Emerging markets have come under intense focus so far this year and while the main worries have centred on countries such as Argentina and Turkey, the market wobbles in 2014 have refocused attention on the health or otherwise of the Chinese economy. As a bottom-up stock picker, Orbis does not invest based on a top-down macro view. However, as 7% of the Orbis Global Equity Fund is invested in Chinese stocks, it is not surprising that clients have been asking about Orbis' view on the country's economy. Seema Dala highlights the trends that appear to be increasingly problematic, and outlines how Orbis has incorporated these into its bottom-up approach. She also discusses some opportunities Orbis has found in developed markets, despite valuations looking stretched overall.
Economists tend to look at credit growth as a key predictor of future financial instability. Throughout history, excessive credit growth and an accompanying property bubble have often been followed by an economic bust. Because of this, Orbis is mindful that some of the conditions that preceded the world's recent financial crises resemble the current environment in China.
Since the November 2008 stimulus package designed to mitigate the shock of the global financial crisis, China's outstanding total social financing (TSF), an approximate measure of the country's debt, has expanded at a compound annual growth rate of about 23%. As a result, China's debt-to-GDP ratio soared from 130% in 2008 to about 200% in 2013. The scale of this expansion outstrips that experienced by either Japan in the late 1980s or the US in the years before 2008. This is of increasing concern given the deceleration in underlying economic activities as measured by indicators including retail sales, Purchasing Managers Index, power generation, railway cargo volumes, port cargo throughput and GDP growth, the latter of which is shown in Graph 1.
Despite ballooning credit, many parts of the real economy have suffered from difficulty in accessing bank loans and rising interest costs, while overcapacity issues have worsened in many capital-intensive industries. Indeed, the Producer Price Index, a measure of the prices of goods as they leave the factory, slipped from 1.7% in 2011 to -1.9% in 2012 and -1.4% in 2013. One explanation for all this is that a large portion of capital invested in China has been misallocated to projects with poor returns and cash flows, such as infrastructure and oversupplied industries. These projects are frequently state-owned or 'too-big-to-fail' yet continue to access financing under China's state-owned banking system. As these 'zombie' projects continue to absorb the credit supply, the provision of credit to other parts of the economy has become crowded out, forcing more financially healthy private enterprises to pay higher rates of interest.
Exacerbating the emerging credit bubble is the duration mismatch between assets and liabilities. On the asset side, an increasing portion of credit has been plunged into very long-term assets, such as infrastructure, property and industrial capacity. However, as shown in Graph 2, financing for this has come increasingly from the shadow banking sector in the form of trust loans, bank acceptances and entrusted loans, which can have short durations and unsteady flows. These shadow banking products are financed in turn by funds with shorter durations, such as interbank lending, which can be callable in as little as one month.
So far, different parts of the Chinese government have allowed the debt binge to continue by bailing out many potential defaults. However, Orbis worries that the scale of non-performing debt might become too great to be bailed out and defaults will surge.
So why invest in Chinese stocks at all?
To answer this question, it is important to remember that Orbis invests clients' capital in shares they think are undervalued irrespective of developments in an economy, and strives to avoid companies that derive meaningful profits from unsustainable activities and depend on short-term funding. For these reasons Orbis has found few shares in certain sectors, such as banks, property developers, miners and investment-driven stocks. However, the Chinese market is diverse and Orbis has found appealing stocks in other areas, such as the technology sector.
Over half of the Orbis Global Equity Fund's Chinese exposure is allocated to two names, Sohu.com and NetEase, both of which have very strong balance sheets and derive the majority of their earnings from consumers' desire to play online games. They are also geared to the secular growth of Chinese internet usage – a trend Orbis believes is largely independent of their concerns with the Chinese economy. Orbis does not believe the market has priced in their long-term growth potential.
Opportunities in the developed world
By contrast, many developed market valuations are looking stretched. Despite this, there are some sectors where Orbis believes the stock market is overly pessimistic about short-term developments. The media sector, for example, is a cyclical industry where the future is likely to resemble the past and the markets' concerns may be resolved in the fullness of time. Orbis currently owns a selection of media shares, in particular cable companies, which together account for 9% of the Fund.
Cable companies stand out as owners of high-quality assets because in many markets they have a monopoly for high-speed broadband, which has increasingly become a 'must have' service. With broadband penetration in the US and Europe still only in the 30-40% range of potential customers, Orbis believes cable has considerable room for future growth, and cable stocks have been mispriced. Naysayers often point to the trend of 'cord cutting', in which customers cancel their cable video subscriptions in favour of online services such as Netflix. Orbis believes this concern is overdone for a few reasons. First, even though Netflix has more than 30 million subscribers in the US – and many more in reality through widespread password sharing – video subscriber losses at US cable companies have been relatively limited, supporting Orbis' view that these services are being used to complement, rather than to replace, cable. Second, Orbis believes traditional cable continues to offer tremendous value to most consumers.
The Fund also stands to benefit from specific factors unique to each company. Charter Communications, for example, can be considered a 'turnaround thesis' in which Orbis expects the future to be very different from the past. Under previous management, the company had underperformed its peers on most operating metrics, but it is now being run by a team of proven cable operators. Meanwhile, Charter's largest shareholder, John Malone, is arguably the industry's best deal-maker and capital allocator. Orbis expects capital spending to normalise after Charter completes its roll-out of new, all-digital equipment. At that point, they expect that the company will be able to earn about US$14 in free cash flow per share. At the current share price, this means that the business yields a more than 11% per annum stream of cash that the company can reinvest or return to shareholders.
A second example in the Fund is Liberty Global, which is a 'consolidation thesis'. Controlled by Malone, Liberty's shares are listed in the US but nearly all of its operations are in Europe. Liberty is steadily gaining market share and subscribers in some of Europe's largest markets. This comes as little surprise to Orbis, as Malone pursued a similar strategy in the US. Orbis established its position last year at an attractive price when the stock was under heavy selling pressure from investors seeking to hedge their exposure to Virgin Media, a UK cable provider that was bought by Liberty. Orbis recently had a similar opportunity to add more shares after the announcement of Liberty's acquisition of Ziggo, a leading Dutch cable company.
In both situations, the market did not give Liberty enough credit for the attractive price being paid and the synergies resulting from consolidation and capital structure changes. As the dust settles from Liberty's recent acquisitions and synergies are realised, Orbis estimates that the company can earn US$4.50 in free cash flow per share – a more than 10% yield to reinvest or return to shareholders. Orbis finds this particularly attractive considering that Liberty's cash flow can continue to grow steadily at a high single-digit rate as more subscribers are added and there is potentially further upside from shareholder-friendly capital allocation decisions.
Long-term outlook gives perspective
Only time will tell how global stock markets will fare in the year ahead. Every investment environment has a set of risks, and this one is no different. Orbis' experience has shown that some of the best opportunities arise whenever fear or uncertainty give rise to short-term thinking or forced selling on the part of other market participants. As always, Orbis seeks to take advantage of both their long-term perspective and a willingness to see things differently – an approach that has served Orbis well through a wide range of market environments.