Regarding… Vol 2 no 33 – The Costanza Paradox

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 29th, the 242nd day of the year. There are 124 days left until the end of the year.

Today also marks the first anniversary of this letter. This is the 49th edition, which means that over the past 52 weeks, I have only missed three: two over the Christmas Holidays last year and one over the Easter holidays this year. I have written while touring in France, cycling from Jeffreys Bay to Cape Town, and being so sick I could barely think.

And it’s been a blast.

I discussed doing this a year ago with my colleagues and showed them something I had written. I didn’t feel the quality of my output was ready to put out into the world, but they pushed me to “just ship it,” which I duly did despite some significant personal misgivings. I still feel like that every week when I press the send button, but I have also developed a sense of joy in uncovering meaning for myself while writing down my thoughts.

This week, I want to write about an exciting investment opportunity that I am in the process of exploiting. Importantly, this is not a solicitation for funds. It merely reflects what I have implemented for myself and a few other friends over the past few weeks.

The opportunity springs from the structure of the fund management industry, which is all about scale and AuM. I touched on this in “Structure Drives Strategy” and my conclusion was that the industry’s structure prioritises accumulating assets over generating satisfactory returns.

In thinking about this, “The Costanza Paradox” is a useful heuristic. In a classic episode of Seinfeld called “The Opposite,” George Costanza – the permanent loser – realises that if he acts completely contrary to his instincts, things will begin to go his way.

This begs the question: What would it look like if one were to do precisely the opposite of what the fund management industry does?

Let’s have a look in the mirror.

In their latest quarterly review, Horizon Kinetics summed up the current institutional investment set-up well:

“If a perfectly good valuation opportunity exists, with a truly superior expected return, it will be rejected if the total investable amount is insufficient to justify the cost or be relevant to the institution. The business calculation, though, will revolve around how much of those assets are available to buy, how much client money can be raised for the strategy, how much annual fee revenue can be expected, and for how many years. That type of market anomaly will tend to dissipate within a couple or few years. The answer will likely be: There are not enough beginning dollars of AUM or years of fees to pay for the analysts, managers, and overhead allocations. Business performance outweighs investment performance.”

The actual investment opportunity lies in the long but thin tail of market opportunity: unpopular assets with poor liquidity.

Many stocks on the JSE tick those boxes today.

As an investment destination, South Africa is highly unpopular locally and internationally. Most local investors can’t get their capital out of the country fast enough. Global investors do not need to invest or are underweight their benchmark, which has quite a low weight to start with. Those few Investors still invested in South Africa have been “risk-managed” into the mega-funds of Coronation, Allan Gray or N91. Due to their size, these funds are simply various flavours of the JSE All-Share Index, which, in turn, is comprised of a collection of random global companies that happen to be listed here. The JSE All Share Index – and, by inference, the large fund managers – have little or no exposure to South African businesses.

Stocks of companies that operate predominantly in South Africa are highly illiquid and trade by appointment only with massive bid-ask spreads. If you try to sell, you push the price against yourself – by a lot. And if you try to buy, the same happens. No one wants to buy because they are anchored on the current share price, which represents a PE multiple of, say, 4 times. So, if you push the price by 50% (!), the multiple only goes to 6. It’s still super cheap. But no one is willing to do that, because then…it’s too expensive? Or so the logic goes. Anchoring at work.

Local fund managers can’t own small caps in their open-ended funds, as the pull to offshore assets means they are getting consistent outflows and might have to become forced sellers of these illiquid situations, pushing the price against themselves. It is best to avoid investing in them. Structure drives strategy.

Stocks of domestic businesses  – especially small-cap ones – have become orphan assets.

So, how do we at RECM, a firm that considers taking advantage of such situations a fundamental part of its DNA, implement the Costanza paradox?

We have assembled a consortium of investors to buy a portfolio of shares of South African businesses. Not one-puff cigar butts, but good quality businesses which are wholly neglected due to the above-mentioned market dynamics.

Importantly, this is not a fund – it will wind up and return the capital to the members as soon as the opportunity has been exploited.

Structure is key. Get the structure right, and the correct strategy follows. So, the consortium has bought into the following principles:

1. The stocks are housed in a tax-efficient vehicle.
2. There are penalties for early withdrawal. The capital commitment is permanent as long as the opportunity persists.
3. The consortium has a total commitment of R150mn, as the opportunity is only scalable up to this size. My family was the first member of the consortium.
4. RECM’s remuneration will consist of an annual fee of 1% and a performance fee. Importantly, the performance fee will accrue within the structure and only be paid out upon termination and liquidation of the consortium. The sooner, the better.

The current portfolio consists of 27 stocks and has the following overall metrics:

• An average return on equity of 16,6%.
• A price-to-book ratio of 0,9 times.
• Expected earnings growth of c.10%.
• A starting dividend yield of 6.6%.
• A starting price-to-earnings ratio of 6,8 times.

The consortium has assembled the right people at the right time with the right assets. We all believe in this opportunity.

The best part is that this is an asymmetric bet. There is limited downside if we go back to the bad times of widespread corruption and state capture. The companies selected for investment have management teams that have proven themselves during tough times, and their current valuations do not expect good times.

PDD owns the company we all hate to buy from: Temu. You know, that online retailer that sells stuff that makes Shein look like a stockist of Birkin bags. Hands up, who hasn’t bought anything from Temu yet? Yip – I see very few hands.

So, it should come as no surprise that despite sluggish consumption and fierce competition in its home market, sales surged 86% year-on-year to $13 billion, doubling the company’s earnings to $4.4 billion in the three months to June.

What is surprising is that its share price has just about halved recently:

The problem with PDD – apart from the serious allegation that it is a Chinese company – is that it has long been known for its bare minimum disclosures. Despite Temu’s high-profile global success, including in the United States, virtually no financial information is available about the business.

It now trades at just 7 times the forecast next 12 months’ earnings, below Alibaba’s 8.8 times despite PDD’s higher expected growth.

The common denominator here is a mistrust of anything Chinese. And when there is poor disclosure, this mistrust is amplified.

A while ago, anything Chinese commanded a premium: growth as far as the eye could see, and no price was too high to pay for it. I know South Africans who are appreciably poorer for having taken money offshore to invest in Chinese-orientated funds.

That sentiment has made a 180-degree turnaround.

My take: Current multiples on Chinese stocks imply low expectations. Charlie Munger said happiness comes from low expectations. Who am I to argue with one of the most intelligent investors ever?

My favourite saying at dinner parties is that the words “property” and “investing” don’t belong in the same sentence. And despite my wife Amanda kicking me under the table to shut me up, I can’t help myself repeating it. Again and again.

Mainly because – as a generalisation – it’s true. And I will debate anyone on this.

However, we recently bought an apartment after renting for many years. To compound matters, I bought shares in Spear REIT. More about the apartment later, but here’s Spear’s share price:

Not shabby.

Most property people don’t understand how property investment works. They think some sort of fairy dust makes property appreciate – conveniently forgetting about frictional costs, taxes, municipal charges and levies. Also, you need to do a serious remodel every 10 to 15 years to maintain value.

A few years ago, I met the exception to the rule – Quintin Rossi, the CEO of Spear REIT. He understands property and all its nuances, making it one of the few REITs I have invested in. Spear REIT’s mandate is also limited to the Western Cape – a part of South Africa where the government kind of understands economics. As a result, property has a chance of being a good investment.

My take: With Spear, you have the odds on your side. And at the current discount to NAV, the price pays you to play. The MWI Value fund is a happy shareholder.

I’ve written about Berkshire many times. After all, it is one of the biggest holdings of the MWI Worldwide Flexible fund (aka the cockroach), and I use it as a proxy for US equity exposure.

In his Bloomberg column today, John Authers neatly set out how cheap Berkshire still is on reaching the milestone of a $1 trillion market capitalisation:

“Taking the classic value investor’s metric of comparing the company’s market cap to the total equity on its balance sheet (the book value that results from subtracting liabilities from assets), Berkshire trades at a 60% premium to its book value. Banks, still humbled 16 years after the Global Financial Crisis, are a bit cheaper. Apart from that, very little out there is better value than Berkshire. Dominated by insurance, Berkshire is cheaper than the average US insurance company and much cheaper than the S&P 500 Value index; it’s better value than value. As for the Magnificent Seven, they trade at 13 times book.”

For the record, Nvidia is at 63 times.

My take: The US market is expensive by any measure you would care to use. As a result, the cockroach underweights that market in its equity exposure. But it uses Berkshire to get that exposure, not the S&P500 index.

It’s hard to believe that we willingly accepted a sequestering less than five years ago due to a global panic attack about a virus.

It’s similarly hard to believe that we managed to merge RECM Asset Management with Counterpoint at the time and buy Bridge Asset Management shortly after that. Effectively, we implemented a three-way merger via Zoom during a pandemic.

Mergers of human capital businesses, like asset managers, are notoriously tricky. Most people – including me – would have said this had failure written all over it. But thanks to our partners at Merchant West, under the leadership of Braam Viljoen (no relation!), things have worked out better than we could have wished for.

Sadly, we have lost some colleagues in the process. This is an inevitable result of mergers. Hopefully, they have good memories of the “old” business. However, we have also gained some new colleagues who are busy shaping a worthy competitor in a highly competitive industry.

Recently, we changed management at the top of the business, and the roles were all filled with internal candidates. I’m super proud of the new CEO-elect, Daniel King, and CIO, Ray Shapiro. Alyssa Viljoen (again, no relation) has also been internally promoted to head of research.

As an aside, there are many Viljoens involved at Merchant West, which can only be a good thing.

But this is what the DFMs won’t tell you: Merchant West Investments manages 15 funds across a wide range of mandates, none in the bottom quartile of their universe over the last three years. In fact, 9 of the 15 are in the top quartile. And 12 have been in the top quartile over the past three months, with not one fund in the bottom quartile.

Yes, I’m bragging. But this is an outstanding picture:

My take: The merger has succeeded against all odds. Merchant West Investments can hold its head up high against all comers today. RECM is a proud shareholder in the business, and I continue to enjoy working with the people there.

X (previously known as Twitter) has a bad rap. But if you curate your timeline carefully and get rid of the anonymous wise guys and self-promoting airbags, it can be wonderful source of information.

This week, I came across a blog called The Tontine Coffee House, a treasure trove of financial market history. It is named after the coffee house which housed the predecessor of the New York Stock Exchange.

Go and spend some time on the site; you’ll be amazed at the stories you find.

My take: The only way to understand markets is to understand history. The Tontine Coffee House is an excellent resource for this.

My good friend Magnus Heystek reposted this clip on X.

It is a clip of Morgan Housel being interviewed by Shane Parrish of Farnam Street fame. It’s only four minutes long and well worth watching.

The money quote: “If you are susceptible to FOMO, there is no hope of you being a successful investor over time. Seeing your neighbour getting richer than you and not being impacted by it is a superpower.”

As Brent Beshore said: “I am very happy to watch you getting incredibly rich doing something that I don’t want to do.”

My take: If you can get into this mindset, you can win the game of investing.

I’ve mentioned “The Friday Song” a few times, but I want to repeat myself here for several reasons. Firstly, there are now at least 400 more subscribers to this letter than the last time I wrote about it. Secondly, because the last time I mentioned it, I didn’t do it proper justice. And finally, because a new cycle of songs has just started.

So, what is this “Friday Song” I’m talking about?

Every Friday morning, around 7 or 8, my good friend Mark Rosin sends a WhatsApp message with a song – often quite a deep cut – and some interesting background information. It’s a joy to receive it.

Last Friday, he sent the song “Happy” by the Rolling Stones. Here is part of his take on the song:

“Hard to believe that after two years of Friday songs, I’ve never chosen a Rolling Stones song performed by the band. Nothing from the start with Brian Jones, the short middle and for me, most fertile musical period with Mick Taylor, from 1969 – 1974, or the last, 50 odd years with Ronnie Wood. All of these three were and are, a key aspect of what the Stones have always been – a two guitarist band and in every case, a player who is a foil for the guitar constant, Keith Richards. While Mick Jagger may be the royal celebrity of the Rolling Stones, Keith Richards is their musical anchor and the guitarist who brought the huge trademark riffs that made the Stones the ‘greatest rock ‘n roll band in the world’.”

Here is a playlist with his first year of Friday songs and here you’ll find the second year. And here, the current year, with only three songs so far.

If you want to receive a great song and write-up on WhatsApp every Friday morning, email Mark at markgrosin@gmail.com

Follow him on Spotify for some other great playlists, too.

Finally, as a side gig, he also DJs at the Oranjezicht Farmers Market, so if you happen to be there while he’s playing, pop in to say hi. You’ll know he’s playing because the tunes will be so good.

And take him a Cortado; he would love that.

Finally, I’m writing this week’s letter amid moving house; it is unsettling. I mentioned earlier that we have bought an apartment after many years of renting. I know I’m going against my better judgment here – renting is just so much better financially than buying.

So why the change of heart?

First, I’m putting my money where my mouth is. I am convinced things are changing for the better in our country. The first time I bought a house was just before the 1994 elections. That turned out well. Thirty years later, I’ve done the same thing: buying just before a watershed election. Let’s see how it turns out this time.

Second, our landlord reneged on a handshake deal to extend our lease, leaving us deeply in the lurch. I’ve always been told the ethics of landlords in the residential sector leave a lot to be desired, and I have now experienced that first-hand. I guess buying-to-let is such a bad business that the owners can’t help themselves but screw their tenants. So, unfortunately, we have had to buy something to protect ourselves against these people.

Third, the saying, “Happy wife, happy life” is one I wholeheartedly subscribe to.

In any case, this is what the environment looks like in which I have been writing this letter:

Thankfully, my wife Amanda has been doing all the orchestrating, and she is a star at it. I’m glad it’s almost done, and so is she. Never again!

And amidst all the chaos life throws at us, it’s worthwhile to remember to be very careful out there.

Piet Viljoen