Regarding… Vol 2 no 26 – Caveat Emptor

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 11th of July, the 193rd day of the year. There are 173 days left until the end of the year. Here in Cape Town, we are experiencing our third winter storm. This week. It’s not called the Cape of Storms for nothing.

Have you ever wondered when life got so complicated? FICA, KYC, TCF, and CPD are all acronyms that have crept into our financial lives over the past decade or so. All of them are well-meaning attempts by regulators to create an environment where the client gets a better deal than she otherwise might have. They all make it more difficult and expensive to do business for the client and the service provider.

I bet you don’t get a warm, fuzzy feeling that your interests are being looked after when the bank phones for the seventh time, threatening to freeze your account if you don’t provide them with physical proof of the last known address of your second cousin twice removed within the next 15 minutes. As well as a signed Freedom Charter – not a copy, the original.

Against my better judgment, I own a holiday house in a gated community in a small town. For a while, the Home Owners Association (HoA) was under the influence of some unscrupulous people with hospitality interests in the town. These interests faced competition from legitimate rental activities within the gated community.  During that time, the HoA and their “useful idiots” acted increasingly aggressively toward their perceived competitors.

Unsurprisingly, trust amongst the community’s inhabitants dissipated, leading to unprecedented litigation. No matter how trivial, almost every matter raised somehow ended up in court. Not much was achieved except for increasingly high levels of unhappiness in the community and higher levies to fund the litigation lunacy.

I tell this story to illustrate what happens when trust breaks down: costs and unhappiness go up. In a society that is becoming increasingly fractured, rules, regulations, pervasive surveillance, and litigation are all attempts to bridge the trust deficit. These things cost time and money and cause aggravation.

You can only do one thing to protect yourself: Caveat Emptor. It’s a free-for-all.

Another unintended consequence of an increased regulatory environment is that it reduces competition. It should come as no surprise that large corporations – like banks – often favour more rules. They have the scale to afford large compliance departments. A complicated regulatory environment creates sticky customers – after all, who wants to jump through all the paperwork it takes to switch your financial service provider? Sticky customers are valuable customers. Large corporates know this and work hard to increase their stickiness by encouraging the regulators to increase their activity levels.

All in the best interest of the client, of course.

A system where trust breaks down becomes more centralised. A centralised system holds incredible rewards for those individuals and corporations who control it. That’s why socialism – a centrally planned system – always devolves to a few incredibly wealthy insiders expropriating their wealth from the impoverished proletariat. As a result, the system goes backwards.

The alternative to this is a high-trust system.

Trust is the oil that lubricates the gears that make society work. A high-trust society runs smoothly. Relationships are clear and well-defined, and transactions are simple to execute. Reputations are built over time and are meaningful – a guarantee of sorts.

Investing time and effort into building trust has a high payoff. Start with your circle of family and friends and expand into your professional network. Happiness goes up, and costs go down.

Of course, there will always be bad-faith actors who will try to arbitrage such a system. But the generalised benefits by far outweigh any specific costs.

Fortunately, technology has stepped in to help us here: blockchain technology brings trust back into the system via cryptography. It can potentially replace a lot of regulatory intervention that causes so much friction in our lives. Plus, it can reduce the time we spend on due diligence.

Blockchain technology is also a strong force for decentralising systems, which is why governments have so much antipathy towards it.

Over the next three weeks, I will explore this much-maligned but potentially incredibly useful technology. Bear with me; it’s worth it.

WBA was a dividend king, with 48 years of consecutive dividend increases, until last year. It’s supposed to be a stable retailer of stuff people need to buy. It operates in a highly concentrated market, having driven most independent pharmacies out of business. Just like Clicks/Dis-Chem here in South Africa.

But this is what has happened to their margins over the past 15 years:

Increased labour costs, higher levels of competition, and lower drug prices have challenged Walgreens Boots Alliance. Retail pharmacists such as WBA don’t have enough leverage to change the pricing model, which is not working for the retail pharmacy business. There is also increased competition from Amazon, Walmart and Target – when your margins are high and you generate a large profit pool, you become a target. That’s how markets work.

WBA tried to acquire their way out of this decline, which only led to an unsustainable increase in the debt-to-equity ratio:

Of course, this never ends well – lower profitability and higher debt mean just one thing: less for shareholders and a dividend cut.

My take: Hell hath no fury like a dividend king (queen?) scorned. It’s hard to see them coming back from this in their current form. It also serves as a warning about getting too excited about defensive, growing retailers. Their profit pool is someone else’s opportunity. It’s just a matter of time.

Corning was the poster child of the dot-com era. It’s an old market aphorism that the best investment isn’t the mine; it’s the company that provides the picks and shovels to the miners. Corning provided the glass fibre that the internet ran on. In 1999/2000, the internet was busy taking over the world. The demand for their product was through the roof, with waiting lists.

At the time, it was common knowledge that there was absolutely nothing the internet couldn’t do. These expectations resulted in huge chunks of effectively free capital being showered on any business involved in the game, however tangentially. Especially those providing the picks and shovels.

Kids, look up the history of a South African company called Dimension Data.

Unsurprisingly, massive overcapacity was created, which came home to roost following the tech bust of 2001. The term “dark fibre” was coined to indicate how much excess fibre optic cable had been laid by the telecom companies – fibre that Corning provided. This created a massive (temporary) revenue boost. When the inevitable bust came, demand for Corning’s products dried up for years. It’s classic capital cycle stuff.

Eventually, there were big winners from this capex boom – but not the “obvious” candidates like Cisco, Intel, or Nokia. All of these were among the top 10 biggest companies in the world by market cap in the year 2000, and all of them have share prices that, 24(!) years later, are still below the level reached in 2000.

No, the big winners from the internet’s build-out were companies that didn’t even exist in 2000 – Meta, Google/Alphabet, or companies seen as also-rans in the early internet era, Apple and Microsoft.

Fast-forward 23 years, and Corning recently released good estimates for sales and EPS, driven by strong adoption of new optical connectivity products for Generative AI.

The share price liked it:

But if you zoom out, even after this AI bump, its share price is still 30% below the levels reached during the dot-com craziness a quarter century ago.

My take: History doesn’t repeat, but it rhymes. I can think of at least one company regarded as AI’s prime “pick and shovel” provider – but who’s to know whether it will be the big winner over the next 10 years? Instead, I think it will be a company we haven’t even heard of yet.

For now, it continues to be all systems go. If you suffer from FOMO, you have to be involved. I don’t.

Banks have been on a run after the positive election outcomes and the formation of the GNU. Capitec, FirstRand, and Standard Bank are significant holdings of the MWI Value fund, and they all hit new all-time highs recently.

The main driver of banks’ profitability is how fast their book grows, i.e., how much their clients borrow. The biggest driver of clients’ appetite to borrow money is confidence – confidence, and low interest rates.

Over the past few years, these ingredients have been missing from the South African economy. However, the election outcome might boost confidence, and lower interest rates might be around the corner.

At least, that’s what the share prices are saying.

Many argue that banks shouldn’t be owned into a declining interest rate cycle due to the endowment effect, which means they earn a lower return on excess capital.

So, I looked at Standard Bank after the previous three rate-cutting and rate-hiking cycles. The upshot? Standard Bank outperformed both in the first 12 and 24 months after rates started being hiked AND when they began being cut.

My take: Banks are good businesses. They have sticky customers and provide a product that customers need. The only time you don’t want to own banks is when there has been an explosion of credit growth. That does not describe the South African banking environment today.

Moneyweb published a very good piece on banks by The Finance Ghost. In it, he explained very well – as only he can – how banks make money. The Ghost’s investment conclusions were quite different from mine, but I guess that’s what makes a market. You can read his piece here.

From Doomberg:

“In a properly functioning democracy, journalists use fact-based reporting to keep the public adequately informed and hold elected officials to account. Absent such neutral refereeing, democracies tend to malfunction, succumbing to the forces of single-party rule, which inevitably leads to mass corruption and loss of faith in the system. Contemporary political parties might answer to different names and disagree with each other on a few issues, but such is largely theatre that serves to deflect attention from the enrichment the political elite are helping themselves to at the public trough. A pliant media is necessary for such boorishness to flourish.

The public’s trust in the media is thus among the best metrics to gauge the health of a country’s political engine, and recent polling data in major Western nations paints a grim picture.”

My take: The debacle around Biden reinforces this view. I have not watched the news on TV or read any mainstream newspaper for a long time. Fortunately, many niche information services are willing and able to fill the gap. I mentioned some of them last week, and this week, we had the news that there was a new start-up publication called Currency, headed by Rob Rose, the former editor of the Financial Mail. Together with Giulietta Talevi and Ann Crotty, they are a formidable team that is not known for pandering to corporate interests. I look forward to reading their work.

Here is the full article by Doomberg from which the previous chart was taken. In summary, arguments that say renewable energy is the cheapest form of energy fail along the following lines:

• They conflate temporarily cheap energy (when the sun is shining, or the wind is blowing) with the average total cost of delivering electricity to consumers.
• Insufficient supply, at times, is inevitable. At night, for instance. This means you have to replicate the entire system as a backup. Whether with batteries or coal plants, the cost is real.
• Renewable energy creates volatility in electricity production, which creates problems for the baseload generators. Problems that cost a lot of money to fix.
• Substantial investment in transmission infrastructure is needed to transport renewable energy to where it is needed.
• Alternatively, one could “shift demand to hours when energy is plentiful”, which would require society to reconfigure how it goes about its daily business, a costly exercise.
• Finally, batteries are getting cheaper but are still expensive. The amount of storage necessary for a grid operator to be installed to prevent blackouts would be prohibitively expensive.

My take: This is a “green energy” plant:

Apart from its colour obviously not being green and its costs not being appropriately calculated, I have more questions about this form of energy. Over what timeframe is this installation being depreciated? What happens to these panels when they reach their end of life? How much energy does it take to make them in the first place? And what form does this energy take?

This was – by far – the best thing I came across on X this week. It’s obviously written by someone who knows something about coding and programming. The author also knows how to write very well. I can’t vouch for the veracity of everything he says, but it’s a handy antidote to the “all AI, all-of-the-time” crowd. Most of whom – like me – don’t even really know what it is. Or even what it is supposed to be.

On the topic of AI, I came across this thread on X as well. Again, you have to make up your own mind about this stuff. But what this guy, Roger McNamee, says should at least ring some alarm bells.

“America loves financial manias”, he says. His argument boils down to this: the capex being invested in the AI and AI tangential sectors will struggle to generate enough profits to justify the investment.

My take: Could this be Corning redux?

From the New York Post, courtesy of Grant’s Interest Rate Observer:

“She’s top of the bots. Kenza Layli, a hijab-wearing bionic belle from Morocco, has been crowned the world’s first-ever Miss AI. “While I don’t feel emotions like humans do,” the chaste cyber siren revealed in an exclusive interview with The Post, “I’m genuinely excited about it.” Crowned the crème de la crème of artificial intelligence models, the leggy Layli – a lifestyle influencer in her home country – crushed more than 1,500 computerised challengers for the coveted title, which comes with a $20,000 grand prize for the human tech exec from her home country who brought her to life. The unprecedented pageant, commissioned in April by the Fanvue World AI Creator Awards, or WAICAs, invited artificial intelligence visionaries from around the globe to flaunt their programming prowess.

Contestants who scored the highest marks in categories such as beauty, technology and social media presence earned bragging rights as the top 10 finalists. A panel of judges made up of both human and android pageant experts, then hand-picked the final three to digitally duke it out for the win.”

Here’s Kenza speaking for herself.

My take: What’s with the bizarre hand movements? And the failure to even lip-synch a little bit? And she won? I wouldn’t want to see the losers. If this is the best AI can come up with after all the money spent so far, I give up.

Now for something more real: Howard Marks on debt, deficits, and the changing financial environment. And, importantly – the outlook for private equity and private credit. In it, he paraphrases Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know that ain’t so that does.”

My take: Howard Marks is always the voice of reason. Ignore him at your peril.

Modest Proposal is an anonymous investor who, according to Patrick O’Shaughnessy who runs the podcast “Invest Like the Best,” is one of the most thoughtful investors in public markets.

After listening to this podcast, I agree. There is a lot of food for thought here, and it warrants more than one listen.

He compares the capital cycle in commodities in the mid-2000s with what’s happening in another cyclical business – chips, of the computer kind – today. He makes some interesting points about Apple, which happens to be, via Berkshire, a significant holding in the MWI Worldwide Flexible fund (aka the cockroach). GLP-1 – the other current major investment fad, also gets a mention.

You can listen to it here; it’s very much worth an hour of your time.

This week, I came across a new album – the first in 12 years – by Little Feat called Sam’s Place. It was a joy to listen to! This band started in 1971, disbanded in 1979, and reformed in 1987. Initially, they leaned towards New Orleans swamp boogie, then moved in a jazzier direction. They have also blended West Coast rock, country, and rockabilly into their sound.

This album takes a firm step towards the blues, and I couldn’t be happier!

Listen to it on Apple Music

Or on Spotify

That’s it for this week.

One more thing, though: be very careful out there.

Piet Viljoen
RECM