Regarding… Vol 2 no 30 – Priceless

Dear Fellow Investors and Friends,

Welcome to this week’s edition of my investment musings, where I try to make sense of the world around me and share stuff that I find interesting.

I do appreciate you taking the time to read this.

Today is Thursday, August 8th, the 221st day of the year. There are 145 days left until the end of the year.

On this day in 1786, the US Congress unanimously chose the dollar as the currency unit for the United States of America. The dollar’s history is fascinating; you can read more about it here.

In 1786, the price of gold was approximately $19.50 per ounce. Therefore, one dollar would have bought about 0.051 ounces of gold. Today, one dollar will buy you 0.00042 ounces of gold. That represents an annual rate of depreciation of 2% p.a.

For $1 – or 0,051 ounces of gold – you could take your family of four for a meal at a local tavern in 1786. Today, a 16-piece bucket at KFC costs $40. That same 0,051 ounces of gold buys you 3 family buckets. Of course, today, you don’t have to hitch your horses to the carriage, and you probably won’t encounter any wolves or highwaymen.

But still, fiat currencies do not preserve wealth over long periods of time.

Over the years, RECM has built a reputation as a dyed-in-the-wool value investor. However, over the past decade, we have become bigger investors in private companies than in public ones. Working with founders and entrepreneurs is a highly rewarding activity, but dealing with “consultants” and “risk managers” in public markets is less so.

Be that as it may, given our value-investing reputation, it’s understandable that owners of private businesses are nervous about transacting with us. The assumption is always that if we sell our business to you value guys, we’re probably selling at too low a price.

However, while we continue to practice value investing in the public market, we have found that it doesn’t work in private markets. So we just don’t do it there.

In private markets, the best deal is the one done at fair value.

In public markets, value investing works because the stock market is basically one big emotional rollercoaster. That, and liquidity, regulatory constraints, and the institutional imperative all contribute to causing prices to diverge dramatically from fair value every now and then. As a result, public markets offer investors the opportunity to practice what is termed “Deep Value Investing,” otherwise known as buying assets at deeply discounted prices.

Let’s deal with each of these aspects individually – although they often work together, just like the synchronised swimming teams in the Olympics:

Emotions: As a young boy, my father used to ask me when I was about to succumb to peer pressure and do something really stupid: “If Johnny jumps into the fire, would you, too?” My answer was invariably a rational No, but my actions were most often an irrational Yes. Group dynamics trumps rational thinking almost every time, even when you’re grown up. And especially when you’re grown up and working in a “client-centric” organisation.

So it is in markets, too. Markets are driven by the behaviour of investors in groups. We like to think of ourselves as independent, but the headlines in the news unify our thinking. In groups, emotions get amplified. When negative emotions like disgust, fear, anxiety, and resentment get amplified, they lead to inordinately low stock market prices. Conversely, positive emotions like euphoria, excitement, and hope that get amplified lead to extremely high prices.

Value investors can use these public market price swings to their advantage.

Private transactions are negotiated between informed buyers and sellers so these emotionally “amplified” prices are just not available.

Liquidity: Publicly traded stocks are generally fairly liquid. Investors tend to think they can exercise “control” over their investments by buying or selling them according to the news flow of the day. Liquidity facilitates this feeling of “control”, even if it is completely false. News flow – even if purely anecdotal – results in increased activity, potentially creating a gap between price and fair value.

This creates opportunities to transact at public market prices, which can vary dramatically from fair value.

Liquidity is generally absent from private markets, so prices are more stable.

Regulations: The regulatory environment in managing public funds has become quite onerous over the years. These regulations sometimes force managers of such funds to buy or sell assets regardless of the price/value relationship.

Buying or selling based on the regulations causes prices in regulated public markets to deviate – sometimes substantially – from fair value.

Private business buyers and sellers are not subject to such a stringent regulatory environment, so prices are not influenced by forced buying or selling.

The institutional imperative: Warren Buffett coined this term. He meant the tendency of organisations to mindlessly imitate what others are doing. Companies are just like teenagers – they desperately want to be part of the “in” group. If the market is rewarding buying back shares, “incorporating AI” into your business plan, moving your data “into the cloud”, or making acquisitions, everyone wants to do it – regardless of whether it actually makes business sense. Or any kind of sense, for that matter.

This can result in public market prices deviating substantially from fair value.

Private companies are not subject to the “social proof” of a publicly quoted share price, so they are less inclined to join the herd.

As a result, our best transactions in private markets have been when both parties were slightly unhappy – the seller thought they should have gotten a bit more, and we thought we should have paid a bit less.

The real reward from buying into private companies does not come from paying a bargain basement price and thereby extracting value from the seller. It comes from working with our new partners to grow the business, thereby creating value for all stakeholders.

These returns from investing privately can be good, but the experience is priceless.

Hands up those of you who first heard of the “carry trade” after the market slump on August 5. As always, market prognosticators were quick off the mark to explain what had just happened. The question I have is: why was no one warning us about this so-called carry trade on August 2,3 or 4?

Matt Levine from Bloomberg had by far the best description of events:

“Market crashes usually have the same mechanism. People like a thing, so they buy it, so it goes up. More people like it, so they buy more of it, so it goes up more. It goes up steadily enough that people think, “Ehh, I should borrow some money to buy even more of this thing,” so they do.

Eventually a lot of very leveraged investors own a lot of the thing. Then something goes wrong with the thing; its price goes down, the leveraged investors get margin calls, and they have to sell the thing to pay back their loans. Their losses are big enough that they have to sell other things, things that were fine, to pay back their loans on the thing that went wrong.

The big leveraged investors who owned a lot of the thing that went wrong also all own the same other things, also with leverage, so there is a generalised crash in the prices of the things that big leveraged investors own.”

When market action gets speculative, you never know what’s going to cause a correction – until the economists tell you afterwards exactly what happened. In my view, there is no doubt that the hype around AI has caused massive speculative activity. This cartoon from an article by Jason Zweig sums it up well:

The interesting thing is that AI is not new and it is not innovative. This is also from a piece by Jason:

If you squint, you’ll see the date on the cover is June 1987.

37 years later, on June 18th 2024, Jensen Huang – the CEO of Nvidia, the company leading the AI charge – was signing women’s bras. While they had them on. Nvidia was at $140 a share. I wrote about it at the time. With the benefit of hindsight, I might just have nailed the speculative top in AI-related stocks. Let’s see.

So what did I do on August 5 and 6 in reaction to the market gyrations? Nothing. Nada. Not one trade. In managing money, the goal is to set out your stall to harvest long-term returns from financial markets. This means avoiding speculative assets and allocating towards a reasonably uncorrelated, diversified collection of attractively priced assets. And then sitting tight. As Charlie Munger said, the magic of compounding often lies in doing nothing.

My take: Notwithstanding the glib explanations from all the experts, what happened over the past few days was another salvo in a desperately needed global deleveraging. The whole US-centric financial system has embedded within it an excessive amount of leverage. This leverage starts at the top with the US government’s national debt and works its way through the system with high debt levels in the private equity and debt markets.

A high probability outcome is that the next 10 to 20 years will be a time of deleveraging, characterised by generally higher interest rates in developed markets and generally lower returns from financial assets. In other words, nothing like we’ve experienced over the past 20/30 years

BH is a significant holding for the MWI Worldwide Flexible fund (aka the cockroach). Generally speaking, the cockroach refrains from stock picking, preferring to get equity exposure via funds or index ETFs. Owning BH is a way to get broad exposure to US equity without introducing the speculative element of AI, which is heavily represented in indices like the S&P 500.

Thus, the cockroach has effectively outsourced the US portion of its equity exposure stock picking to Warren Buffett and BH. Last Friday, BH’s released their 2nd quarter results. In the announcement, they disclosed that they had sold 390 million shares of Apple. This effectively cut their exposure to Apple in half and built up their cash reserves significantly. It was the seventh consecutive quarter that they had sold more stocks than they bought.

BH’s cash pile hit a new high in the last quarter:

The stock itself hasn’t done badly:

My take: Whether markets go up or down over the next day, week or month is not important. What is important is that investments are positioned in line with long-term risk / return fundamentals. Buffett has done that for the cockroach. We like it when the people who work for us do a good job.

I’m sorry, but despite reports to the contrary, it’s not all rosy in the (computer) chip sector. The OG of chipmaking, Intel, is taking drastic steps, cutting its dividend and 15% of its workforce as part of a $10 billion cost-reduction program. Of all things, its AI unit (Intel had an AI unit?) posted a 3% YoY revenue decline. Understandably, this raised concerns among investors:

This week, its share price is no higher than it was in 1998 – just before the Internet mania took off. At the time, Intel was seen as a no-brainer. It was the most important provider of picks and shovels into the turn of the century Internet boom. Twenty-five years later, it’s a has-been. All the AI cool kids go “OK, Boomer” when Intel says it will rebuild its technological edge.

25 years ago, when Intel was king, it sported a P/E of 35. That means you are comfortable that business fundamentals will stay solid for the next 35 years. This is a long time. A lot of the people paying 35 P/E’s for fashionable stocks aren’t even 35 years old. It’s quite possible they have no concept of how long 35 years actually is.

In 1998, we were all certain Intel would be the dominant tech firm for the next 35 years. But in much less time than that, Intel has gone from king to pauper.

My take: I have three questions:

1. Which technological kings of today are trading on multiples of 35 and more?
2. Do you think you have a good grasp of what tech will be dominant in 35 years’ time?
3. Do you feel lucky, punk? (apologies to Clint Eastwood)

“We merely must recognise that in dealing with people in mass or with governments, one is dealing with something very similar to a natural or elemental force. No one would consider for one moment entering into a contract with the Pacific Ocean by which it agreed to stay calm or of accepting the promise of the North Wind to blow only once each quarter.”

– Robert Lovett.

The Library of Mistakes is a free public library in Edinburgh, Scotland, that focuses on the world’s business and financial history. It was established in 2014 by one of the best market historians and analysts, Russell Napier. He believes that studying past mistakes is crucial for understanding how financial markets and economics interact in the real world. I couldn’t agree more. The people who best understand current developments are those who best understand history.

Unsurprisingly, the goal of the Library of Mistakes is to “promote the study of financial markets and improve financial understanding one mistake at a time”.

You can check it out here. Their site contains a ton of interesting material. This week, given developments in markets that have been blamed on the “carry trade”, I’d like to highlight this podcast.

In it, Russell Napier talks to Tim Lee and Kevin Coldiron, the authors of The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis.

That title is quite a mouthful, but it accurately and comprehensively describes their thesis: Due to the excessive financialisation of global asset markets, central banks have become hostage to leveraged financial institutions and have lost their ability to independently set monetary policy.

My take: I think we are going through a process of fundamental political – and thus economic – change. It’s happening slowly but surely. Over the next twenty years, all the working assumptions of two or more generations of investors will have to be revised. Any sensible investment policy needs to take account of this possibility.

Most fund management businesses will say and do whatever it takes to increase their AuM. This generally means they regurgitate platitudes and roll out forecasts, which are simply extrapolations of whatever is happening right now. This keeps their clients happy in the short-term and coming back for more whippings at the post. I wrote about how this works in “Structure Drives Strategy”.

Horizon Kinetics is not such a firm.

Their quarterly commentary is one of my reading highlights. In this edition, they discussed:

• The strong disinflationary trends of the past 40 years and how they are coming to an end.
• The paradox of indexation and the emerging risks to the large, primary indices.
• An interesting solution to the power challenge that AI faces.

The money quote: “Market history has a way of recurring, but not often enough for the prior era’s lessons to inform the next generation. The experience that investors accumulate over some “normal” stretch of 30 years, even with an MBA or CFA, can’t by itself prepare them to understand that normal can change.”

Here’s some market history:

This one graph – USA debt to GDP – describes  the sweep of US financial policy and its effect on asset markets over the past 80 years. Right now there is too much debt in the system. Everything will follow from this.

My take: HK’s quarterly document is a treasure trove of long term, broad perspective thinking. It’s not going to help with this month’s performance. But if you buy into their logic – and I do – it will improve longer term investment outcomes.

I’ve spent the week working in Mauritius. Here is the view from my “office”:

It made for a nice change from the wintry Cape Town weather!

During my time here, the main business was finalising Astoria’s financial results, which were released today. You can find them here.

In Astoria (listed on the JSE and the Mauritian Stock Exchange), we own interests in a collection of good private businesses run by good people. Our journey so far with the management teams of these businesses has been hugely rewarding. Priceless, in fact.

We said goodbye to our Chairperson, Ms. Catherine McIlraith who retires after a long stint with the company, dating from before RECM took over management. She did a great job and was a pleasure to work with. I’m sure I speak on behalf of my colleagues when I thank her for her valuable contribution.

Cathy has assured me she will continue to subscribe to this letter despite my frequent prolixity.

We also welcomed Ms Carli Botha to the board and look forward to working with her. She is in a fortunate position to be spared this letter, as her business email system blocks spam.

Oh well…

That’s it for this week!

As if it were necessary, this week’s market gyrations reminded us once again to be very, very careful out there.

Piet Viljoen