Periods of short-term underperformance are a price we must pay for seeking superior long-term returns. The third quarter certainly qualified as one of those times. We saw extreme and fairly indiscriminate selling in many stocks and even across whole markets and sectors. We can’t pretend that these periods are fun, but with hard work we can create a silver lining.
In the fullness of time, these occasions often appear to be ‘no brainer’ buying opportunities when viewed with perfect hindsight. But in the heat of the moment, it is hard enough to resist the urge to sell let alone summon the courage to buy more. It takes both skill and concerted effort by our investment team to confirm that these occasions are genuine opportunities and not value traps. What seems like a temporary decline can sometimes prove to be just the beginning of something much worse, and blindly buying more of such a stock can result in even greater losses. We must therefore dig deep, challenge our assumptions, and get comfortable with potential downside scenarios before committing additional capital. Similarly, we must also stand ready to take advantage of new opportunities that appear to have been excessively punished.
Adding to existing high-conviction holdings
It doesn’t get much more extreme than shares of XPO Logistics, which dropped about 50% from early June to late September. The US-based company, which provides a wide range of transportation services, spooked investors when it announced its acquisition of Con-Way, a trucking and logistics company, during an increasingly edgy market environment. The proposed deal would significantly increase XPO’s debt load at a time when economic fears are rising and the Con-Way addition would increase the company’s overall sensitivity to economic cycles.
After taking a step back and conducting thorough analysis, we concluded that the market’s fears were likely to be exaggerated. Even under pessimistic assumptions such as another financial crisis, we believe that XPO can still comfortably meet its financial obligations. The company’s existing debt also does not mature for another four to six years, by which time we expect profitability will have improved considerably and debt will have been reduced through free cash flow generation. While there is no doubt that there could be more near-term volatility if XPO’s management does not properly manage the market’s expectations, we believe that the risk of capital impairment is low and the risk-reward proposition is favourable. We therefore took advantage of the weakness to substantially increase the Funds’ holdings in XPO, as the graph shows.
While not as dramatic as the XPO example, we also took advantage of recent share price declines to add meaningfully to holdings in Qualcomm, Vivendi, and Merck among others. If these companies perform as we expect, their shares should deliver good returns over our investment horizon.
Finding new opportunities
We have also found some compelling new opportunities. Many investors have recently been particularly nervous about the Chinese economy, and this has allowed us to buy shares of JD.com — one of the country’s dominant e-commerce players — at what we believe will prove to be an attractive price. Shares of JD fell about 35% from mid-June to September amid fears of poor economic headlines and China’s stock market turmoil in August.
As with Amazon, critics also contend that JD is not profitable, but we believe this is short-sighted. Since China’s purchase fulfillment infrastructure is poor, JD has deliberately chosen to invest heavily in logistics in order to control the customer experience from start to finish. In this sense, JD can almost be thought of as ‘Amazon plus FedEx’. This approach will take longer and be more expensive up front, but that’s how great retailers are built: by focusing first on providing customers with excellent value for money rather than maximising short-term profit. Thanks to these investments and its customer-centric mindset, JD’s overall quality of service — including speed of delivery, ease of returns and trustworthiness — has allowed it to grow at an even faster rate than competitors such as Alibaba.
While we are confident that the decisions being made by the management teams at JD and XPO will ultimately create value for shareholders, the stock market doesn’t see it that way at the moment. It is a pattern that has been all too common across the Orbis Funds in recent months. Nothing is more painful and frustrating than to invest your capital in carefully researched businesses, only to see their shares grind lower and lower for days on end. But just like any business owner, we are confident that taking a long-term perspective, filtering out the noise, confirming conviction, and adding where warranted can add significantly to long-term returns.
All references as at 31 October 2015.
This article was originally published by our offshore partner Orbis and is available under the ‘Our thinking’ tab on their website. Any queries can be referred to Tamryn Lamb, Head of Orbis Client Servicing in South Africa.