Price-to-earnings (P/E) ratios are a commonly used metric when assessing investments but Orbis Global Equity manager Ben Preston warns that they should not the seen as the be-all and end-all and believes better guides to value are out there.
Preston argued that the more intrinsic value-based approach used by Orbis isn’t like most classic value-based approaches but can offer advantages over the standard ways of analysing stocks.
The definition that he uses for intrinsic value is “the price at which a rational businessperson would pay for a business, if they were to buy it today and then never sell”.
This involves thinking about the range of possibilities and determining what it would mean if someone were to buy a company today with a view to never selling it, and what that value would be.
He explained: “We don't then follow that up by specifying exactly how we do that calculation, because that's kind of the point.
“Sometimes, it could be that we find companies with very low price-to-earnings ratios, other times it might be companies which aren't earning very much today but we think they have an opportunity in the future either to rebound from some cyclical problems or to build an earnings stream over many years.”
In other cases, Preston might be attracted purely to a company's assets.
The P/E ratio is one of the most common metrics investors use to value stocks, yet the Orbis Global Equity strategy seems to have both low P/E and high P/Es stocks.
Its largest holding, British American Tobacco, has a P/E of roughly 10. Its second and third largest holdings, NetEase and Naspers, have a P/E ratios of 37 and 34. Its fourth largest holding, XPO Logistics, has a P/E ratio of 181.
When it comes to earnings, Preston believes that if a company’s profits become so depressed that pushes the P/E ratio to 100 or 200, it doesn’t make sense to spend time comparing those ratios.
“What we look at is, the earnings power over the long term - what the company might be earning in five years’ time,” he explained.
Preston continued: “We will look at earnings, we'll look at cash flows, we'll look at discounted cash flows, we'll look at a company's sustainability, its potential future growth.
“We’ll look at how big its addressable markets are, how saturated it is in those addressable markets, how much value that management can add through their own capital allocation or other otherwise good business decisions.
“There's a lot of different inputs and our job as analysts is to take all of those and weigh them each and integrate them together and use that to come up with a with a view of intrinsic value that then informs the investment decision.”
He believes this is the main point of difference between Orbis’ intrinsic value philosophy and what some investors would label a ‘classic value’ philosophy - where they would be more specifically looking for certain ratios.
At Orbis, in some cases the managers are not afraid to invest in companies that have negative earnings. Rolls Royce was one example.
Performance of Rolls Royce over 5yrs
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Source: FE Analytics
Discussing Rolls Royce’s business, Preston said: “There's only really kind of two companies that that make aircraft engines, so in theory it's quite a consolidated business.
“They get paid mainly not by selling the engines, but by servicing and repairing the engines and they’ve got a reasonable business underneath it. But then when Covid hit, they're only getting paid to service the engines actually being used.”
When the pandemic struck and airlines halted travel around the world, it was beyond any worst case that Preston examined historically and unsurprisingly Rolls Royce today as a result have negative earnings.
However, he said: “They have negative earnings because they've cut costs as fast as they can, but there's no way you can cut costs as fast that the revenue was being cut.
“But the real question for intrinsic value - fair long-term value – is not how much are they earning in 2021. It’s how much is their sustainable earnings power in a mid-cycle normal environment?
“Price-to-earnings from valuation is not the be-all and end-all.”
Preston believes it is important to be able to look beyond just the pure accounting numbers and ask what the true economics of a business are.
He said: “We will happily buy companies that are earning nothing today, because perhaps they were the bottom of a cycle.
“You might see a commodity company where the best time to buy them is actually when earnings are negative. It's when everybody's earning negative money in a commodity, then people are going to stop investing, they're going to pull back money and soon you'll get a supply constraint - and that's what makes the cycle turn.”
Another example is in Amazon, where in 2017 he didn’t think the true economics of the company were reflected in the accounting numbers.
“When we owned Amazon, I think it might even have had either negative or very low earnings, but it was it was fiction,” he said.
“The earnings weren't really low, they just looked low. This is because the way that the accounting numbers are produced meant that Amazon was spending a lot of money on digital marketing to give people a free Prime subscription and that was a marketing cost for them.
“But it's really an investment in their future, so it depresses their earnings. If you regard that form of spending as an investment instead of an expense, then you kind of see what Jeff Bezos was saying, which was ‘if we invest this money, we get this nice payback’.
“We do own shares that don't always have earnings there, but it has to stack up in other ways. We have to believe that there is true value.”
Over the last five years, Orbis Global Equity has delivered a total return of 95.34 per cent, compared to 96.66 per cent from the average IA Global fund and 100.46 per cent from the MSCI World benchmark.
Performance of fund over 5yrs
Source: FE Analytics
Orbis Investments does not charge an annual management fee and instead takes a performance fee if its funds beat their benchmark; conversely, investors are refunded if the fund underperforms.
While the Orbis Global Equity Oeic launched for UK retail investors in January 2014, the strategy started in 1990 and has since delivered an 11.1 per cent annualised rate of return, compared to 7.8 per cent from the MSCI World index and 7.4 per cent from the average IA Global fund.