Regarding… Vol 2 no 16 – Sanctions Don’t Work

Dear Fellow Investors and Friends

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

I’m Piet Viljoen, and today is Thursday, the 2nd of May, the 123rd day of the year. There are 243 days left until the end of the year. On this day in 2016, Leicester City won the English Premier League title after starting the season at 5,000-to-1 odds. Low-probability, high-impact events happen more often than expected – especially in financial markets. It pays to consider this when structuring a portfolio.

Growing up in South Africa in the ’70s, there was no Burger King or McDonald’s. But there was Wimpy and Juicy Lucy, which – we thought – was just as good. There was no Budweiser, but there was Castle Lager. It was better. There was Coke, Fanta and Sprite. But that’s it – no Mountain Dew, Seven-Up, or Orangina.

There were oil sanctions so we couldn’t fill up after 5 o’clock or over weekends. The speed limit was 100 km/h. It didn’t bother us – the roads were safer. There were weapons sanctions, so they built Armscor. There were sports sanctions, but then there was Naas Botha and the Currie Cup, rebel rugby and cricket tours, and the million-dollar golf at Sun City.

Look, I’m not saying it was all tra-la-la and jolly hockey sticks; far from it. I am saying that people are ingenuous and they get around obstacles. That is human nature. Many people – including corrupt government officials – became insanely rich by finding ways to circumvent sanctions.

As a result, life carried on. If you grew up here as a young, white, privileged person, you would have been largely unaware that South Africa was the pariah of the world due to its abhorrent racial policies. Most people affected by sanctions were those from marginalised communities – precisely those the sanctions were supposed to help – whose access to economic resources was crippled.

What finally brought about a policy change was not sanctions, but rather financial mismanagement. After taking on too much foreign debt and then defaulting on it in 1986, the Apartheid regime could never dig itself out of its self-imposed financial hole. Faced with ruin or financial salvation, they changed their ways; they chose wisely.

By all accounts, things are just fine in the economy of the newest global pariah, Russia. Shortly after they invaded Ukraine, the West imposed more than 16,000 sanctions, with the main target being Russia’s financial system. Half of their currency reserves were frozen, and assets of some banks were also frozen. Banks were also precluded from using Swift, an international financial messaging service widely used to transfer money.

Before they invaded Ukraine, the country was in good economic shape with low debt levels and substantial reserves. If anything, they were well-positioned to ride out any sanctions storm. It’s almost as if they knew what was coming their way.

Bloomberg recently reported, “Key sectors of Russia’s economy are adapting and in some cases completely rebounding from unprecedented international sanctions imposed over the war in Ukraine. Russia’s economic growth and surging consumer demand, boosted by ample government spending, have allowed businesses as diverse as banks, car manufacturers and airlines to find ways to cope and, in some cases, thrive despite US and European restrictions aimed at tanking the economy in retaliation for the war.”

Notably, India and China are short of what Russia has most of: commodities. China generally doesn’t care much about what the West thinks of it. So, it would be no surprise that they are taking advantage of the situation. The Indians have always been great traders, so for them to act as a conduit for Russian goods to other countries is also not surprising.

The Russian stock market – the MOEX – has recovered all the losses incurred since the Ukraine invasion. It’s as if it never happened. Except that Western investors in Russian stocks – of which the MWI Worldwide Flexible fund (aka the cockroach) is one – are caught in a classic Catch-22 situation.

The book Catch-22 by Joseph Heller is set during World War 2. Its main character, Yossarian, doesn’t want to fly any more missions, as they are pretty dangerous. The only way to get out of them is to declare himself insane. But the rules say that if you say you are insane, thereby avoiding further missions, that means you are sane, as you would have to be insane to want to fly missions in the first place. So you have to fly more missions.

That is precisely where outside passive minority investors in Russian stocks find themselves today: the rules say they are not allowed to hold Russian financial assets, so they are written down to 0, despite trading at pre-war levels on the Russian exchange. But if the fund tries to sell them, the intermediaries (brokers and custodians) say they are not allowed to touch the shares, so the fund can’t transact.

Go figure. In the meantime, large corporations like McDonald’s can disinvest from Russia. Those who suffer the most downside from sanctions are ordinary man-in-the-street fund investors in New York, London and Cape Town.

And the politicians and regulators go to bed at night feeling smug that their performative interventions illustrate their solidarity with the people of Ukraine.

In Russia, it’s business as usual. Like cancel culture, sanctions just don’t work.

This is a great concept stock. It has both concepts that South African investors can’t resist despite years and years of evidence to the contrary: ”property” and “offshore”. Even worse, this “offshore” is Australia, the killing ground of the hopes and dreams of generations of South African investors.

Here’s a chart from The Passive Income Guy, @hazelwood_dave, on X:

My take: It is now lower than the Covid low. Enough said.

After reporting strong first-quarter results, Google’s stock surpassed a $2 trillion valuation mark. GOOG’s advertising business showed robust growth, with total sales rising 15% YoY and ad sales increasing 13% YoY. The introduction of a dividend and a $70 billion share repurchase plan were well-received by investors. Investors feared AI would disrupt GOOG’s search engine, but the recent results have somewhat allayed these fears. The share price was up strongly as a result:

Slowly but surely, the magnificent 7 are being whittled down to a smaller group. Tesla and Apple have been struggling recently, while Meta, Nvidia and Microsoft have shown some short-term weakness. Only GOOG and AMZN have hit new highs recently.

My take: I still think we are in a technology-lead bull market, but companies outside of the Magnificent 7 are increasingly driving the market. I discussed my views on these stocks in “Squeeze Play” a few months ago. I still think investors globally are overexposed to these stocks and underexposed to tomorrow’s market leaders. But getting the timing right for the rotation is easier said than done.

Banks everywhere in the world are hitting new highs. JP Morgan, Wells Fargo, Goldman in the USA, Itau in Brazil, Mitsubishi in Japan, SE Banken in Sweden, and Barclays in the UK. It’s a bull market in big bank stocks.

Here is a chart of the iShares Global Financials ETF:

My take: This is a bull market that no one is talking about. Most investors have little exposure to this sector. It is a sector that will play a leading role as fiscal domination asserts itself in financial repression. Negative real interest rates – the hallmark of a good repression – are great for banking profitability. If we care to listen carefully enough, I guess this is what the market is trying to tell us.

After trading below its IPO price for two years after listing in late 2021, UMG recently surpassed its post-IPO share price level. The music business is doing well, with Spotify coming out with good results and the Hipgnosis Song Fund potentially being taken private. Here is a chart of UMG, one of the “big three” music rights owners in the industry:

Bob Lefsetz – an American media lawyer and consultant to major labels) writes a daily letter in which he talks mainly about the music industry – and if you love music as much as I do, it is an entertaining read. You can subscribe here. His main talking points recently have been about how well the labels are doing but how hard it is for artists to break through. The market is affirming his view.

My take: Streaming has made more music available to more people and has enabled more artists to produce music, some of it even pretty good. The long tail writ large. But it seems people still only listen to “eighties music”, which is great for the labels, publishers and rights owners but challenging for upcoming young artists. In a bull market, the business of music does well.

And now for something completely different – a South African small-cap stock! Calgro M3 is a home builder servicing the lower-income market. It went through a tough time after finding itself in an overleveraged situation when interest rates started going up. It bottomed at R2 per share in 2021 and has recently gone up to over R5 per share, a new high since 2020.

Calgro M3 has a net asset value of almost R12 per share and should earn close to R2,00 per share in the year ending February 2024 (results are due shortly), putting it on a P/E multiple of less than three.

South Africa is packed with situations of deep value like this. Companies with management teams that are doing a good job, and businesses that are faring reasonably well in a challenging environment are trading on ground-hugging multiples. If you can buy a growing company with an earnings yield of 33%, nothing much has to happen for you to make a lot of money over time.

Stocks like CalgroM3 are not on low multiples because investors have researched them deeply and concluded their fundamentals could be better. They are on such low prices because investors wanting nothing to do with South Africa are selling out of local funds and effectively buying the Magnificent 7. As a result, local funds are forced sellers of these stocks.

My take: This stock, and the many others like it, offers a massive opportunity for those willing to countenance at least some exposure to South African assets. The Merchant West Investment Value fund is full of stocks like Calgro M3. I’m bullish.

Here’s proof: the Chinese stock market has gone nowhere for thirty years despite the most substantial economic growth rate over the most extended period we have ever experienced. Even Japan has done better, as well as that hotbed of political uncertainty, South America.

From Gavekal:

In other unrelated news, that place where economists go to die, Turkey, has a stock market that has matched the world’s best-performing market, the USA, over the past few years. That’s in US$, with dividends reinvested. Go figure!

Again, from Gavekal:

My take: Prices are set by the interaction of demand and supply. When investors rush to invest in great stories, like China, they sometimes need to remember the fundamentals, such as investing in a communist country, where ownership rights might not always be respected. Alternatively, when capital is scarce, the returns on that capital tend to be high. Like Turkey. Or, dare I say it…..South Africa? We will only know in ten years or so when we can look in the rear-view mirror and sound wise.

I have been showing variations of this chart for a few years now:

It describes the roughly 15- to 20-year cycle of commodity assets vs financial assets. Mining is a long-term, capital-intensive business. It takes a lot of money and time to build a mine. However, mines only get built when commodity prices are high enough to incentivise miners to do so. Commodity prices only go up when commodities are scarce due to previous under-investment after a period of low commodity prices. And so it goes.

Today, commodities have underperformed for 15 years after the boom preceding the GFC. I thought the turn was happening after Covid, but it turned out I was early. The money printing to stimulate economies after lockdowns pushed up the prices of financial assets and extended the duration of the cycle. And after my previous bout of being too early, which you can read about in “Stoic WP”, I was cautious about being too gung-ho this time. Rightly so, it turns out. But the turning of the cycle is getting closer and closer.

My take: Previous under-investment in commodity extraction and the need to rebuild infrastructure in the developed world will drive the new cycle. When this happens, it will be good for all those previously neglected assets: Emerging Market equities (and currencies), Material stocks, Energy stocks and Financial stocks. The MWI Worldwide Flexible fund (aka the cockroach) has broad exposure to these assets.

Here’s an interesting riff on how to think about – and how to deal with – rare events. What does it mean for your model of the football league when Leicester wins it?

And here’s some timeless advice from Kevin Kelly (@kevin2kelly on X) on his 73rd birthday. One of the many gems: “Read a lot of history so you can understand how weird the past was; that way you will be comfortable with how weird the future will be.”

The MWI Worldwide Flexible Fund (aka the cockroach) has released its quarterly report. If you’re interested in the fund, you can read about it here. In the report, I set out exactly what the fund tries to achieve for its investors and report on the short-term fluctuations that inevitably occur on the long-run path.

Astoria, our Mauritian-domiciled investment holding company, released its quarterly results last week. Just after that, Jan van Niekerk and I recorded an “Unlock the Stock” session with Mark Tobin and investor relations firm Keyter Rech Investor Solutions (KRIS). “Unlock the Stock” provides direct and dedicated access to listed companies looking to connect with retail investors on a more personal level.

You can watch the recording here.

The best music of 1984. Those of you who have been reading this letter for a while now know I am on a journey to document the best music of every year since I was born. A couple of weeks ago, I finished 1983. You can find that playlist here in “The Trolley Problem.”

Here are my top 20 songs – for me – of 1984:

On Apple Music

On Spotify

And the best albums – because we all need to listen to the whole of the album that artists produce. Like reading a book, you can’t read just one chapter.

On Apple Music

Sorry, I didn’t do it on Spotify.

That’s all for this week! I’ve spent a restful week in the Madikwe game reserve. Watching a pride of lions hunt a herd of gnu showed me again that you have to be careful out there.

Piet Viljoen
RECM