Regarding… Vol 2 no 32 – Certificates of Confiscation

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 22nd, the 235th day of the year. There are 131 days left until the end of the year. That is not a big number.

Celebrated South African Science and Maths teacher William Smith passed away yesterday, surrounded by family in Perth, Australia, following a short battle with cancer.

I remember watching him teach algebra on TV3 on an overhead projector. He was an absolute hero, systematically following the logical steps with his smudged fingers. Unlike most teachers, he made algebra easy.

This news makes me doubly sad. Losing a great teacher is a huge loss. But to read that he was “surrounded by family in Perth” raises all sorts of other questions, which make me sad for the potential our country has lost due to our incompetent, corrupt, and venal government.

Speaking of which, my first ever job was at the South African Reserve Bank (SARB). I started as a junior economic analyst, which was a less-than-stimulating affair. But it was a job. Then I read “Bonfire of the Vanities” by Tom Wolfe and knew what I wanted to do. The book, published in 1987, was about a rich Wall Street Bond trader. You see, bonds were at that stage in a roaring bull market – at least in the USA – after yields had peaked at 13% in 1981. This guy seemed to be having a lot of fun, and I wanted in on the action. I knew I had to become involved in the bond market.

Of course, at the age of 25, fresh out of military conscription, I had no idea. I eventually wangled my way onto the bond trading desk of the SARB with the help of a good friend from university, Kosie Brits. But that’s another, different story.

It turned out that life on the bond desk at the SARB was not as glamorous as the life of a bond trader on Wall Street. At the time, the SARB played the role of market-maker for the Treasury Department, and our main job was to sell enough bonds into the market to fund the government. We got a weekly allocation of bonds from the Treasury – a “tap” – and we would then have to sell them into the market.

At the time, interest rates in South Africa were high and not declining. Inflation was stuck at levels of 15% to 20%. Although bond yields were high in nominal terms, in real terms – i.e. after inflation – they were negative. In trying to keep the Apartheid government afloat, too much debt had been issued, and the country couldn’t afford positive real interest rates. Financial repression was the chosen policy to keep interest rates at affordable levels.

Bonds were called “certificates of confiscation” – you were guaranteed to lose money, in real terms, if you invested in them. No investor in their right mind would allocate capital to bonds.

Yet, we managed to sell enough bonds to the market every week to keep the government afloat. This begs the question: Who were the crazy people buying these guaranteed-to-fail investments called government bonds?

Enter “Prescribed Assets”. Or, as they were formally known, “Prudential Investment Guidelines”.

The “guideline” was – because of prudence, you know – that regulated savings institutions, pension funds, insurance funds, and the like had to have at least 50% of their assets invested in government bonds. So we were selling to unwilling but forced buyers, resulting in a game of cat and mouse between us and the buyers. It was hard work, not glamorous work.

At the same time, the equity guys were having a ball. Cheap funding always juices the equity stack in the capital structure. Unsurprisingly, from 1985 to 1987, there was a hot IPO market on the JSE, with 82 listings in 1986 and 211 in 1987. Wild days in the equity market, indeed.

Amongst investors, there was fierce competition to get an allocation to an IPO, as you were almost certain to make a stagging profit. People wouldn’t know what a stagging profit is, even if it hit them in the face – this market has been bereft of excitement for so long. Dial-a-Movie, Mike’s Kitchen, Juicy Lucy, World of Music, Mighty Meat Holdings, Oakfields Thoroughbreds and Saambou Bank were some of the luminaries that were able to sell their shares to the unwitting public in the form of a JSE listing during that time.

Fast forward to today.

Western economies are highly indebted. Debt-to-GDP ratios in the USA, most of Europe, and Japan are at historically high levels. Ultimately, some form of financial repression is inevitable. Fortunately, we have seen the movie in South Africa and know how things work during repressions.

In short, avoid nominal assets like bonds and buy real assets like commodities and equities. Under South Africa’s repression in the eighties, even cars were a better store of value than cash or bonds.

Investors are increasingly experiencing bonds from OECD countries as certificates of confiscation, just like we experienced the old RSA government bonds of the eighties. And, just like South Africa in the eighties, these investors will likely keep seeking out alternative stores of value. Cue the strength in broader equity markets. These trends are likely to continue until we see a significant shift in fiscal policies across the developed world.

The MWI Worldwide Flexible fund (aka the cockroach) does not own long-dated bonds issued by Western governments. 25% of the fund is always allocated to bonds, predominantly South African and other emerging market bonds.

That barbarous relic hit a new all-time high this week. No, I don’t know why, either. Many commentators have lots of different explanations, but I don’t think anyone actually knows.

The fact is that gold has held its value relative to everything, including equities, over the long term:

President Nixon decoupled the US$ from gold in 1971. At that point, gold was priced at $35 per ounce. Using today’s price of just over $2,500 per ounce, gold has compounded at 8.4% p.a. since 1971. Compounding at 8.4% p.a. over a long period – in hard currency terms – can be life-changing.

I know Warren Buffett doesn’t like gold, but I think it fulfils a valuable role in a diversified portfolio – a portfolio like the cockroach, which owns around 20% in gold and gold streaming businesses. It also owns no shares in gold mines. You want to own the asset, not the means of extraction, which is always subject to inflationary pressures, management missteps, or acts of God.

Gold’s critical attribute is that it is no one else’s liability. As such, it is a unique hedge against adverse outcomes. Hopefully, these adverse outcomes don’t happen, and other parts of a sensibly diversified portfolio do just fine.

My take: No one who takes out an insurance policy wishes they could claim on it. But you sleep better having it.

Specifically, South African small caps hit a new all-time high this week. This is one asset class South African investors are short of. Most of us have moved as much of our investments offshore as possible. What’s left here is either in the All-Share Index or with some institutional asset manager like Coronation, Allan Gray, or N91, which are functionally all the same thing.

No one has any exposure to the small and mid-cap segments of the South African stock market. Since July, the small cap index has been hitting new highs daily. I wonder what happened then?

This part of the market contains many fantastic businesses trading on low single-digit P/Es, discounts to book value, and reasonably high returns on equity – all this after a tough few years in the economy.

Looking forward, one can easily imagine a slightly more favourable business environment: fewer (no?) power outages, lower interest rates, less government intervention, and a boost to consumer spending from the two-pot pension system.

Imagine what these companies, run by intelligent businesspeople who are used to toughing it out, can achieve in a more favourable environment. Imagine how excited the market could get about the kind of earnings growth that will result. Then, have a look at current valuations.

My take: There is a non-zero chance that an epic bull market is building in this sector. FOMO is a compelling force. I first mentioned SA small caps in February this year in “Riding the Dragon”.

If this isn’t a bull market, I don’t know what is:

After tripling off the Covid lows, Standard Bank today trades on a P/E of 9 and a dividend yield of 6%. You won’t get much more yield from money market investments. And Standard Bank will grow its dividend over the next 10 years.

The beauty of South African banks is that interest rates have been so high that nobody has wanted to borrow money from them. This implies that their asset base is solid – I expect very few bad debts to emerge, even though we have been going through an economically tough time. If interest rates start to come down and a little bit of confidence comes back into the economy, animal spirits could be revived. People might just want to borrow more to build things.

My take: Nothing is so bullish for a bank as a growing lending book. We haven’t seen this in South Africa for a very long time. When equity is leveraged 10 to 1, asset growth is magnified magnificently at the shareholder level.

Desert Lion is a fund managed by Rudi van Niekerk. RECM has an interest in the fund, which is great because we get to work with him daily. Desert Lion invests exclusively in South African stocks. And it’s kicking butt. Here’s the fund’s latest fact sheet.

Year to date, it is up 25%. In US$ terms!

Over the longer term, the fund has substantially outperformed the All-Share Index.

The bad news is that Desert Lion is domiciled in the USA and, as such, is only available to US investors. The good news is that Rudi has joined the MWI investment team and is working with me on the MWI Value fund. He replaces Brian Pyle, who recently resigned.

I first wrote about Desert Lion in November last year in “Regime Change” – in that piece, I linked Rudi’s letter to investors for September 2023. It’s worth re-reading today. You can find it here. The letter was written during a time when many investors were experiencing deep despondency about South Africa’s prospects. Rudi challenged that thinking, and it turns out correctly so.

My take: The MWI Value fund is well positioned to capitalise on what seems to be an emerging bull market in South African stocks. It is one of the few South African general equity funds that invests only in South African stocks. Rudi brings with him considerable enthusiasm and experience in the realm of value investing. Working with him on the fund is a pleasure and an honour. And it’s working.

Being cyclical, a sensible way to look at those earnings is to take a 5- or 10-year average number. Based on 10-year average earnings of 29cps and a current share price of R1,45, Merafe is being priced on a 5x P/E. During this time, earnings per share have been as high as 70cps and as low as -3,4cps. The latest six-month number is 28,2cps.

Merafe, due in no small part to Glencore’s judicious capital allocation policies, refrains from investing in new projects – that destroyer of every mining investor’s hopes and dreams. It can, therefore, pay a regular, substantial dividend. The latest interim dividend is 20 cents.

Today, Merafe is on a dividend yield of 29%.

My take: I call Merafe the little stock that could. It has been a great investment for the MWI Value fund under the able guidance of its CEO, Ms. Zanele Matlala, who also happens to be on the board of the RECM Foundation and Goldrush Holdings. Both entities have benefitted tremendously from her guidance.

We all hate taxes, right? And we all believe we are over-taxed, right? Well, I saw this graphic recently, which showed the tax taken by different governments relative to their country’s GDP:

My take: Be careful what you wish for – the grass is not always greener on the other side.

This brings me directly to:

I follow a hedge fund manager called Kupperman, or “Kuppy” for short, on X. He is the CIO of Praetorian Capital. For tax reasons, he lives predominantly in Puerto Rico. Puerto Rico is to Americans like Mauritius is to South Africans – a place you are only prepared to live in if “paying less tax” ranks above your “love and belonging” need on your Maslowian hierarchy.

And there’s nothing wrong with that. Different people have different hierarchies.

However, it may create an interesting investment opportunity, which he discusses in his piece “The .1% refugee crisis.”

The money quote: “The peasants are along for the ride, wherever Socialism takes them. However, the 0.1% have flexibility, and they’re increasingly fleeing.”

My take: Given their fiscal position, taxes in Western economies will not be declining soon. The 0,1% will do what they need to do. However, more barriers to the migration of people and capital should be expected to be erected over the next 20 to 30 years. Governments will do what they need to do.

Regular readers will know that Mr Cave is one of my favourite artists. I have been a fan since his first band, “The Birthday Party.” They basically just made a bunch of noise, but it was the type of noise that appealed to my 18-year-old self. We are the same age; his music has progressed and dragged me along on the journey, which has been a joy.

Below you’ll find an interview with Stephen Colbert to mark the release of his new album, due out at the end of the month. The money quotes: “Music is a thing that makes things better” and “Music is a glue that binds us together.” I couldn’t agree more!

Amongst many jewels in the interview, he tells the story of singing with one of his heroes, Johnny Cash, just before Cash died.

I subscribe to the Red Hand Files, a platform on which Nick Cave answers his fans’ questions in interesting ways. He says it grew out of his reaction to the death of his child – as a kind of therapy, I guess. The Red Hand Files is a sort of “ask me anything”. I have always thought he is a better writer than a singer, and these “missives” show that.

Just yesterday, issue #297 landed in my mailbox. In it, he answers the question: “Are songs from God?” He partly answers the question by saying, “I can only assume God is a Coldplay fan because from where I stand, God does not send songs, dispatch, deliver or gift them; or if He does, He’s sure not sending them to me.”

He does have a way with words.

Also, here is the Red Hand Files playlist, which he published about a year ago. It’s almost like a “Best of Nick Cave” playlist. If you’re unfamiliar with his music, it’s a gentle introduction. If you know his music, you will appreciate each song here.

Culture data analyst Daniel Parris, who often gets mentioned in The Honest Broker, recently analysed how hit songs have changed in recent decades.

This chart, from his piece, shows that hit songs now involve more talking and less playing. For better or worse, music is not as musical as it once was and is far more verbal.

Author of The Honest Broker, Ted Gioia, goes on to say, “Looking at this trend, I can’t help but be reminded of Iain McGilchrist’s claim that we are now living in a left-brain dominated world where verbalisation, generalisation, and brute-force rationality are dominant, while more nuanced elements in our lives – emotion, holistic thinking, spirituality, creativity, and (yes) musicality – get squeezed out of the public sphere.

My take: Nick Cave’s music is a perfect antidote to this.

That’s about it for this week. Except to say that Merchant West Investments is having its monthly online “Coffee with Merchant West” on Wednesday the 3rd of September. My colleagues and I will be talking about the investment landscape.

If you would like to attend, you can register here. Alternatively, you can email me directly if you have a question you would like us to address during the webinar.

BizNews hosts its inaugural investment-focused conference on September 12, 2024, at the Hermanus Municipal Auditorium in Hermanus, South Africa. On the stage will be luminaries like political scientist Dr Frans Cronje, Eskom Chairman Mteto Nyati, and investment experts Cy Jacobs, Sean Peche, and Magnus Heystek.

I will also be speaking. You can find out more here and book tickets if any are still available. Alec Hogg runs a good conference. I have been to each one since its inception, and it really is worthwhile.

Finally, I have also been invited to speak at the Johannesburg Indaba on October 3rd. The Indaba is a mining and resource-orientated conference that has been running for 12 years. Bernard Swanepoel runs it, and those who know him will know he is a straight shooter. The conference is no different! So, if you want to find out more about the mining industry from the horse’s mouth, so to speak, you can find out more here.

All that’s left to say is to remember to be super careful out there.

Piet Viljoen