Regarding… Vol 2 no 25 – Avoiding the Slaughterhouse

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 4th of July, the 186th day of the year. There are 180 days left until the end of the year. We are over the hump; it’s downhill from here.

On this day in 1865, Lewis Carroll’s Alice’s Adventures in Wonderland was published. Also, philosopher Henry David Thoreau moved to his retreat at Walden Pond, where he eventually wrote a series of reflective essays titled Walden; or, Life in the Woods.

In Alice in Wonderland, Alice navigates an unfamiliar world full of arbitrary adult rules, where fear is often the driving force for participants’ decisions. The answers to riddles are questionable or non-existent. Alice’s good sense and her feeling for justice are indispensable to her eventual success. Sound judgment helps her survive and unveil the egotism, angst and violence surrounding her.

Walden explores the themes of self-reliance, simplicity, and the beauty of nature, advocating for a life lived intentionally.

Amanda and I visited Walden Pond just north of Boston a few years ago. Here is a replica of Thoreau’s cabin:

And here is the pond itself (it’s actually a small lake):

Both books are highly relevant to our lives today, and a reading – or re-reading – can be highly instructive. I read Walden for the second time a few years ago, and it left even more of an impression on me.

Here’s a picture of me at Walden Pond in front of the “Quote of the Day”:

Quite dramatic and, today, hard to do. But doing the hard thing is often the best way through a difficulty. And, like Alice, doing the sensible thing usually gets you through to the other side. Mostly intact.

A very short fifty years after these books were published, Mae West became one of the first sex symbols spawned by Hollywood. In a more conservative era, she was known for pushing the boundaries of sexual innuendo and regularly got into trouble with the authorities because of her uninhibited productions. Thoreau would not have approved.

Some famous quotes from her:

• When caught between two evils, I generally pick the one I’ve never tried before.
• Too much of a good thing can be wonderful.
• You only live once, but if you do it right, once is enough.

By pushing hard on the boundaries of decency, Mae West gave the punters exactly what they wanted. Mae West knew how well sex sold and used it to promote herself and her show.

Financial markets are like Mae West.

They figure out very quickly what the punters want and then deliver it to them in spades, fully subscribing to her notion that too much of a good thing can be wonderful – for the product providers, of course, not the punters.

If one thing unites all investors, it’s their appetite for yield. When faced with the prospect of earning a juicy yield, they will rationalise anything.

There are two ways to get yield: you can take credit risk, i.e., lend to riskier entities, or you can take duration risk, i.e., make longer-term loans to high-quality lenders.

Historically, banks have been in the business of taking credit risk. Customers would come to them with a request to borrow money. The bank would then do a thorough credit analysis and propose the terms for a loan if the outcome was satisfactory. It would fund this loan off its balance sheet, which was, in turn, funded by customer deposits.

However, in the aftermath of the great financial crisis, regulators have increasingly discouraged banks from expanding their loan books.

Enter private credit. “Private” is such a great word, potentially implying exclusivity, differentiation and scarcity – words that are sure to push the “I want” button with investors.

Private lenders offer bespoke loans to borrowers and typically don’t trade the debt, locking their money up for long periods. Interest rates are often higher than at banks and public debt markets. Instead of taking deposits like banks to fund themselves, private lenders raise funds from investors attracted by the higher interest rates.

Over the last decade, incentives have aligned to make private credit a significant asset class.

• To investors, it promises high yields – which investor doesn’t like high yields?
• To the intermediary, it promises a rich stream of fees – which intermediary doesn’t like fees?
• To the borrower, it promises a faster, more efficient way of borrowing than going to a bank – which borrower likes dealing with a bank?
• To the lender, it promises a way to avoid pesky regulators – who likes a regulator?

As a result, private credit funds are swamped with inflows, forcing them to continue buying into risky credits, thereby compressing the yield that investors earn on those inherently risky assets. All the while, they pretend to investors that they are investing in a liquid asset. You can take your money out at any time, can’t you?

Whenever high growth funded by easy access to credit prevails, you can bet your firstborn there will be accidents. So when that inevitable credit event hits, and you get side-carred, say goodbye to your liquidity.

From Grants Interest Rate Observer:

“Missing from the prospectuses of funds that invest in private credit are:

1. This strategy has not weathered a complete credit cycle.
2. We have, in effect, bet the ranch that rising interest rates are incompatible with recession or depression.
3. A very good question is whether our triple-C-rated or equivalent portfolio companies have the earning power to continue to pay elevated interest rates.

Truism: The business of borrowed money is inherently unstable and forever cyclical.”

Nothing is more dangerous than a cyclical asset funded with loads of debt in a lightly regulated (i.e. private) market. Ask the shareholders of Transaction Capital or African Bank. Or their funders in the private credit market. Many other examples are bubbling up, but a former blue-chip like Pick ‘n Pay breaking covenants with lenders is not a credit-friendly event.

Even worse, many of these income funds are being run by economists, who know little about credit, unlike the bankers or credit analysts employed by banks.

“Private lenders that took disproportionate risks in recent years have been disproportionately rewarded,” John Pavelski, co-head of North American credit opportunities at the Carlyle Group, told the WSJ. “That’s going to change.”

Fortunately, in South Africa, we have an escape hatch: due to our steep yield curve, long-dated government bonds – a low credit risk asset – have high yields. This makes them a good place to hide. If you want to generate income, the risk you want to take is duration, not credit.

If your income fund is long credit but short duration, like Alice, you might want to ask some questions. The performance might look good in the rearview mirror, but all bets are off in the future. Do you understand the risks you are exposed to? Are you willing to accept them? In financial markets, investors who ignore risk in a greedy search for yield are called “yield pigs”. One thing invariably happens to pigs: they get slaughtered.

My thesis: A weak economy and high short-term rates (amongst the highest in the world) make credit risky, while the accompanying steep yield curve makes duration cheap.

If you’re looking for income, look in the right place. Be sensible and live deliberately.

Avoid the slaughterhouse.

Nike’s years-long strategy to move away from relying on traditional retail partners to become a digital and brick-and-mortar shoe seller is turning out to be less than successful. The promise was that, after a significant investment to get operations up and running, Nike could cut out costly middlemen. Despite early successes, things are now going the wrong way: revenue from direct sales fell 8% this quarter, while wholesale revenue rose 5%.

The share price didn’t like this outcome:

Right now, if you had bought into one of the most iconic brands in the world at any time over the last decade, you either lost money or earned a way below-par return.

When I started RECM in 2003, I fought hard against the “product platforms” who wanted part of the fees on the funds I managed for the service they provided to their clients, the actual investors. I thought they were overreaching. I was wrong. Distribution – creating a convenient way for the customer to access your product – can be the most valuable part of the chain. Sometimes, I now realise, it is more valuable than creating the product itself.

My take: Two points. One, is it possible that mighty Nike is busy learning a lesson? Or have they simply neglected their product? Either way that leads me to Two: it’s tough in the retail world. And if you, like Nike, have been trading on inflated earnings multiples, investment returns are guaranteed to be even worse than business returns.

Like Lewis, which I wrote about last week, Afrimat shows what can be done here in South Africa despite our inept politicians, energy constraints and general negativity. While most materials businesses’ share prices are struggling, Afrimat has just hit a new all-time high:

Both Lewis and Afrimat have grown per-share value for shareholders by making astute acquisitions. Lewis has been acquiring a company it knows very well by buying back its own shares. On the other hand, Afrimat has been acquiring other businesses.

Both companies have management that understand their respective industries well and have allocated capital accordingly. Both management teams also happen to be the best in their respective industries.

Over the past decade, Afrimat has grown from a small construction materials business to a medium-sized bulk mining and construction materials business through acquisitions.

Most acquisitions fail to create value, especially in the mining sector – ask Impala Platinum about their recent acquisition of RB Plats! Afrimat buys when things are tough, thereby avoiding a bidding war. In so doing, they pay a low price, increasing their margin of safety. Then, they send in the best people to run the new acquisition.

Capital allocation and execution sets them apart from the milling crowd.

My take: I regard this management team and company highly. Afrimat will be a large business one day. Right now, it’s a big holding in the MWI Value fund.

I think I have mentioned this blog before. If you haven’t yet subscribed, do yourself a favour. It’s free, and you can do so here. Essentially, it’s a forum for Nick Cave to answer questions from his fans – both existential and banal. His answers, though, are always insightful and well-written. It’s a joy to read, if only for his beautiful prose.

These two quotes from this week’s piece stood out for me:

“Our humanness is not given to us. Instead, it requires our participation in its construction and realisation, which often comes about through collapse or calamity.”

“I do my best to move through life with a joy that is reconciled to the sorrow of things but is not subsumed by it, that apprehends darkness and is not afraid of it.”

I have quoted Ben many times in my letters. However, the piece he wrote this week after the Biden/Trump debate nearly broke the internet because it was so appropriate. You can read it here.

In the piece, Ben explains how narrative drives behaviour through what he calls “Common Knowledge”—what everyone knows that everyone else knows. When this changes, it creates a seismic shift. Ben says a shift happened with the debate, and we have entered what he calls the Great Ravine.

According to Ben, the Great Ravine is the end of an age: “It is the end of the cheap money and labour of easy globalisation. It is the end of the unipolar moment of American dominance and its wars of choice and drones. It is the end of trust in our most crucial institutions – all of them! – charged with the core social functions of public health, public education, public finance and public safety.”

My take: Scary, but I think we fully comprehend this shift down here on the southern tip. We shifted a long time ago; we’ve been in the great ravine for quite a while already. Life goes on. As Ben says, you just need to find your pack.

This article set out the rise of private credit quite well, much better than my earlier attempt in this letter.

The money quote: “This explosive growth is attracting not only new pockets of capital, including retail investors but also scrutiny over potential financial stability concerns.”

My take: Caveat Emptor. The words “explosive growth” and “credit” should never be used in the same sentence. When you see it, be extra careful.

I’ve said it many times before, but it bears repeating. The less news media you consume, the happier your life will be. As Johannes Kerkorrel famously sang of TV during the Apartheid era: “Sit dit af!”

I do not subscribe to any mainstream news media at all. I do, however, consume media of the less sensationalist, more rational kind, people like Alec Hogg and his service Biznews or Gareth Cliff and his service, simply called Gareth Cliff.

Yesterday, I watched Gareth being interviewed by Alec Hogg. You can watch it here.

My take: Gareth very nicely explains why he thinks South Africa has turned a positive corner and is an excellent place to be right now.

Many of you might know I am on a musical journey, documenting the best music – according to me! – from each year since I was born.

This week, I finished going through 1985. (It takes me about 2 months per year’s music).

What a year! What memories!

In 1985, at the start of my honours year at the University of Pretoria, the Statistics department approached me to teach Stats 1 to the first years. I took the job because it meant I could stop working as a waiter, which was how I had been paying my bills through varsity.

The job meant that, at 22, I had to teach a class of roughly 200 students, most of whom didn’t want to be there. Also, many students were the same age or even older than me. Those days, most guys first did their 2 years of compulsory military service before going to Varsity. At that point, I was still ducking and diving to stay out of the army, and studying for as long as possible was one of those ways. Standing in front of all those students was a daunting task, and I vividly recall how my legs shook during the first few lectures.

That year, I shared a three-bedroom townhouse with four other guys. Don’t ask; it was cheap. The upside was that some of those guys are still my best friends today. Of course, they complained about my musical taste then and still do today.

Also, it was during that year that I dated Marina, who would – one day – become the mother of our son, Nic, of whom I am immensely proud. She was studying at Stellenbosch. I still recall flying down to visit her one weekend, and one of the guys I met in her digs was a super laid-back surfer named Francois. Today, Francois Gouws is the high-performing CEO of one of the top companies on the JSE, PSG Konsult. Who would have thunk?

In any case, these songs bring back the memories of that year – studying hard, working hard and partying slightly less hard, although harder than I guess I should have.

It was a good year.

Here are my top 10 albums on Apple Music

Here is my long list of best songs of the year on Apple Music

Here are my top 20 songs on Apple Music and Spotify. These are roughly from nr. 20 to nr. 1, in a sort of a countdown. Reach for the stars and all that (IYKYK).

That’s it for this week.

Except for one thing: be careful out there!

Piet Viljoen
RECM