People tend to observe the world through a deterministic lens, with outcomes determined to be a consequence of a series of logical and “inevitable” steps. 
In reality, the path of history is chaotic, with outcomes hugely sensitive to small changes in, and interactions between, thousands of variables. This is a long-winded way of saying that the future is inherently uncertain, and this uncertainty – the fact that infinitely more things can happen than will happen – is the nature of investment risk.
The illusion of determinism is one reason why investors spend a great deal of time trying to predict things. Where will the S&P 500 be at the end of 2018? Will the Fed raise rates three or four times? Will “FAANG” (Facebook, Apple, Amazon, Netflix, Google) or “MCBM” (McDonald’s, Caterpillar, Boeing and 3M, apparently pronounced “mac-bim”) continue to outpace the market?
But the chaotic nature of investment renders predictions unproductive at best and harmful to your long-term financial health at worst.
Rather than forecasting, our approach is to estimate what a business is worth via an assessment of the likely range of outcomes for growth and cash flow over the very long term.
Source: Orbis Investments
If we can find instances where we believe a share price embeds a significantly less optimistic outlook for the fundamentals of the company than our estimate then we will buy the shares. If we are successful, we end up with a selection of investments that have a range of outcomes that are superior to that of the average stock.
We cannot know the outcomes for any share in advance, but it is based on real data and should be a reasonable approximation. From this it is interesting to observe the degree to which “uncertainty” or “risk” will likely dictate the outcome for any single investment.
The high “noise to signal” ratio highlights the importance of careful position size management as well as being able to identify a number of uncorrelated mispricings in order to diversify risk. It also illustrates why “lumpy” fund returns are almost mathematically certain (irrespective of how much skill you have in identifying undervalued stocks) as well as why it is extremely rare to find manager “hit rates” (the ex-post ratio of winners to losers in a portfolio) that exceed 50 per cent by any meaningful degree. Too many ex-ante “good decisions” will end up as ex-post losers, purely by chance.
The above is especially apt today, an environment in which we continue to find more attractive opportunities in the less predictable areas of the market.
Consider Rolls-Royce Holdings, a stock we first bought in 2015 following a string of profit warnings. Today’s Rolls (not to be confused with the luxury car brand, which has been owned by BMW since 1998) designs and manufactures jet and diesel engines and propulsion systems, with the majority of revenues and cash flows coming from the wide-body (twin-aisle) civil aerospace division.
The core business should, in our view, be highly profitable. The industry is structured as a duopoly with General Electric with high barriers to entry as a result of the required engineering skill, meaningful capital expenditure and the fact that the engines are typically sold at an upfront loss. The bulk of profits are generated through long-term service agreements which are somewhat analogous to insurance contracts. Rolls agrees to regular servicing and repair over the life of an engine in return for a recurring fee. If underwritten skilfully, which we expect to be the case given Rolls’ in depth knowledge of the quality of their engines, these insurance contracts should be quite profitable. Insurance as an industry is itself highly profitable when you cut out all the middle layers, and for Rolls these contracts are agreed directly with the customer.
Despite what seems like an attractive setup, the company has struggled for years to achieve margins anywhere close to General Electric’s aviation division. As we wrote back in 2016, we believe this is a result of persistent under-management of what is a fundamentally sound company. Under Rolls’ relatively new chief executive Warren East and team, who seem to be a far better cultural fit for the company than their predecessors, we believe the business will gradually improve.
Restructuring is never easy, but it is coming at a good time. Rolls has doubled down its focus, in an appealingly contrarian way, on wide-body engines at a time when others have shifted to the somewhat faster-growing narrow-body (single-aisle) segment. This focus has enabled Rolls to grow market share, and we expect them to have gained the lion’s share of wide-body deliveries by the early 2020s. Dominant market share provides more scale and pricing power, and growth takes some of the pain out of cost cutting, operational efficiency improvements, and supply chain optimisation. The current share price reflects modest expectation of profit improvement from current depressed levels, but based on our research we believe that the market is overly pessimistic on the long-term outlook.
Of course, assessing that the range of outcomes are favourably skewed far from guarantees a pleasing realised return. As noted earlier, neither we, nor other investors, nor even Rolls’ management are able to forecast what will unfold in the coming years. The cash flow that Rolls is able to generate over the next decade will be sensitive to a number of unpredictable variables. How will new engine technologies hold up in real world environments? Will the aerospace cycle, which has been strong for an unnervingly long time, start to stutter? We can’t predict the future.
Volatile outcomes are a natural and inevitable consequence of active investing, which is why we partner with clients who are in a position to look through shorter-term gyrations and focus on the long term. If, on average, we can find investments like Rolls-Royce, whose share prices embed what we believe to be overly pessimistic fundamental outcomes, then we think we have more than a fighting chance of continuing to deliver value on your behalf over the long term.
Graeme Forster is a portfolio manager at Orbis Investments. The views expressed above are his own and should not be taken as investment advice.