Regarding… Vol 2 no 35 – Lollapalooza

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, September 12th, the 255th day of the year. There are 110 days left until the end of the year.

On September 11, 2001, the iconic twin towers in New York City were destroyed. In one of the most dramatic incidents I can recall, airplanes hijacked by terrorists flew into the towers minutes apart.

At the time, I was working for Investec Asset Management (now called N91), and we hosted a conference for clients in Johannesburg. During a presentation by economist Jeffrey Sachs – ironically being live-streamed from New York – people in the audience’s phones started buzzing, notifying them of the first attack. Our CEO, Hendrik du Toit, had to interrupt Sachs to let him know what was happening in his city.

That ended the conference proceedings, and the tech guys were asked to get the CNN link up on the big screen so the conference audience could watch. Feverishly, they got working and successfully got the hotel’s porn channel up on their first try. Being tech guys, it didn’t take them long to find the correct channel.

What will stay with me forever, though, was the horror of seeing the second plane hitting its target, thinking about the people inside the plane and the building. I think it is fair to say the world changed that day – travel became more complicated, and relations with the Middle East became even more strained.

The rest of this week’s letter is my talk at the (sold-out) BizNews Investment Conference this morning. The BizNews community is exceptional and I love my interactions with it. BizNews is one of the few media outlets that provides information, not opinion, often providing a platform for BOTH sides of the story, allowing you to make up your own mind. If you don’t know them, check them out here.

Charlie Munger has used the term “lollapalooza” to highlight the importance of understanding how multiple factors can combine to produce powerful, non-linear effects, both positively and negatively.

9-11, as the Americans call it, with their back-to-front way of dating events, was a lollapalooza event. Today, we may disagree on its historical significance, but at the time, it had no significant effect on markets.

What we are looking for in markets is the investment that blows your socks off, a ten-bagger in no time – a ridiculously good investment. A lollapalooza stock.

That’s what we all want.

But lollapalooza effects are scarce, like unicorns. So, you need to know where to look to find them.

Charlie Munger also said the best way to solve a problem was to invert. So, if we are looking for a ridiculously good investment, we can start by thinking about what a ridiculously bad investment is. An investment no one in their right mind would touch. An investment that can destroy your whole portfolio – a sure loser of the investment world, so to speak.

On the road to discovering what makes for a ridiculously bad investment, let’s start at a familiar place: the common or garden variety lousy investment.

Lousy investments are a dime a dozen. Most of us make more of them than we care to remember, or are willing to admit it, even to ourselves. Unlike ridiculously bad investments, plain lousy investments are common but have a limited impact on our overall financial well-being.

That is because we recognise the risks attached to these investments when we make them. Therefore, we demand a discounted price and limit our exposure. When bad outcomes do materialise, the impact on our overall portfolio is muted. That is the essence of risk management.

Even 100-year Argentinian bonds have turned out to be a lousy, but not disastrous, investment – only down by 40% since they were issued. Also, you probably wouldn’t find them in most portfolios. It’s a bad – not ridiculously bad – investment because investors were correctly cautious about investing in the bonds of a country that is a serial defaulter. So, it has had a limited impact on most investors.

Unlike mere bad investments, ridiculously bad investments are not common. They are defined by the mortal wounds they inflict on investment portfolios at scale.

For this to happen, there must have been widespread consensus that it was, in fact, an investment with a highly promising outlook at the time. The emperor’s new clothes would have engendered envy because everyone would have wanted similar threads. Immediately. This would also have been reflected in the price paid to acquire this fantastic designer clothing: a steep one, which, due to social proof, most people would have been willing to pay.

I have encountered only a few such ridiculously bad investments in my investing career.

In his note “Sea Change,” Howard Marks tells the story of the Nifty Fifty stocks. These were stocks of companies widely regarded as the best in America at the time. As Marks says, “So good that nothing could happen to them. No price was too high to pay for them.” But if you bought these stocks in 1969, well before they peaked, then five years later these widely-held stocks had lost 90% of their value.

I lived through the TMT bubble in 1999-2001. It was a new era where everyone would be connected via the internet. It turns out that is what happened. But the share prices of the companies associated with this new era cratered. Some, Like Didata, lost almost all their value and were subsequently acquired. Others, like Cisco and the Telecoms companies have never recovered their previous highs. TMT stocks turned out to be ridiculously bad investments: widely-held stocks that lost most of their value.

Steinhoff listed in South Africa in 1998. Initially regarded with some skepticism, by 2015 it was one of the most widely-held stocks in South African portfolios. Some of the most brilliant businesspeople had substantial portions of their wealth in the stock, not to speak of the institutional funds competing to see who could be more overweight the stock. You were regarded as out of touch if you didn’t own it. In 2016, Steinhoff turned out to be a ridiculously bad investment, eventually going to 0, severely affecting most investor’s portfolios.

Ridiculously bad investments have one characteristic in common – they are widely expected to be ridiculously good investments at the outset. As such, basic tenets of risk management are suspended, allowing investors to become overexposed to them.

If we invert once more, the place to find a ridiculously good investment would be to look where investment prospects are currently regarded as ridiculously bad. If the characteristic of a ridiculously bad investment is that it is generally accepted as a sure thing, widely-held and highly-priced, a ridiculously good investment will most likely be regarded as guaranteed to fail, under-owned, and cheap.

In 1995, Naspers was an old-school newspaper publishing business that was traded on the OTC market. Very few investors owned it; it was a fuddy-duddy business. However, the company was highly cash-generative, and management invested this cash in all sorts of start-up tech-orientated investments, mostly unsuccessfully, adding to the market’s disillusionment with them – until they acquired a significant minority stake in Tencent, a fledgling Chinese tech company, and turned it into a ridiculously good investment.

In 2012, Nvidia was primarily known as a leading manufacturer of graphics processing units (GPUs) for the gaming and PC markets. At the time, the company had already begun exploring the use of its GPUs for AI and machine learning applications. However, the demand for AI hardware was still minimal and viewed as an unproven technology with uncertain commercial potential. At the same time, the PC market was stagnating. The company was also recovering from a failed launch of its NV1 GPU in the 1990s that nearly caused it to go bankrupt. It’s safe to say that 10 years ago, Nvidia was not a popular, widely held investment. Today, it has turned into a ridiculously good investment.

Also, in 2012, Microsoft was regarded as a purveyor of old-school software, whose margins were being competed away rapidly. Steve Ballmer, then-CEO, was seen as unable to adapt to the rapidly changing technology landscapes and had low approval ratings. In 2014, his tenure culminated in the ill-fated acquisition of Nokia, ultimately leading to massive write-offs and Microsoft becoming the laughingstock of the tech world. Since then, Microsoft’s share price has increased by 20 times – a ridiculously good investment.

At the time, these were not popular or widely held investments – quite the opposite. The point I want to make here is that lollapalooza outcomes only happen when they are widely regarded as the opposite.

Currently, I can think of a few such situations globally:

• The climate crisis and net zero are the catchphrases of the day. Very few know exactly what they mean, but they get repeated so often that it is taken for granted that global warming is a crisis, and as a result, we must move to zero carbon emissions ASAP. If you have read Vaclav Smil’s work, you will know it isn’t that simple. The truth is we will be using carbon fuels for a long time. However, the result is a complete lack of interest in investing in “dirty” energy companies.
• GMO says that deep-value stocks are currently their most high-conviction long-only investment. They define “deep value” as cheap stocks, often screamingly so, relative to their fair value appraisal. They also try to avoid deceptively cheap junky cyclicals and value traps. Today, deep value, defined this way, is the cheapest it has ever been. On top of that, value looks to have turned outside the U.S.
• South African equities, especially small and mid-caps, are a special case in the deep value universe outside the USA. No one owns them. They have been subject to consistent, forced selling pressure for a few years now by local unit trusts as South Africans move their money offshore and liquidate their local fund holdings. South Africa is a corrupt, bankrupt country run by communists where the rule of law no longer holds. Who would touch its equities in such an environment?

Any one of the above assets can have an excellent – even ridiculously good outcome.

A true lollapalooza.

I am often asked: What is the outlook for South African stocks relative to US stocks? Will the outperformance of US stocks against SA (and everything else) continue?

To judge the likelihood of this, consider the ownership profile of each.

The USA makes up 26% of global GDP – yet US stocks make up 63% of the MSCI ACWI. So, if you think you are buying a broadly diversified index (which is the point, isn’t it?) when you buy the MSCI ACWI, I think you are mistaken. On top of that, US stocks are historically overvalued, and the US$ is overvalued against almost every currency on earth.

The BRICS nations make up 29% of global GDP, or 36% when adjusted for purchasing power parity. Additionally, other big emerging markets are not included in the BRICS grouping. Do you know how big the entire Emerging Market exposure in the MSCI ACWI is? The answer is 13%.

South Africa makes up less than 3% of the Emerging Market Index. So, the exposure of big global investors to South Africa is the functional equivalent of 0.

In addition, to the extent local investors still have exposure to the SA market, it is, by definition, via large fund management businesses like Allan Gray, Coronation, and N91. The problem is that these funds are so big that they can only own the biggest shares in the ALSI, which is, by and large, an arbitrary grouping of foreign businesses that accidentally happen to be listed on the JSE.

The functional exposure of local investors to SA companies is 0.

You can assemble a portfolio of good-quality small and mid-cap South African businesses today. These businesses have a RoE of 16% and trade under book value. The average P/E is 7, and the dividend yield on the portfolio is 6% – higher than inflation!

It isn’t a stretch to think that global investors might be overexposed to an expensive US market and underexposed to emerging markets in general – and extremely cheap South Africa specifically.

The table is set for some lollapalooza outcomes here.

I do have some bad news, however. Today is not the best time to buy SA. It’s a good time, but not the best time. The best time was 2-3 years ago, at the height of pessimism around our country, when financial advisors found it an easy sell to convince their clients to move their money offshore.

That might sound facetious, but here are the facts:

Almost three years ago, one of the members of the BizNews community put R500,000 – real money – into the MWI Value fund (which I co-manage with Rudi van Niekerk) and R500,000 into an offshore portfolio picked by a prominent financial advisor. The MWI Value fund invests only in South African stocks, mainly small and mid-sized ones, I might add.

The result? At last count, the Value fund was up 22% and the offshore selection was down 3%. Both in Rand, both in real money.

This party is only getting started.

Mr. White has a new album out called “No Name.” It’s raw rock music, much like the White Stripes used to do. Powerful riffs and driving drums. The kind of music that makes you want to turn up the dial to full volume. You can listen to it on Spotify and Apple Music.

You might also want to check out the documentary “It Might Get Loud.” It features three generations of rock guitarists: White, Jimmy Page (Led Zeppelin) and The Edge (U2). They discuss how they developed their skills, their influences, and some personal stories, illustrating how each developed their unique sound.

It’s a few years old now, but if you like the sound of electric guitar, it’s a must-watch. Loudly! The opening scene, where Jack White builds and plays a makeshift guitar, is classic.

You can watch it here.

Noted Wine critic Tim Atkin released his 12th – and most comprehensive – report on the South African wine industry a few weeks ago. If you are a wine lover, it’s a must-buy report. It’s a treasure trove of information on local wines, wineries and winemakers.

Atkin says South Africa is making the best wines in its history, and I agree. Our wines are just another area where we can’t stop winning.

You can buy his report here. It’s not free or even cheap, but it’s worth it.

Another less structured source of information on the local wine scene is Johann Biermann. Yes, that’s two N’s in both the name and the surname!

He has a handle on X – @WinesILike – where he posts about great South African wines and puts together a case of outstanding examples every few months. The next case will come out in October – so go to his website and sign up.  Unless you buy one of his cases, which I highly recommend you do, it’s free.

If you think buying an EV will avert the “climate crisis”, you need to think again. Here is a chart showing the consumption of fossil fuels in different countries. It doesn’t matter what anyone in developed markets does. China and India are where the action is.

The money quote: “Fossil fuel consumption reached new record highs in 2023, driven by increased coal and oil use in China, despite the global boom in renewable energy.”

Despite subsidies and incentives, renewables are just not making a dent. It’s time to rethink what the clickbait of legacy media is pushing. Nuclear and natural gas are far better options for “greening the economy.”

Okay, rant over.

That’s all for this week, except to say that Amanda and I are finally going on holiday! First, we visit our son Zac in London and then her parents in Lincolnshire for a few days. After that, we head for some sun, water, cycling, and wine – hopefully, a lot of each.

This also means there will be no letter for the next two weeks.

I can hear the sighs of relief.

Remember to still be careful out there, even if I don’t have the occasion to remind you for the next two weeks.

Piet Viljoen
RECM