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Perspectives

Ignore the ‘bond-like’ stock boom and seize the opportunity in uncertainty

Graeme Forster
Adam Karr
By Graeme Forster and Adam Karr
September 2017
5 mins. To Read

As bottom-up stockpickers, we love idiosyncratic opportunities—situations where a company trades at a discount to intrinsic value for reasons specific to that company. We also love clustered opportunities, where a number of shares with some common trait all trade at low valuations. When clusters represent large parts of the market, this can lead to opportunities that offer the best of both worlds: an especially attractive stock within an especially attractive part of the market. We’ve found a few such ideas in the broader cluster of companies that we believe have been excessively punished for their perceived uncertainty.

To see how a cluster of companies can be affected by attitudes towards uncertainty, it helps to borrow a concept from the fixed-income world—the term premium. Yields for long-term government bonds can be broken into three parts: inflation expectations, the expected path of real interest rates, and the term premium. The term premium can be thought of as the compensation offered to investors for taking on a long-dated risk. Logically, the term premium should always be positive, but today, term premiums in most developed markets are near zero, and some, astonishingly, are negative. A negative term premium means that investors are paying for the privilege of taking on term risk. This is at best unusual, and at worst nonsensical.

In our view, this is fundamentally different to claiming “yields are too low”! Yields can be low for good reasons, but it’s hard to imagine a good reason for the term premium to be negative. This looks like a real inefficiency—a mispricing.

One culprit is quantitative easing (QE), the process where central banks buy bonds and other assets using newly printed money. Pumping more money into the economy is meant to stimulate bank lending and growth, while buying up lots of bonds reduces their yields, forcing investors to seek riskier assets in search of higher returns.

In the US, the financial press has lost interest in QE—probably because the Federal Reserve’s QE has run its course. But today, global QE is running at an all-time high in US dollar terms. European QE is running at about 5% of gross domestic product (GDP), and Japan’s stated purchase rate is close to 15% of GDP. That matters for the US because QE in one market can leak into others. As central banks in Europe and Japan try to push down their bond yields, this makes US bond yields look more attractive in comparison. If investors respond by selling European and Japanese bonds to buy US Treasuries, they are essentially transporting QE from those regions to the US. This can be seen in the chart below. Since the US stopped its QE program in 2014, the spread available to a Japanese or European investor in US Treasury bonds has narrowed.

QE has a direct effect on bonds, but it also influences equities. The cost of capital for a bond is easy to see—it is the yield. Equity also has a cost, which is the expected return investors demand to hold a stock. Like bond yields, the cost of equity can be broken into parts. One part is the yield on long-term bonds. If a safe bond and a risky stock offer the same returns, who would go for the equity? Because equity investments are less certain than the repayment on a bond, equities should offer a higher return than bonds. This additional compensation is the so-called equity risk premium. The riskier the company, the bigger the equity risk premium will be. The following illustrations show how the breakdown might look for companies with low vs. high fundamental uncertainty.

A business with low uncertainty is more “bond-like”. The equity risk premium is smaller, so the term premium represents a larger chunk of the total compensation investors expect. For high-uncertainty companies, the term premium has a smaller impact on the cost of equity. If the term premium changes, then, it will affect low-uncertainty businesses much more than high-uncertainty businesses.

To see how much stable, low-uncertainty shares have benefitted from the falling term premium, let’s look at a representative example with Clorox. Clorox makes bleach, floor cleaners, trash bags, and barbeque charcoal. These are not businesses with fantastic growth potential—over the past ten years, the company has grown revenues by just 2% per annum. But it is predictable, so investors perceive the company as low-risk. Given this, we would expect the collapsing term premium to have a larger impact on Clorox’s valuation. The data bears that out. Clorox has rarely been this expensive compared to the S&P 500, and the previous occasion did not end well.

While the collapse in the term premium has led to expensive valuations for predictable businesses, it has been a punishing environment for companies perceived as uncertain. In many cases, such companies’ valuations have fallen to the cheapest levels since the global financial crisis. In those shares, we see opportunity.

Wells Fargo & Company is an example of a company that has been severely penalised for uncertainty. Once almost universally seen as America’s premier bank, Wells has gone from darling to deplorable in less than a year thanks to a high profile “fake accounts” scandal. Its shares have underperformed world stockmarkets by roughly 15 percentage points over the past two years.

Although the scandal has certainly been damaging for Wells, the core franchise is intact, and the bank’s credit quality and capitalisation levels remain exceedingly strong. Even though current earnings are depressed from high expense levels, low rates, and muted marketing efforts in the wake of the scandal, the bank still manages to generate $5 billion of earnings per quarter—a run rate of $20 billion per year relative to its market capitalisation of about $270 billion. To put this in perspective, Wells’ valuation on a normalised price-to-earnings basis is roughly 10 times and near an all-time low relative to the US market average of approximately 20 times. Yet we believe Wells can sustain an annualised 14-18% return on tangible equity— making its fundamentals above-average.

It is also encouraging that the scandal has catalysed Wells to launch a massive $4 billion cost-cutting initiative. We expect half of the savings to be reinvested in the business, but the rest should drop straight to the bottom line, supporting low-teens earnings per share growth in the coming years.

Beyond these idiosyncratic improvements, the company could benefit from corporate tax reform, reduced regulatory friction in the US, and/or a return of the term premium to normal levels. As a bank, Wells has a particularly direct link to the term premium, because its business is funded with short-term borrowing (deposits) and it generates income through longer-term loans. A higher term premium leads to a larger spread between the interest Wells gets on loans and the interest it pays on deposits, which enhances profitability.

These factors give Wells many of the hallmarks of an “Orbis Classic” investment. It is a company with an excellent long-term track record that is undergoing what we believe to be a temporary setback. It is trading at a valuation which we believe offers a meaningful margin of safety at a time when equity prices are generally elevated. And with dismal expectations and poor sentiment, the risk-reward proposition is skewed in favour of pleasant surprises. While none of this may satisfy investors who are craving short-term certainty, we believe investors will be well-rewarded for being patient if Wells can successfully repair its reputation in the years to come.

This Report does not constitute advice nor a recommendation to buy, sell or hold, nor an offer to sell or a solicitation to buy interests or shares in the Orbis Funds or other securities in the companies mentioned in it (“relevant securities”). It has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Orbis, its affiliates, directors and employees (together, the “Orbis Group”) are not subject to restrictions on dealing in relevant securities ahead of the dissemination of this Report. Subscriptions are only valid if made on the basis of the current Prospectus of an Orbis Fund.


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