temporary, and that the current adversity offers a compelling opportunity for us as contrarians with a long-term perspective. At just 11 times our estimate of 2016 earnings, the company trades well below the S&P 500’s weighted median multiple of 17 times forward earnings. The shares are even more attractive considering that QUALCOMM’s profit margins are at depressed levels and its net cash and other current assets are worth more than 25% of its market value.
While QUALCOMM’s future growth rate will likely be slower relative to its history, we believe the share price currently reflects assumptions that are far too pessimistic. The company has a durable and predictable earnings stream, which we believe can grow at an above-average rate of about 10% per annum over our investment horizon, driven by increased smartphone sales, especially in emerging markets, and a dominant research and development capability. QUALCOMM can also generate meaningful revenues from previously untapped segments, including notebooks, servers, automobiles and the various network-connected items called the ’Internet of Things’.
Motorola Solutions is an under- appreciated, high-quality business. It is the dominant provider of communications systems for public safety networks and mission-critical applications such as law enforcement and emergency responders. While the market sees a company with dated radio technology that is struggling to grow, we see a company with an entrenched competitive position —about 80% market share—that can deliver revenue growth in the low-mid single digits across the cycle, while generating return on investment of greater than 30%. Although management has already significantly improved the profitability of the business through substantial cost reductions, we see ample opportunity to expand margins with further streamlining of the business. Additionally, we expect the company to return nearly US$5 billion to shareholders over the next four years, equivalent to about 35% of its current market capitalisation. Despite these attractive attributes, the shares trade at less than 12 times our estimate of next year’s free cash flow, a substantial discount to the S&P 500’s multiple of 20 times. Only time will tell whether the market’s current pessimism or our current optimism is better founded.
Investing with conviction
As was the case with NetEase a few years ago, there are a number of large positions in the Fund that have detracted from relative performance since their inception, but in which we still have a great deal of excitement. That’s not to say we are merely being ’patient’ and hoping for the best. Quite the contrary, we are constantly challenging our assumptions about existing holdings — just as we did with NetEase — while actively looking for new opportunities.
We share your pain and frustration as many of these stock selections have yet to reflect the true value that we believe is inherent in the underlying businesses. But we have learned from our winners and losers alike that withstanding periods of uncomfortable performance is an essential part of successful investing and we are confident that our discipline at times like these will be rewarded over the long term.