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Hunting for value in unpopular neighbourhoods

Graeme Forster
By Graeme Forster
March 2017
4 mins. To Read

It has been eight years since global equity markets bottomed on 9 March 2009. Since then stockmarkets have been robust, with the MSCI World Index delivering a solid price return of 13% per annum. This has substantially outpaced the return on cash-like securities, implying that compensation for taking on equity risk has been well above normal.

But the healthy headline return hides substantial underlying dispersion. For example, the MSCI World ex-US Index has risen in price by 9% per annum—not bad, but not extreme either. On the other hand, the US stockmarket return has been truly extraordinary, delivering 17% per annum price returns since the 2009 lows. This has been matched only by the historic bull markets of the 1920s, 1950s and 1990s.

There are plenty of reasons to be positive about the prospects for US businesses, but excitement and optimism rarely go hand in hand with attractive prospective investment returns. Outperformance has driven the US equity weight in the World Index close to a three decade high. Idiosyncratic opportunities still exist in the US, but like house hunting in a highly desirable neighbourhood, bargains are hard to come by.

Outside of the US, equities have also risen since 2009, but it’s tough to find the type of unbounded enthusiasm that typifies frothiness. For example, markets have been led higher not by cyclicals, which would be more indicative of growth enthusiasm, but by the shares of more defensive businesses. We would argue that the resultant relative expensiveness of the defensives is one of many distortions created by dominant price-insensitive market participants such as the central banks. Add passive vehicles (ETFs) and trend-following strategies into the mix and you are left with a recipe for substantial mispricings.

So to take our house-hunt analogy a little further, the most popular neighbourhoods are currently in the US and in the least economically sensitive sectors. It is therefore unsurprising that we are finding greater fundamental value elsewhere. An example would be the financial sector, where select investments from Europe, Japan and emerging markets look attractively priced.

Being economically sensitive and leveraged, financials clearly do not fall into the “stable” bucket that has benefitted most from trends since the global financial crisis. The policies adopted by central banks have been broadly negative for financials on a few related fronts. Fundamentally, lower interest rates and extremely shallow yield curves significantly compress loan spreads, and therefore bank profitability. And valuation-wise, lower discount rates are less helpful for cyclical, lower-growth businesses that derive a smaller proportion of their current value from future cash flow expectations. Layer on increased regulation plus onerous capital requirements and you end up in a tough neighbourhood indeed.

But low optimism leads to low prices. In aggregate, shares of non-US banks can be purchased at depressed levels in absolute terms, versus history and versus the broader market. And these below-normal prices are available at a time when balance sheets are substantially stronger than they have been historically.

A good example is ING Groep, a leading northern European retail and commercial bank. Much of ING’s loan book is collateralised, its loan loss provisions are well covered by pre-provision profits, the business is geographically diversified, and we consider management to be prudent risk-takers. The bank leads the way in offsetting some of the many industry headwinds through technology enhancements that enable efficiency gains. While we pay a little more for the quality of the franchise, we consider the price to be very reasonable for what we believe will be a resilient long-term winner in the European banking sector.

Banking hasn’t changed much over the last two thousand years, and its core function as the lubricant of the global economy will likely hold for the next two millennia. Conditions will wax and wane through time, and the operating environment that we find ourselves in today is particularly challenging. But the share prices for ING and our other favoured holdings in the banking sector do not discount substantial improvement. The low expectations embedded in these prices are such that satisfying long-term shareholder returns are not contingent upon the neighbourhood becoming highly desirable, it just has to become a little “less bad”.

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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