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Holly LaFon
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Orbis Commentary: Can Risk Create Bargains?

Whilst we all worry about risk and deal with it in our everyday lives, it is probably the most important but least understood concept in finance

October 09, 2018 | About:

Whilst we all worry about risk and deal with it in our everyday lives, it is probably the most important but least understood concept in finance. Because it is so hard to pin down and define, we use proxies like volatility, value at risk, beta or tracking error. These all capture an aspect of risk and are appealing for their simplicity, but they are wholly inadequate when it comes to capturing what we really care about.

Many more things can happen than will happen. A strategy that carries an exposure to a highly unlikely but catastrophic outcome—a tail risk—may well have a high chance of generating an above average return in any single year (via the premium it picks up through carrying the risk) but will likely fail to survive over multiple years or decades. It is the power of compounding returns over very long periods that leads to the best outcomes, so avoiding tail risks that endanger survival is absolutely critical.

Risks change dynamically over time, which is why we closely monitor the companies we hold. But the market’s assessment of risk tends to change far more than the underlying risks themselves. Counterintuitively, it is when a risk becomes fully appreciated that a stock is least likely to be overpriced. Put another way, when everyone is worried about something—such as is the case today for Chinese consumer growth—is when you are most likely to find a bargain. This is the basis for contrarian investing.

The Chinese technology and mobile game developer NetEase is a good illustration. It carries several key risks—some of these are outside the company’s control such as the future growth rate of Chinese consumer wealth, the country’s internet penetration rate and the local regulatory landscape. Other risks are within the company’s control such as research and development, and corporate governance. Market participants will individually price these and other risks, and those estimates will form a collective assessment embedded in the share price. In NetEase’s case, we believe the market has overestimated the impact of these risks on the company’s value and significantly understated the company’s long-term earnings prospects, which we believe are bright.

Another good example is Taiwan Semiconductor Manufacturing Company Limited (TSMC), the largest pure-play semiconductor foundry in the world. In the early days of computing, most semiconductor companies were “integrated” in the sense that they both designed and manufactured computer chips. As chip design became more complex and manufacturing became more commoditised, the industry largely split into two camps: companies that focused on value-added chip design, and those focused solely on manufacturing. The latter attracted many competitors, and returns on capital were both highly cyclical and generally low. 

However, the industry has evolved yet again as chip technology has advanced. Moore’s Law—named after Intel co-founder Gordon Moore—states that the number of transistors in an integrated circuit (chip) doubles roughly every two years, dramatically increasing power and efficiency. This has also meant that chip manufacturing has become more complex and costly over the years as the technology becomes more advanced. As a result, production of the most advanced chips has evolved from a 20-30 player industry to just three players today: Intel, Samsung Electronics, and TSMC. Among them, only TSMC is a pure-play foundry, which often makes it the partner of choice for design companies, allowing it to command a 56% global market share as at the end of the first half of 2018.

At a time when chip suppliers have consolidated, we are potentially on the cusp of an inflection point in the demand for leading-edge chips. This is a result of the arms race for computationally intensive innovations across a number of areas such as machine learning, autonomous vehicles, digitisation of machinery and the Internet of Things. Share prices of leading US chip designers such as Nvidia already reflect high growth expectations from these areas, but TSMC is arguably a more meaningful beneficiary.

In a bizarre reversal of historical precedent, it is now the design space that is becoming more competitive, with new entrants like Google and Alibaba increasingly looking to design their own chips rather than pay hefty fees to the design companies. With accelerating demand from a more fragmented customer base, TSMC and other manufacturers should enjoy greater pricing power, reduced cyclicality and higher return on capital. In addition, the “moat” around their competitive position is more formidable as the cost and complexity of building new leading-edge chip production facilities is a substantial barrier to new competitors.

The result is a future for TSMC that in our view looks increasingly better than the past, yet its shares trade at only a slight premium to historical valuations. The discount looks even more compelling compared to companies such as Nvidia that are exposed to similar long-term trends. In other words, we believe that the market is substantially overestimating the downside risk to TSMC’s earnings by anchoring too much on historical patterns of cyclicality. TSMC has a fantastic long-term track record, is conservatively managed, and has a reputation for attracting and keeping the best talent in the industry.

Aside from a dispassionate and long-term approach to valuing risk at individual companies such as NetEase and TSMC, it is equally important to avoid too much concentration in any single risk, regardless of how mispriced that risk may be. This speaks squarely to our point above on survival.

While we are excited about the bottom-up opportunities that we see in shares such as NetEase and TSMC, we are also cognisant of the fact that many of our favoured shares carry a degree of economic sensitivity, with above average exposure to global growth. The reason is that we have found surprisingly few mispriced shares in the more defensive areas of the market. Combined with this, we are concerned that global markets may be entering a tightening cycle for the first time in a decade as central banks begin to unwind the unprecedented injection of liquidity that came in response to the global financial crisis. Should markets tighten, we stand ready to take advantage of any pockets of weakness in our favoured ideas.

Past performance is not a reliable indicator of future results. The value of investments in the Orbis Funds may fall as well as rise and you may get back less than you originally invested. It is therefore important that you understand the risks involved before investing. This report represents Orbis' view at a point in time and provides reasoning or rationale on why we bought or sold a particular security for the Orbis Funds. We may take the opposite view/position from that stated in this report. This is because our view may change as facts or circumstances change. This report constitutes general advice only and not personal financial product, tax, legal, or investment advice, and does not take into account the specific investment objectives, financial situation or individual needs of any particular person. This report does not prohibit the Orbis Funds from dealing in the securities before or after the report is published.

About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

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