Nothing kills return on capital like capital itself. And nothing illustrates this dynamic better than a historical comparison of two very different industries: technology and tobacco. 
The first commercial microprocessor was produced in 1971, giving birth to an enormous secular trend that’s still alive today. In the same year, the US Public Health Cigarette Smoking Act made it illegal for tobacco companies to advertise cigarettes on television and radio, just one of a series of regulations that would see per capita cigarette consumption in the US fall by 75 per cent over the next five decades.
As an investor in the early 1970s, which industry would you have invested in?
It would seem like a no-brainer. Technology was entering a period of extraordinary secular growth, and tobacco was in seemingly terminal decline. However, looking at Datastream sector indices, $1,000 invested in tobacco in 1973 would have grown to nearly $900,000 today. That same $1,000 invested in technology? Only $86,000!
There are many reasons for this counterintuitive outcome, but the overwhelming factor was the flow of capital. Technology innovations turned out to be every bit as spectacular as promised, but there was also an enormous pool of capital chasing those opportunities and thus depressing returns.
Conversely, shrinking demand and greater regulatory burdens scared away capital in tobacco—but left handsome returns for the capital that remained.
The same dynamic can be seen across global markets. Capital tends to flow to where the growth is, raising competition, increasing share count and depressing per share earnings. That’s why fast-growing economies don’t necessarily translate into excessive stock market returns. Goldman Sachs coined the acronym “BRICs” (Brazil, Russia, India and China) in a 2001 report, sparking a frenzy of interest in emerging market investing and a flood of BRIC-flavoured funds and exchange traded funds in the following years. Like technology in the 1970s, those economies grew as promised, but returns over the past decade have been underwhelming.
For contrarian investors, looking for the equivalent of tobacco stocks in the 1970s appears to be a good tactic. What is everyone else afraid to touch?
At present, we believe Russian banks would certainly tick that box and one that stands out is Sberbank. Sanctions have limited the supply of capital in Russia, yet demand remains robust due to underpenetrated credit. This supply-demand imbalance has led to high net interest margins for Sberbank, the dominant local lender. At current prices, an investor pays only a slight premium to book value and under six times earnings for a bank that can grow earnings sustainably at 10 per cent per annum with an 8 per cent expected dividend yield. With a great management team and strong competitive position, Sberbank would trade at a premium valuation in almost any other market except Russia. Of course, we can’t ignore the Russia risk, which is real, but we think the discount more than compensates for the embedded risk of tail events.
Another fascinating area is offshore oil drillers. With the boom in US shale production, capital flooded onshore at the expense of more conventional offshore drilling. The shift has been so dramatic that one firm, Borr Drilling, was able to purchase dozens of premium shallow-water rigs, many of which were brand new, for an average of about 60 per cent of replacement cost. Such is the extreme lack of capital in the offshore industry now that Borr was the only bidder on almost all of these purchases. This type of capital imbalance is extremely rare in crowded capital markets and likely points to a highly favourable risk-reward proposition on these assets.
During the fourth quarter of 2018, the stock dropped to below book value. A level that suggested the market believed Borr’s top-of-the-line drilling assets, which have over 30-year lives, will fail to achieve their cost of capital. This is an extraordinarily negative assumption.
We don’t know how the energy capex cycle will evolve. Nobody does. But it seems incongruous for the share prices of these companies to embed such negative outcomes. To us, it looks more like classic capital cycle behaviour, and a great opportunity for those willing to lean into the uncertainty.
While it’s impossible to forecast the future of the oil market, we can make some educated guesses. Offshore production accounts for roughly a quarter of global oil supply. Shale is growing quickly, but still represents just 6-9 per cent, and oil sands represent less than 5 per cent. The rest comes from conventional onshore sources, including from OPEC countries that are currently cutting production. Even if shale continues to grow rapidly, millions of new barrels will be needed from other sources to offset natural decline rates and demand growth. In other words, while we don’t know the exact number of barrels, we can be fairly confident that offshore production still has a role to play in fulfilling the world’s energy needs.
The investment environment over the last 10 years has been challenging. It has been reminiscent of the early-1970s in the US, the late-1980s in Japan, or the late-1990s in the sense that a great deal of security-level dispersion and mispricing is being masked by headline exuberance—a classic “beta” market. These inefficiencies are often the source of future alpha generation.
Graeme Forster is a portfolio manager at Orbis Investments. The views expressed above are his own and should not be taken as investment advice.