Dear Fellow Investors and Friends
Hi! Welcome to the second newsletter of 2024. My name is Piet Viljoen, and today is Thursday, 18 January. It is the 18th day of the year, and there are 348 days left to do what you need to do this year.
Twenty-four years ago today – according to Benzinga.com – Kemper Funds chief investment strategist Robert Froelich gave an infamously ill-timed interview recommending investors buy tech stocks at any price. The dot-com bubble would peak shortly thereafter. Froelich made a number of statements about the frothy tech market that are painful to read in hindsight.
“It’s impossible to pay too much for a good stock,” Froelich said. “We see people discard all the right companies with all the right people with the right vision because their stock price is too high—that’s the worst mistake an investor can make.”
At the time, Froelich argued the tech environment was a “new world order” and recommended investors buy Cisco Systems, Motorola Solutions and Intel Corp. Within a year, Cisco was down 27.5%, Intel was down 40.8%, and Motorola was down 55.1%.
Forecasting (n): The attempt to predict the unknowable by measuring the irrelevant. A task that, in one way or another, employs most people on Wall Street. And Claremont.
– From the Devils’ dictionary, by Jason Zweig (although I added that last bit about Claremont)
So much for forecasting.
Quote of the day
“Every forecast takes a number from today and multiplies it by a story about tomorrow.”
Morgan Housel
I would modify this by saying if your story about tomorrow is wrong, it doesn’t matter which number you multiply it by – the forecast will be garbage. This is what they are, as most stories don’t even get the next ten minutes right, let alone tomorrow.
So why do the market prognosticators continue to do so?
People hate uncertainty. Uncertainty creates anxiety and distress. That is why, since time immemorial, the pronouncements of luminaries such as the Oracles of Delphi, the Sybils of Rome, the major biblical prophets, and Nostradamus have been sought after.
Their “prophecies” were always couched in vague, uncertain terms, yet gave the impression of certainty as they could be interpreted in many ways. And that certainty, albeit an illusion, made people feel certain about the future and thus, more comfortable.
Such prophets have always been held in high esteem by their contemporaries, consulting kings and queens. Today, “financial market strategists” employ exactly the same techniques and are held in equally high esteem by investors.
In Housel’s new book, Same as Ever: A Guide To What Never Changes, he suggests that we should stop trying to predict the future. Instead, we should use what we know from the past to help us react to changes as they inevitably come up. In effect, he is urging us to play the hand as it is dealt, not to anticipate it.
It is with this background that I formulated my “Preview for 2024”. In doing so, I will make no forecasts, present the cards as they lie, and then draw some conclusions as to future outcomes not based on correlations or extrapolations but rather on the embedded incentives in the system, and what has happened in the past under similar circumstance.
Looking at the world around me, the following strikes me as self-evident:
- Developed markets, including China, have extreme amounts of debt relative to the size of their economies.
- Emerging market debt levels relative to their economies are much more manageable. Their main problem is a lack of equity capital, as the black hole of American capital markets exerts its giant sucking force.
- Everyone is overweight US “exceptionalism” – equities, bonds and the currency. By contrast, almost everything else is under-owned. See point 2 above.
- There is a split happening between the “Global South”, aka the BRICs, etc, and the Western, developed world. This is affecting supply chains in particular and trade in general.
- There is a significant underinvestment in resource exploitation because of the unintended consequences of “green policies.”
- This is compounded by increasing resource nationalism (see point 4 above).
In the interest of keeping this letter down to a manageable length, I will deal with each of those points separately and in more depth in future letters.
For now, it is worth noting that Developed countries (and I include China in this category) are running record levels of debt relative to their GDP. Monetary authorities everywhere, egged on by their political handlers, have been spraying cash around in the hope that it would revive growth.
This was happening before Covid, and the “crisis” of Covid accelerated the process. Today, we also have the “climate change crisis” as well as the “Ukraine war crisis” to blame for further money printing/debt accumulation. Expect more crises.
In the US, the government’s budget deficit is running at levels in line with what it was at the depths of the great financial crisis of 2007/8. And this is in a non-recessionary period. In China, debt levels have ballooned because of ever-increasing spending on infrastructure, with ever-decreasing marginal gains in output. Worst of all is Japan, which has been printing money in an effort to ward off deflation for 20 years now.
None of these countries can afford to have high rates, as servicing the debt then will break the budget (even more). So, their monetary authorities worldwide have kept interest rates at artificially low levels.
As Walter Bagehot said in the 19th century – John Bull (i.e. the man in the street) can stand many things, but he cannot stand 2%. What Bagehot meant is that low interest rates lead to speculation, as people cannot survive on the interest income from their savings.
Speculative activity has been most prevalent in the USA as a direct result of its deep and liquid capital markets, its grounding in the free market spirit and tremendous self-belief.
In setting out our investment stall for this year and beyond, we need to think about how developed markets solve their very big debt-to-GDP problem and the incentives at play. They only really have two choices: reduce the numerator – debt – by saving a lot, or reduce the denominator (GDP) by growing a lot.
Saving means spending less. This will not be acceptable to politicians. This leaves growth as the only option. Fortunately, creating growth is easy: high rates of inflation do the trick, as GDP growth is a combination of real growth and inflation. The higher the inflation rate, the higher the nominal growth is.
The actual constraints governments in developed markets face are not growth per se but the level of interest rates. If you let the inflation genie out of the bottle, the bond vigilantes will step in and push up interest rates to try and put it back in again. As a result, indebted nations cannot afford high interest rates.
Enter financial repression, i.e. keeping interest rates artificially low. It is easily achievable via a combination of prescribed assets, capital controls and regulatory intervention. Remember South Africa in the 70’s and 80’s? That’s your template.
Pension funds had to have 50% of their assets in government bonds, ensuring a steady demand for bond issuance to fund the high debt levels. Also, strict capital (exchange) controls further entrenched the local bond market as an investment destination. Regulations directed this stranded capital to certain favoured sectors of the economy. Finally, we also defaulted on our $-denominated debt in 1985, which helped us reduce and reschedule it.
In applying this financial repression, the South African government kept interest rates below the rate of inflation, thereby reducing debt to GDP levels over time.
The US government applied similar measures with great success in the post-WW2 period, so this wasn’t a uniquely South African solution. It has been applied all over the works since time immemorial.
Fast forward to today, and the question is, who will blink first? My money is on Japan, given their high debt levels and low growth rates. Mrs Watanabe has been investing outside of Japan for over a generation due to the low rates of return available on Japanese investments. The consequences of Mrs Watanabe being forced to repatriate her savings to Japan could be far-ranging. Those assets that are overrepresented in her portfolio would be especially negatively affected.
Other developed countries will undoubtedly follow with their own set of controls.
By contrast, most emerging markets (including South Africa) have reasonably low levels of debt relative to GDP. This is not because they are such fiscal conservatives. In fact, given half a chance, emerging markets will make a drunk sailor look like Mr Scrooge. But their high levels of interest rates mean they can’t afford to borrow too much money, dampening speculative spirits.
In the world of the blind, the one-eyed man is king.
The investment implications are profound, especially since two generations of investors have been living through a period of declining interest rates and corresponding increasing asset values, especially in the USA.
Of course, none of these are forecasts. Magic might happen, and fiscal and monetary authorities may pull a rabbit out of a hat. A big one. And current trends will continue for another generation. But the question investors must ask themselves is: are their portfolios even a little bit prepared for a very different future than the experience of the last two generations of investors?
“New highs are bullish”
1. The Magnificent Seven
This is a chart of the Magnificent Seven Index, which was only established a year ago. They used to be called the FAANGs – or perhaps it should’ve been FANGs as when everyone was underweight, their outperformance bit investors. Now, Nvidia has entered the group and everyone’s overweight, so you can’t call them FANGs anymore, because it’s not good for the investment banking business. Who is comfortable with something that might bite you? You can’t use FAANGs either, since Facebook and Google subsequently changed names. No, keeping the customers happy and coining the phrase “The Magnificent Seven” is much better for business now.
Of course, this new incarnation hit a new high in December.
Its constituents are Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla. Of these, Nvidia, Apple and Microsoft individually also hit new all-time highs.
My take: none of these stocks are cheap. But, as Chuck Prince once famously said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.” And most investors are dancing. The music will stop, but I have no idea when. So, if you own them (I don’t), dance close to the door.
2. Uranium
The uranium price has shot through the roof. Uranium as an element is ubiquitous, but it is hard to process. And the price was low for so long that some of the bigger uranium mines went into care and maintenance. So, supply is constrained.
At the same time, the green energy transition crowd, realising that they were busy painting themselves into a corner, have started the process of rehabilitating nuclear energy from the devil incarnate to a necessary building block of a “green future”, the upshot being that existing nuclear plant lives are being extended, and more new plants are being built and planned.
The result is, that – for the moment – uranium buyers are struggling to get hold of the stuff.
Yellow Cake is an investment trust that holds Uranium as its only asset. Here is its share price:
My take: Yellow Cake, a core commodity holding of the Merchant West Worldwide Flexible fund (i.e. the cockroach), has tripled over the past three years. At some point, the price of uranium will be high enough to incentivise the build-out of new production. Once that happens, it will be time to sell. But we are not there yet.
3. Nintendo
Nintendo is a Japanese video game company founded in 1889 and headquartered in Kyoto, Japan. It owns a few of the most popular games in the world – Super Mario Bros, Animal Crossing and the Legend of Zelda. It is also cheap, with net cash on the balance sheet and a large investment in Pokémon, a valuable franchise of its own.
Video gaming is a massive growth industry. The chart below shows the progression of the industry over the past 50 years and how the platforms have changed. For boomers – like me – who were around at the start of this industry’s evolution (remember Pong, Space Invaders and Pac-Man!), it’s amazing to see how it has developed.
By the way, Donkey Kong is also a Nintendo franchise.
Source: Visual Capitalist
Here is the full article, for those who want to dive a bit deeper.
My take: This $180bn industry can’t be ignored. Nintendo, one of the dominant players in the industry, is a top holding of the Merchant West Global Value fund. We also used to own Activision Blizzard, until Microsoft bought it out in October of last year. Here is the Nintendo share price:
“New lows are bearish”
1. China 300 Index
These were the recent headlines on the Chinese market:
- China’s share of the MSCI index dropped to its lowest since 2017, accounting for 24% of the MSCI Emerging Markets Index as of Dec. 31, 2023.
- The current weight is about 16% below the country’s peak weight in 2020.
- The nation’s stocks have erased almost $4tn in value since 2021
There are many reasons to be bearish on China – a communist government, a massive misallocation of capital into unproductive sectors (i.e. property) resulting in onerous debt levels, global trade wars, etc. But the price action strikes me as being the main reason. The market has recently reached five-year lows, while most on the sell-side (and even buy-side) remain bullish. Until I see large-scale despondency, coupled with policy changes, I will believe the price action, not the analyst rhetoric.
My take: Stay on the sidelines here. A good rule of thumb is to only invest in a country where you understand the legal system. Do you know what a VIE is? Don’t let the Chinese show you.
2. Walgreens
Walgreens is a former “dividend aristocrat” – having paid a consistent dividend for the last 91(!) years. But at the last set of results, its board slashed its quarterly dividend from $0.48 to $0.25. Just before the cut, the falling share price had inflated the (historic) yield to 7,5%.
My take – well, takes, as there are so many interesting aspects to this story:
- Beware of a large cap, dividend stalwart trading on a high yield. It could mean the market is wrong, and the share is super cheap. Alternatively, it means the market is right, and the dividend is about to be cut. In my experience, the market is more often right than not.
- If you think selling home, health and beauty goods is a business with an intrinsically strong moat, think again. Any retail business – even those selling staples – is generally only as good as its management. As they say in the classics, retail is detail. It’s probably not sensible to pay a very high multiple for such businesses – as the one thing you can be certain about is that management will change.
- Some of you might have read about the shoplifting epidemic in the USA. Well, Walgreens endured roughly $400 million in theft in the first quarter, based on the 1,1% compression in gross margin cited by the CEO! That number may be inflated, but it is nonetheless indicative of a problem.
- At current prices, the P/E at 7,4 might look low, but the EV to EBITDA ratio is a high 11,6X – indicative of uncomfortable debt levels.
Finally, retail turnarounds are notoriously difficult. So, I would stay on the sidelines with this former dividend aristocrat here.
3. Kering
Kering is the holding company of Gucci. Yes, Gucci, that favourite of the nouveau riche everywhere. Kering also owns Saint Laurent, Bottega Veneta, Balenciaga, Alexander McQueen, Brioni, and Boucheron. And a few other names I have never even heard of.
In Vol 1… No. 6 (Luxury for less), I mentioned that the sector contained high-quality business but had been underperforming. And, as they were still too expensive, I would stay on the sidelines. Here is an update, and the news is still bad. As if to confirm that not only were multiples compressing, but business was also starting to slow down, Burberry came out with shocking results this week. Its share price is now at the same level as it was ten years ago, while Kering is at 5 year lows:
My take: It’s still far too early, even for brave investors. Of course, this morning, Richemont came out with solid results, but one swallow does not make a summer.
Did you know?
1. Retail is hard
Famous US Retail chain Macy’s received a buyout offer from private equity in December. The offer was for $21 per share, a 32% premium over the closing price. Here is a thread by Christopher Bloomstran on the value destruction that has taken place at Macy’s over the years.
My take: as I mentioned earlier, retail turnarounds are hard. Very hard.
2. Novo Nordisk is big
Novo Nordisk is now the biggest company (by market cap) in Europe, having surpassed LVMH over the past few weeks. How did this happen? They developed a drug called Ozempic, a brand name for a GLP-1 class of drug. In English, Ozempic (or Wegovy as it is also commonly called) was originally meant to be a diabetes medication, also known as an incretin mimetic. But then someone found out it helped with rapid weight loss, and its use exploded. Here is a chart showing how the market value of Novo/Nordisk has also exploded:
My take: there is nothing people like more than having their cake and eating it, which we can literally do now that this drug is freely available. It’s a license to print money, as you can see above. As for the longer-term side-effects for non-diabetics taking the drug? We’ll have to wait for that. In the meantime, I’ve missed out on this one.
3. Taxes are high
RMB/Morgan Stanley reported that SARS published its Tax Statistics for 2022/ 2023, and it makes for pretty tough reading.
R2.07tn was collected in gross tax revenue, 9.7% more than in the prior year. They refunded taxes worth R381bn, or 18.7% more than in the prior year. Thus, they netted tax revenue amounting to R1.69tn, or 7.8% more than in the preceding year.
The tax-to-GDP ratio increased from 23.7% in 2018/19 to 25.1% in 2022/23 – the highest ratio attained since 1994/95.
The OECD publishes a table showing composite effective tax rates, expressed as a % of GDP for most countries in the world. You can find it here. The OECD numbers are lower than the numbers above.
My take: although South Africa lies in the middle of the pack when it comes to tax incidence, when one takes into consideration the declining quality (and quantity) of what we receive in return, it’s a travesty.
What I’m reading
This piece by Edward Chancellor provides a nice framework for thinking about interest rates. An added bonus is how well he writes.
The Permanent Equity annual letter is out. Permanent Equity is a very interesting private equity firm based in Columbus, Missouri. I had the fortunate experience of travelling there and meeting with them a few years back. It is a wonderful place with wonderful people and a wonderful business. This letter has – for me, at least, overtaken the Berkshire Hathaway annual letter as my most anticipated of the year.
What I’m listening to
Lyn Alden has written a book called Broken Money. I haven’t read it yet, but I plan to do so this year. In the meantime, there is a three-part podcast where she is interviewed about her views on the global financial system. I found it nothing if not insightful. And, if you want to learn more about Bitcoin, she is quite a useful resource.
Here is part one (the history of money), part two (how money broke) and part three (how bitcoin fixes money).
And before the “Bitcoin is a scam” people start yelling at me – it is always useful to understand the other side of the argument before you formulate your side.
What I’m watching
Amanda and I have just finished watching Killers of the Flower Moon, a three-hour-plus epic directed by Martin Scorsese. It stars (a very old) Robert de Niro, Leonardo Di Caprio and Lily Gladstone. I found it riveting despite its length. It’s quite intense with a soundtrack to match, which was a collaboration between Scorsese and Robbie Robertson (of The Band fame), who died two months prior to the film’s release. The film is dedicated to Robbie. As an added bonus, it features appearances by modern Americana royalty Jason Isbell and Sturgill Simpson.
I can highly recommend it – and it will probably win more than one Oscar this year.
That’s it for this week. 2024 awaits with all its twists and turns, and it will pay to be careful out there.
Piet Viljoen
RECM