Regarding… Vol 2 no 11 – The Trolley Problem

Dear Fellow Investors and Friends

Welcome! I do appreciate you taking the time to read this.

I’m Piet Viljoen. Today is Thursday, March 28th, the 88th day of the year. There are only 278 days left until the end of the year.

Some of you noticed I didn’t write a letter last week, as I enjoyed some downtime with my family in Knysna. But I’m glad to be back this week!

On this day in 1979, an incident happened at Three Mile Island in Pennsylvania, USA. The term “Three Mile Island” was seared into our collective consciousness as a shortcut for “one of the worst nuclear disasters in history”. As such, it has been used as one of the arguments against nuclear power in America and worldwide.

During the crisis, plant workers were exposed to unhealthy levels of radiation, but no one died. It speaks to the power of narrative that such a relatively minor incident delayed the deployment of such a great form of reliable and clean energy.

Fast-forward 45 years, and the nuclear renaissance is taking off. Whatever your stance on the climate change debate, a reliable source of clean energy – and cheap at scale – can only benefit the world.

China is solving the problem quite rapidly. In the USA, officials announced Wednesday that the federal government will provide a $1.5 billion loan to restart a nuclear power plant in Southwestern Michigan.

The trolley problem is a thought experiment about a fictional scenario in which an onlooker can save five people in danger of being hit by a trolley. All she must do is flick a switch to divert the trolley onto a path with only one person.

This experiment draws a sharp contrast between two concepts of morality: that we should choose the action with the best relative consequences, like only one person dying instead of five, or that we should always stick to absolute principles, like “never kill a human being.”

Absolute concepts work much less well than relative ones in complex systems, as the trade-offs are many and inevitable.

Humans have previously lived through two major energy transitions: first from biomass to coal, and then from coal to oil and gas. Each successive energy source was cheaper and more powerful: the “energy return on energy invested” was higher.  As a result, the average person enjoyed sharply increased living standards.

It’s hard for large machines to do anything useful using wood as the energy input, but put coal in the mix, and hey, presto, you have a strong and useful machine that increases productivity and living standards. It’s no accident that human quality of life, measured across many vectors – health, wealth, and education – has improved with our access to better and cheaper energy.

However, historical transitions occurred naturally and gradually. Today, we face a forced transition – governments, regulators, and social pressure groups are combining to rapidly pressure businesses and consumers to switch to renewable energy sources. There are two problems here: one, the pace at which the transition is expected to happen, and two, the quality of the energy.

This is where the trade-offs come in. If we force a transition to renewable energy, the energy cost will likely go up. This hurts poor, energy-vulnerable countries dramatically more than rich, energy-efficient countries. Poor emerging markets can’t afford to transition rapidly. Emerging markets are also the markets whose energy requirements will grow most quickly. They need cheap, efficient energy to prosper and grow, as the developed world did a hundred years ago.

More than a quarter of the world’s population has no access to electricity, and two-fifths still rely mainly on traditional biomass for their basic energy needs. The WHO has called biomass burning in developing countries a major global health issue, estimating that 3.8 million children die annually from indoor air pollution. We are less aware of this significant issue because it doesn’t make for good TV, like earthquakes, droughts or floods.

The choices and trade-offs are extreme when it comes to the energy systems we choose – and force on others. But the results of our choices often happen “somewhere else” – in a poor neighbourhood or the distant future. The least damaging trade-off is choosing a system that will enable emerging markets to grow rapidly, increasing their prosperity and quality of life. And the best way to do so is not to control their pollution output, but to help them develop access to cheap, efficient energy as quickly as possible.

Preventing the development of cheap energy resources in emerging markets in the name of ESG does not make the world a better place for most of its population. It dooms them to unending poverty and low quality of life along all the important vectors. Increasing inequality has many vital ramifications, none of them positive.

So, do we flick the switch towards a forced transition to clean energy and a stable environment for the West, with millions of poor children dying of dirty air and hunger elsewhere, or do we flick it towards a gradual transition with access to reliable, cheap, and efficient energy and an increasing living standard for most of the world’s population?

The answer has important investment implications.

Remgro is the doyen of investment holding companies in South Africa. It used to be that no self-respecting portfolio would be without it. But times have changed, and Remgro has lost its way.

Since 2010, its NAV per share has compounded by 5% p.a. Annual dividends have added around 1% to this growth. A few unbundlings (FirstRand, Grindrod) have also contributed a bit. However, the JSE All Share Index has compounded by over 12% (including dividends) over the same period.

Recent transactions, such as overpaying for the Heineken assets in the merger with Distell and the high multiple on which they value their Mediclinic and CIVH assets, do not augur well for future returns.

Investment holding companies’ valuation relative to their NAV should reflect a discount for corporate costs, which in Remgro’s case is relatively low. Poor investment performance in Remgro’s case is significant, though. Remgro now trades at a 50% discount on its last disclosed NAV. I guess that’s probably about right.

Anyway, here is their share price over the past 10 years:

My take: Stellenbosch has produced many success stories, such as Richemont, Capitec, and PSG. Remgro is not one of them.

Here is another disaster of an investment holding company. I first wrote about Hipgnosis in Regarding…Vol 1 Nr 8. Hipgnosis is a fund that invests purely in music catalogues; in return, it earns a small fee every time a song is played. It hoped to buy catalogues and then market the songs aggressively to increase the number of times they were played – in commercials, movies, or TikToks. As such, it was marketed to prospective investors as “uncorrelated” to general market movements.

It turns out song catalogues aren’t that special. They are just like any other financial instrument: a stream of cash flows into the future, discounted back to present value terms. And if the discount rate you use in your valuation work is too low, things will not turn out well.

For Hipgnosis shareholders, things have turned out spectacularly badly, as most of their catalogue acquisitions happened at a time of low interest rates.

Howard Marks wrote in his memo how low interest rates can lead to suboptimal investment decisions called Easy Money. Hipgnosis could be the poster child for this memo.

My take: When someone tries to sell you an “uncorrelated” asset, it pays to think clearly about the proposition. Most of the time, its uncorrelated nature is a temporary phenomenon; a sales gimmick.

Japan hiked their policy rate to a range of 0% to 0,1% last week. This rate was set at 0% in 2010 and -0,1% in 2016. The hike means that no countries are left with negative interest rates.

Here is a chart of Japan’s policy rate over time:

The only thing that has shown rapid growth in Japan over the past 20 years is its level of national debt, which now sits at over 400% of GDP. I guess this shouldn’t be a surprise, given their low interest rates over such a long time (see Howard Marks’ memo above).

Inflation will become a problem if wages are anything to go by. However, Japan will not be able to afford high bond yields, which would be a normal market reaction to higher inflation.

My take: Japan will lead financial repression over the next few years. Their debt situation leaves them with no alternative but to force Japanese institutions to buy government debt at artificially low levels. Interestingly, this could be bullish for the Yen and bearish for global developed market bonds, as these institutions repatriate funds from offshore to buy the bonds the government will force them to buy.

Japan is one of my favourite places in the world. It’s not even close. The food, the people and the sights are all amazing. Visiting Japan during the cherry blossom season is high on my bucket list. So here is the cherry blossom forecast for 2024.

My take: I can’t go this year, but if you can – do it!

And the stock is flying. The shares, which debuted at $34 last Thursday, currently trade at $58, a gain of 70%. What was not mentioned in the listing hype was that Reddit had a private market valuation of $10 billion in 2021 when it last raised a funding round, according to Pitchbook. On listing, it was valued at roughly $6.5 billion based on its IPO price. Another little-mentioned factoid is that Reddit has never made a profit in its 20-year history.

My take: Avoid IPOs like the plague. I wrote about them here, here, and here.

You can read the annual report here. The shareholders’ letter, written by my partner Jan, starts on page 4 and is worth reading to see how our companies are dealing with tough times.

Since we took over management of the company, its NAV per share has grown by 24.8% p.a. in US$ terms. But Jan and I can’t claim credit for that – on the contrary. It’s because the management teams in our businesses are so good. They go above and beyond and aim to delight their customers every step of the way. As my partner Jan wrote in the shareholders’ letter, we owe them a huge debt of gratitude.

My take: It’s a privilege to work with the people we have assembled in all the different businesses in Astoria.

Vaclav Smil – zero carbon won’t happen

A few weeks ago, I mentioned that I was reading Vaclav Smil’s book, “How the World Really Works”. It’s a highly engaging but sober look at how the world uses energy, in which politics do not obscure facts. I came across another article by him that tears the “zero carbon” argument to shreds. You can read it here. These are the main points of his argument:

• We have only a single generation (about 25 years) to do it.
• We have not even reached the peak of global consumption of fossil carbon.
• The peak will not be followed by precipitous declines.
• We still have not deployed any zero-carbon large-scale commercial processes to produce essential materials; and
• The electrification has, at the end of 2022, converted only about 2 per cent of passenger vehicles (more than 26 million) to different varieties of battery-powered cars and that decarbonization is yet to affect heavy road transport, shipping, and flying (IEA, 2023c).

My take: Smil cuts through a lot of noise. Ignore him at your peril.

Music. Always music.

1. My journey through the music of my lifetime continues. I have just worked my way through 1983 after having started my journey 6 years ago with the “best of 1962” – the year I was born. Yes, I know, there’s a place on the spectrum for everyone. In any case, I’m not sure I would have picked precisely these twenty songs in this order when I was 21 in 1983. But this is my top 20 now, in Apple Music and in Spotify. They are ranked from 20 to 1. As David Gresham used to say in his countdown on Springbok radio – “keep your feet on the ground and reach for the stars!”. And if you remember that, you’re old, man.

Also, Karl Wallinger died recently. Karl was a member of the Waterboys (see song nr 9 in the top 20 of 1983) but left them after two albums to start his band, World Party. I liked (still like!) Waterboys a lot and liked Word Party but had forgotten about them. My friend Mark Rosin chose a World Party song for his “Friday Song” shortly after Wallinger died. This started me down a Karl Wallinger rabbit hole, which I enjoyed. Here is my “Best of Karl Wallinger” in Apple Music and Spotify.

That’s all for this week.

One more thing: be careful out there. You never know who’s watching.

Piet Viljoen
RECM

P.S. Daniel Kahneman died yesterday. Here is a picture Richard Thaler posted on X:

“I was so lucky to have Danny Kahneman as a best friend and collaborator for decades. He usually ended our conversations with “to be continued…” but I now have to simulate his part, which is impossible. My favourite image is of us “working”.”

You can do a lot worse in life than read everything Kahneman wrote. One quote from him stands out: “The easiest way to increase happiness is to control your use of time”.

RIP, Mr. Kahneman. You contributed so much to our thinking about choices, biases, rationality, and life in general.