Large-cap companies with low volatility could in fact be a major risk for income investors, according to Orbis Investments’ Dan Brocklebank, despite their ‘bond proxy’ appearance.
The risk in household names such as soft drinks manufacturer Coca-Cola, fast food giant McDonald’s and multi-national consumer goods company Unilever is that their fundamentals are “stretched”, said the Orbis Investments UK head.
This means that their margins are above average and may not be sustainable in the long term, according to Brocklebank, who said such dividend-paying stocks have become more popular since the financial crisis.
Source: Orbis Investments
He said: “These are all companies which have performed extremely well [in the past]. On average making returns of 22 per cent [from the end of 2017 until June this year].
“But these are not businesses which are growing at that fast a rate. So, the share price is going up a lot, which means that the gap between price and value has become more stretched.”
Highlighting Coca-Cola, Brocklebank (pictured) noted that the company’s trailing net profit margin was 111 per cent of the 10-year median. As such, its shares are currently trading at 33x price-to-trailing 12-month earnings, significantly higher than the long-term historical average of 22x.
This suggests that a high profit expectation is currently built into the current share price.
“That’s not a source of opportunity going forward,” he explained. “If anything, it’s a source of risk if they were to come back down to normal [levels].
“If they were growing faster that would be a good thing as you’ll essentially earn your investment back much quicker.
“But that’s not what’s happening. The average growth revenue over the last 10 years has been under 3 per cent [of the 10 stock examples].”
“We would avoid these companies,” Brocklebank said. “We don’t find them, attractive. They don’t appear in our screenings, but we will often just go back and check in case we are missing something.”
This disparity between company growth and profits which pushes apart the value and price of the holdings is enough to dismiss the regular dividend these holdings pay out to investors in Brocklebank’s opinion.
“They have got a slightly higher dividend yield,” he explained. “And I think a lot of people are looking at the dividend yield, the stability of the dividend yield and the stability of the share price and thinking ‘well, that feels a bit like a bond to me, so it must be safe’.
“But no investment is safe, especially when you’re paying too much for it in the first place.”
The disparity is not normal, according to Brocklebank, with stock market efficiency ensuring share prices usually stay reasonably close to their intrinsic value.
These “stretched” gaps occur primarily for two reasons, according to Brocklebank, and they’re both down to human psychology: fear & greed investing and not taking a fully long-term approach.
“Humans are prone to episodes of greed and fear,” Brocklebank said. “And you see it time and time again. It’s something that will never go away as that’s how we’re hard-wired.
“But an investor has to make sure they don’t get sucked into it. If people are fearful they will sell shares, regardless of the value on offer, and that will push share prices below intrinsic value.
“And when they get greedy, which they might be doing in various parts of the market at the moment.”
One such area of the market this “cycle of emotional investing” has been particularly strong is in the US tech space which has driven the S&P 500 for a number of years, largely thanks to the strong growth of the FAANGs – Facebook, Amazon, Apple, Netflix and Google-parent Alphabet.
As such Brocklebank, said the firm’s £74.5m Orbis Global Equity fund is rooted in a long-term bottom-up approach that isn’t afraid of being different to its peers.
“You have to be different to outperform,” Brocklebank said. “But you can’t just be different. If you drive up the motorway the wrong way that’s being different, but it’s a stupid thing to do.”
Orbis Global Equity targets higher long-term total returns than global stock markets without taking on greater risk of loss, as measured against the MSCI World index.
Performance of fund vs sector & benchmark over 5yrs
Source: FE Analytics
The fund has no up-front charges but does have a performance fee of 50 per cent of the outperformance of the fund over the MSCI World benchmark.
According to the most recent key investor information document, the fund rebated investors 1.9 per cent in 2018 after falling to a 12.5 per cent loss against the benchmark’s 3 per cent fall.
The fund has made a total return of 70.01 per cent over the past five years, compared with a 86.1 per cent gain for the MSCI World benchmark and a 69.17 per cent return for the average IA Global peer.