Regarding… Vol 1 no 5 – Old dogs, new tricks?

Dear Fellow Investors and Friends

Today is Thursday, the 28th of September. It is the 271st day of the year; 94 days remain until the end of the year. This week, we had the holiest day on the Jewish calendar, Yom Kippur.

On this day 50 years ago, history’s biggest oil price shock happened as several different Arab nations invaded Israel and sparked the chain of events that led to a massive oil embargo. This led to “stagflation” — inflation and economic stagnation — in the developed world for much of the next decade. As I have said to anyone who would listen (and even, sometimes, those who don’t want to), history never rhymes but repeats.

Also, today is the day my wife Amanda and I plan to ride Mont Ventoux, one of the most famous climbs of the Tour de France. This implies I am on holiday, which further implies a shorter letter than normal.

Let’s see.

The US 10-year Treasury bond price is widely regarded as the most important market price in the world. It is the ultimate risk-free asset, off which all other assets are priced. As bond geeks know, the price of bonds is inversely related to their yields.

So, when yields reach new highs, as they currently do, prices are reaching new lows. And if the price of the world’s risk-free asset collapses, then all other assets are in danger. That might or might not lie in our future. Risk assets seem under pressure now, but it may be short-lived.

Who knows? History is littered with people who were wrong in their short-term forecasts.

What is more valuable to think about is the longer-term implications if the 40-year downtrend of interest rates globally has started to reverse. US interest rates peaked in the (northern hemisphere) autumn of 1981 at a yield of 15,82%. At the time, they were called “certificates of confiscation”, as anyone who had invested in them over the previous 30 years had lost money!

Investors’ allocations to bonds were at a minimum.

Today, investors are record-long bonds after a 40-year bull market, which ended with 10-year yields in the USA at 0,5% in August 2020. Just this week, Bloomberg reported that “the iShares 20 Plus Year Treasury Bond ETF (ticker: TLT) gathered $750 million in assets, bringing its net inflow during the year-to-date to $16.3 billion, equivalent to nearly half of the vehicle’s $38.2 billion in total assets.”

After 40 years of declining interest rates, investors seem hard-wired to buy bonds after an uptick in yields. Two generations of investors, or almost everyone managing money today, have made money buying bonds.

Why should it be different this time?

Markets love throwing curveballs at investors, and the current set-up in the ultimate global risk-free asset does not look healthy. Lots of supply is coming to the market – due to lower tax receipts and higher spending, the US government deficit is expected to be $2 trillion this year, or over 7% of GDP. This shortfall must be funded by selling government bonds to a market where demand is faltering. US investors are full-up, and China may prefer gold over their historic go-to asset: US government bonds.

This over-supply of bonds could be in place for an extended period of time due to the funding requirement for the fight against climate change, tax incentives for onshoring, the fight against inequality, support for Ukraine in the war against Russia or any other crisis “du jour.”

One of the important functions of market prices is to match supply with demand – and if supply is too high for the level of demand, and the higher level of supply is sustained, prices need to decline to a level where demand picks up. And this decline could be in place for an extended period of time.

It is not impossible that we are in the throes of a structural change in the direction of interest rates.

If this is the case – and that is a very big if – everything we “know” to be true regarding how asset prices behave can be thrown out of the window. Especially everything we “know” since the GFC of 2008, when Central Banks globally started reducing interest rates to ultra-low levels.

Old dogs will have to learn new tricks.

1. The oil price

The day Goldman Sachs said it no longer sees oil reaching $100 this year was the commodity’s lowest closing price of 2023. It has since rallied 35%, causing the bank to “predict” that oil will now hit $100. As always with investment banks, heads they win, tails you lose.

My take is that the oil price is the best hedge against unexpected inflation. It (and/or) the oil stocks deserve a place in any sensible portfolio these days.

2. Truworths

Can you believe it?!? During a retail meltdown in SA, Truworths hits a new 5-year high. The market consensus was that their lending book would implode, putting the business’ solvency at risk.  As a result, the market value of the business traded at a massive discount to its peers. Apparently, it was an unjustified discount. Even now, after going up by 100% over the past two years, it is only on an 8,5 PE and a 7% DY.

My take – when a business with a high-quality track record is discounted due to “macro concerns”, it pays to take a closer look.

Source: Koyfin

1. Astral Foods

Astral Foods is South Africa’s AI stock. Read on before you think I’ve lost my mind.

Blackouts, municipal decay and now AI (Avian Influenza, not Artificial Intelligence) have combined to decimate the productive capability of the “Saudi Arabia” of SA chicken – as one of my favourite small-cap analysts, Anthony Clark (@smalltalkdaily on X) calls them. Egg sector production has been massively reduced, and broiler production might follow suit. We could be facing a national shortage of chicken.

Capital cycles are driven by supply, as demand remains fairly stable over the long term for most consumer products. We could be facing the mother of all capital cycles in the chicken industry in SA. My take: watch this space – this is still very early in the innings, but opportunity is looming.

On the bright side – if ever there was a catalyst for regime change – a chicken shortage at KFC could be it.

2. American Tower Corp

This company is “a leading independent owner, operator and developer of multitenant communications real estate.” It is also one of the largest REITs in the world.

If ever there was a poster child for capital misallocation, this is it.

American Tower is the lead steer of a class of companies that own cell phone towers and have contracts with highly indebted clients in highly regulated industries at ridiculously low cap rates. In English – these companies have highly risky cash flows discounted to present value at very low interest rates. On top of that, their corporate structure, called REIT (Real Estate Investment Trust), forces them to pay out most of their income, leaving very little for maintenance. And as anyone who has owned property knows – maintenance spend is real. It’s also more than you would build into your spreadsheet before you own the property.

What could go wrong?

Well the share price for one. My take is that there is a lot more pain to come here. Also, see my thoughts on bond yields above.

Source: Koyfin

I have mentioned Cliff Asness a few times before. He is a quant and one of the brightest out there. He will take you out mercilessly if you ever get on his wrong side on X.

In any case, there is a debate in markets on whether value is just an interest rate bet. Cliff says it isn’t, and I tend to believe him. I also want to believe him, but at least he’s got the numbers to back up his argument.

You can read the article at this link.

Seeing as its holiday time (for me, at least!) I’m watching a series, which I don’t usually get much time for during the year.

My pick – Top Boy. It’s a gritty look at the London underground world. Very much in the vein of The Wire, one of the OG series. Top tip – turn on the subtitles; the British / West Indian patois can be hard to follow.

Check it out on Netflix.

That’s all for this week. And be very, very careful out there!

Piet Viljoen
RECM