Russia’s invasion of Ukraine is a painful reminder that there is more to life than markets, and our concern goes out to the people suffering. As investors, our job is to assess the impact on our clients’ portfolios. Alec Cutler, from our offshore partner, Orbis, focuses on the Orbis SICAV Global Balanced Fund.
Coming into this year, the Orbis SICAV Global Balanced Fund (“the Fund”) held no Russian positions. We did hold BP, which has since walked away from its 20% stake in Rosneft, but we sold out between late January and mid-February, feeling that the Russia-related risk was underappreciated. We recycled much of the cash from BP into more attractive energy ideas.
We recycled much of the cash from BP into more attractive energy ideas.
In markets, the conflict has accelerated shifts that had already begun – towards higher inflation, shortages in energy and commodities, a retreat from globalisation, and rising geopolitical risk. We have worried about these risks for some time, and have sought to mitigate them in the Fund.
The Fund has fared much better than its 60/40 benchmark amid the conflict-related volatility. As already-high inflation has eclipsed 7% in the US, 10-year Treasury yields have risen from 1.5% in December 2021 to 2.3% today. That has punished global government bonds, which have lost 6.2%. It has also punished the richly priced growth stocks that are valued on future hopes rather than present profits. While global value shares are roughly flat this year, the Nasdaq is down 9%.
Those moves feel huge if you’re reading the headlines every day. But they have barely made a dent in the trends of recent decades. Bond yields remain near 120-year lows in the US, 260-year lows in the UK, and 700-year lows globally. And over the past 15 years, the Nasdaq has only once been more richly priced relative to global value shares – and that was during the COVID-19 lockdowns.
We continue to believe that buying businesses for less than they are worth is the surer way to avoid losses.
So while our cash, gold, inflation-linked bonds and hedged equity positions have (finally) thrashed conventional bonds this year, we continue to find those assets very attractive compared to the return-free risk of long-term nominal bonds. Similarly, owning neglected shares has worked much better than paying up for the perception of perpetual profitable growth thus far this year. We continue to believe that buying businesses for less than they are worth is the surer way to avoid losses. Will the real defensives please stand up?
Bell-bottoms, government cheese and UB40s
The shifts towards higher inflation, scarcer resources, and a more divided world did not start on 24 February. Many aspects of the current environment recall the 1970s: monetary stimulus, policy experimentation, fiscal stimulus, politicians’ intolerance of recession, supply-driven commodity inflation, resurgent labour, and geopolitical upheaval – all scary similarities. In that era of bell-bottoms, government cheese and UB40s, the prices of stocks and bonds went down, while the price of everything else went up. In real terms, investors in a US 60/40 portfolio got 3% poorer every year for a decade.
Some aspects of the current environment look worse than in the 1970s, despite official reassurances. Having printed money at an unprecedented rate, central bankers are now talking up their self-described “toolkits” to manage inflation. In the UK, the Bank of England’s toolkit apparently includes telling workers to show “restraint” in pay bargaining. Such aloofness is not unique to the UK. In the US, Federal Reserve chair Jerome Powell has called the job market “tight to an unhealthy level”, and he has drawn comparisons to Paul Volcker for his tough talk on inflation. Mr. Powell may need an orthodontist after all that jawboning – real interest rates in the US are at their most negative levels in 40 years.
Yet inflation expectations have continued to rise. That is dangerous, because inflation is unlike most financial risks. With most financial risks, the more you worry about it, the less likely it is to happen. With inflation, the more you worry about it, the more likely it is to get worse.
Inflation is not the only area where Russia’s invasion has exacerbated trends that were already underway. In the Fund, we have found opportunities aligned with three of these trends: a global energy crisis, a global food shortage, and a resumption of the Cold War. Each of these represents a reversal of the prevailing trends in recent decades, and each could shape the world for decades to come.
Global energy crisis
We have expected a supply crunch in energy for some time. Over the past seven years, oil producers have underinvested to the tune of hundreds of billions of dollars, chastened by the price declines of 2014-2015, the negative prices of 2020, and growing environmental, social and governance (ESG) pressure throughout. By early February this year, oil prices had risen to US$90 a barrel, but were still not enough to coax production growth out of listed producers and their bruised shareholders. At the same time, OPEC producers with scant spare capacity are struggling to meet their own production quotas, and despite record draws from the US Strategic Petroleum Reserve, commercial petroleum inventories are at their lowest levels since 2014.
Then Russia invaded Ukraine, immediately rendering 10% of world oil production and over 30% of Europe’s gas supply insecure and toxic. As the world divides between oil producers and consumers, and between consumers willing to buy from Russia and those who aren’t, we look to be on the cusp of a global energy war. It is becoming obvious that the US must lead the way in providing the West, and Europe in particular, with energy security. In fact, Europe and the US have already signed an agreement to increase transatlantic liquefied natural gas (LNG) shipments.
The most obvious beneficiaries are responsible Western companies that can contribute to the energy security effort. Much of that LNG will be handled by Shell, one of the world’s largest LNG producers and traders. 40% of gas consumed in the US flows through the pipelines of Kinder Morgan, which also owns stakes in LNG export terminals. As European LNG demand boosts prices in Asia, gas producers in Australia such as Woodside and Inpex will benefit. And companies like Schlumberger and Hunting, which provide the technology and equipment to increase oil and gas production, stand to benefit as countries and companies finally attempt to increase supply.
As obvious as all that seems, this is not reflected in valuations. Shell, Woodside and Inpex all trade at more than 20% free cash flow yields on today’s US$105 per barrel oil price, and on double-digit free cash flow yields with lower long-term oil price assumptions. The share prices of Schlumberger and Hunting are 50% below their 2018 levels, despite what we see as a far brighter outlook. And Kinder Morgan offers a well-covered 5.7% dividend yield that is backed by inflation-linked “take or pay” contracts where customers must pay for pipeline volumes whether they use them or not. Over the past few months, we have rotated the Fund’s energy holdings from politically vulnerable producers towards the more neglected services firms, while maintaining the overall energy exposure near 20% of the portfolio.
Longer term, the energy shortage may hasten Europe’s desire to increase energy efficiency and transition to renewable power. One of the easiest efficiency wins is to use LED light bulbs, which should provide a tailwind to Signify, maker of Philips-branded LED bulbs. Yet it too offers a double-digit free cash flow yield. And investment in renewable energy should support both the wind turbine and electrical grid equipment businesses of Siemens Energy, whose stock price has languished near its lowest levels since listing in late 2020.
Global food shortage
Russia is by far the world’s largest wheat exporter, and in normal times, Russia and Ukraine together account for a quarter of the world’s wheat exports. As that supply is threatened, food prices have spiked globally. Replacing any lost supply will be made more difficult by high prices for potash and natural gas, two key ingredients in fertiliser production. Russia and Belarus are two of the world’s largest potash producers and are constraining exports. That will make it essential for producers in other regions to maximise crop yields.
The Fund also gains some protection against rising food prices through its Treasury Inflation Protected Securities.
Top holding Bayer, with its world-leading portfolio of yield-enhancing seeds, fertilisers and pesticides, may be due a reappraisal. Once loathed for genetically modified seeds and Roundup (glyphosate), Bayer now seems utterly forgotten, even as its Roundup legal fortunes improve. As it dawns on countries that food can be scarce, Bayer should enjoy healthy demand for its products, yet it trades for less than 10 times earnings. Nufarm, a smaller Australia-listed agribusiness, should enjoy similar tailwinds.
The Fund also gains some protection against rising food prices through its Treasury Inflation Protected Securities. The principal value of these bonds adjusts according to changes in consumer prices, and food and energy account for roughly a quarter of the consumer price basket.
The Cold War resumes
With Russia’s invasion of Ukraine, the era of predictable European and Asian peace that started in the early 1990s is now well and truly eliminated – along with all of the economic blessings that came with it. With the peace dividend gone, countries and alliances need to make up for a decades-long investment deficit in defence. That need is being felt most acutely in Europe and Japan, where defence contractors have performed poorly for 20 years, recently exacerbated by investor unease about the social responsibility of investing in those firms. Now, we appear to be on the cusp of a boomerang-like turn in both fundamentals and sentiment.
On the fundamental side, European powers are already ramping up defence spending, and are favouring local contractors such as BAE Systems, Saab, Rheinmetall, Rolls-Royce, Leonardo and Thales. Japan and Mitsubishi Heavy, the maker of Japan’s military ships and aircraft, are experiencing a similar dynamic. Together these represent over 4% of the Fund following their recent outperformance. Most offer high dividend yields that are well covered by cash flows on current contracts, with additional upside should defence spending increase. And on the sentiment side, investors are reassessing the importance of defence companies in protecting liberal democracies.
… we remain enthusiastic about the Fund’s long-term relative return potential.
We did not buy these companies because we foresaw events in Ukraine. But as relations between former Cold War rivals have gone from tepid, to cool, to frosty over recent years, we believed rising geopolitical risks were not reflected in their valuations, and we had been slowly building positions for several months. At the end of January, before the conflict, these shares represented 2.5% of the Fund.
A yawning gap
Amid all the volatility of recent months, we have resisted the urge to trim positions that have performed well in favour of shares that have recently started to lag. In our view, the boomerang in markets has only started to turn, and the much-discussed “value rotation” is mainly a sell-off in shares that looked absurdly expensive before and still look extreme.
After a good quarter for relative returns, the equities in the Fund still trade at a 30% discount to the MSCI World Index on price-to-earnings, and a 40% discount on a free cash flow basis. Accordingly, we remain enthusiastic about the Fund’s long-term relative return potential.