Regarding… Vol 2 no 5 – Getting the foundation right

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 8th of February, the 39th day of the year. 327 days remain until the end of the year. As a public service announcement – this month has an extra day. Make good use of it!

On this day in 1971, the Nasdaq Composite stock market index debuted with 50 companies and a starting value of 100. Last night, the NASDAQ 100 index closed at a new all-time high of 17 755. This represents a compound annual return of 10,3% p.a. (excluding dividends).

By contrast, the JSE All Share Index languishes almost 10% below its all-time high. South African assets are cheap. Long bond yields issued by the government – the highest credit quality available – yield 6% more than inflation. You can easily assemble a basket of good South African equities paying a dividend yield higher than inflation. And this would be a growing dividend.

Why are local assets so cheap?

We all know about the government’s inability to maintain what’s already there, let alone build an infrastructural platform that is conducive to growth and creating jobs. The private sector is also not completely innocent of capitulating in the face of rampant corruption and joining the “party”.

Given the resultant protracted decline in the business environment, buyers of South African assets have all but dried up. Institutions are investing offshore or in the local large cap “Rand Hedges,” and there is no appetite for buying local “bargains“. Given their poor returns over the past 5 to 10 years, the local private equity industry is struggling to raise new funds and is also out of the ring.

The only pockets of limited appetite are in some of the smaller family offices. Along with prices, volumes on the stock market are trending down.

To get buyers involved again will require a catalyst. And there are only two catalysts I can think of.

One is an upturn in the commodity cycle, which is not unlikely over the next five years. However, given the state of the country’s infrastructure, such a positive cycle will not provide a long-lasting impetus. It will simply dissipate, like all previous cycles, so if there were to be an upswing in the commodity cycle in the short term, that would be a selling opportunity, not a signal of a change in the long-term trend.

The other potential catalyst is the resumption of a consistent and affordable power supply to consumers and industry. I love simple formulas, and here is my one for life:

Energy = life.

It’s as simple as that. Without energy, we die. And South Africa – as a viable investment destination – is busy dying. Or, to put it in the words of Harvard University’s Professor Ricardo Hausmann, “Two decades of power cuts, exacerbated by the government’s inability to make decisions and its adherence to hidebound ideology, have de-industrialized what was once a promising economy.”

That’s what the declining share price of SA Inc. is reflecting. There is only one way to change it – not an election outcome, commodity cycle, or Rugby World Cup.

We need energy. And lots of it. At affordable prices. Only that will return the buyers to the stock market.

What to do? In my cockroach fund, which can invest in any asset anywhere in the world, I am maintaining a small position in SA equities and a bigger position in SA government bonds. Overall, they make up around 25% of the total portfolio. The rest is offshore.

That strikes me as a sensible exposure course of (investment) action. In other local areas, RECM is making some significant long-term investments. For instance:

In a month’s time, my partner Jan, my wife Amanda, I and 13 other cyclists will embark on an amazing journey; a journey from Jeffreys Bay to Cape Town over five days, ending with the Cape Town Cycle Tour on Sunday, the 10th of March. For some of the group, it will be their first long-distance cycling event, while others are more experienced in these somewhat crazy affairs.

Most of the riders are affiliated with the RECM group in one way or another, and some of us have done quite a few “interesting” events together. All of us aim to have a lot of fun on this ride. As you might expect, some of us – but not all of us – have been out on some training rides. Here’s the evidence:

We need to do a few more rides, so if you see us out on the road – give us some space and give us a hoot! Feel free to jump on and enjoy the gees if you’re out cycling.

Participants who haven’t yet joined the training rides appear to have decided they will get fit on the route itself. I look forward to reporting on their general well-being in my letter after the tour.

The event itself is possible firstly as a result of every rider (each rider pays their way) and secondly due to our generous sponsors, including RECM, True Mera Peak, Leatt and John O’Connor Cycles.

Apart from having fun, we also have ulterior motives – we will raise funds for the RECM Foundation. Funds raised will go directly to the Foundation’s initiatives, and the cyclists will have the privilege of stopping at two of them.

Established in 2011, the RECM Foundation is a registered NPO (non-profit organisation) and PBO (public benefit organisation) funding the early childhood development (ECD) sector. The foundation has built a strong capital base since its founding, enabling it to contribute sustainably to its chosen projects. You can learn more about the Foundation here.

Unfortunately – like so many other things – our self-absorbed government has largely abandoned the education sector, leaving it to its own devices, with predictably disastrous outcomes, especially for the most vulnerable.

It is well known that children’s first learning experiences deeply affect their future cognitive development. In this regard, the conditions under which most vulnerable young children in marginalised communities have these formative experiences are not conducive to positive outcomes.

Optimising educational outcomes in the early years of children’s lives is a true long-term investment with a massively positive payoff profile. This is why our Foundation has chosen to partner with the Centre for Early Childhood Development. You can read their annual report here.

An educated population is more productive, more employable and generally happier.

We are proud to be associated with the CECD; its reputation speaks for itself. The work they have achieved both on the ground in communities and in advocating for the sector is testimony to the organisation’s ethos, values and credibility.

Eric Atmore is the founder and director of the CECD (a brilliant cyclist and triathlete in his day), and his daughter, Sarah, is a program manager there. Sarah will be joining us on our ride. Apart from putting the rest of us under a lot of pressure during the ride (she is super strong and clearly inherited her father’s genes!), she will be cooking up new ideas for the Foundation to support.

We look forward to that. The new ideas – not the hurt box Sarah will put us in.

If you want to support the Foundation’s mission and the rider’s fundraising target, you can do so here. Amanda (who is passionate about the projects the Foundation undertakes) has said she will drink a Tequila for every R1 000 that comes in. Of course, not to be outdone, Jan has said he will do the same.

My role will simply be to make sure it happens and, of course, report back to you.

You know what to do now…

This company was built by a private equity house from Brazil called 3G. They merged Belgian brewer Interbrew with Ambev, a Brazilian brewer, and used that as a platform for a series of global brewing acquisitions. These acquisitions included Budweiser and SAB. Many of the acquisitions were financed with debt, which led to some financial fragility. The share price collapsed from $128 in 2016 to around $32 during the Covid pandemic. In Rand it went form R1 500 per share to around R500.

We started building a position in the Merchant West Value fund in 2000 with the thesis of a stable revenue stream enabling the company to reduce debt levels. This would make the equity more valuable, with any uplift in the enterprise value multiples coming as a bonus. This thesis received a bit of a setback with the Dylan Mulvaney marketing blunder. But it seems to be back on track again, as the latest survey numbers show BUD winning back market share in the USA.

My take: high-quality businesses can withstand a lot of negatives. AB InBev has had its fair share of them but is still churning out the profits. Its share price went to a new 4-year high yesterday. It is one of the biggest positions in the Merchant West Value fund.

Toyota is the biggest motor manufacturer in the world. It sold 10,5 million vehicles worldwide last year. It also sold a grand total of 24,000 EVs. By way of comparison, Tesla sold 1,3 million vehicles last year. Toyota has long been regarded as a laggard in the EV stakes, and its share price suffered as a result.

But now it seems EVs are losing favour with consumers, with hybrids gaining share. According to the NY Times, nearly one in 10 new vehicles sold is a hybrid. And guess what – Toyota has been focused on its hybrid vehicle strategy, beginning with its Prius model several decades ago. Nearly a third of the cars Toyota sold last year were hybrids.

And here is Toyota’s share price (in US$):

My take: This chart looks very different to that of Tesla or BYD. Or even Ford, GM or Volkswagen. In a good way. It is also one of the bigger holdings in the Merchant West Global Value fund. I quoted the Toyota chairman in Regarding… Vol 1 No. 10 in November last year as saying: “People are finally seeing reality,” referencing declining growth expectations for electric vehicles. He seems to have been prescient.

Uber has always tried to define itself as a logistics company, not a taxi company, with the core of the business being a scalable software product. I guess the clue is in their name. And it used to be valued like a software company despite (or maybe because of) consistently making losses.

This week, Uber reported its first full year of operating profits after it racked up a total of more than $30bn in operating losses since 2014. The market liked the result, pushing it to an all-time high since its IPO in 2019.

My take: UBER is one of those iconic companies that have managed to embed themselves in the popular mind. Last week, in Regarding…Vol 2 No. 4, I discussed the concept of Anthimeria. Uber has achieved that, creating a strong moat around the business. At present, it’s too rich for my liking, but it remains on my watchlist.

Newmont is the largest gold mining company in the world. It is also the only gold mining company in the S&P 500 index. Its share price is making new cycle lows, as you can see in the chart below. At its previous low, in 2016, the gold price was $1100oz, while the Newmont share price was around $16. Today, the gold price has almost doubled to $2030oz, while the Newmont share price has slightly more than doubled. Shareholders have earned a meagre 3,8% p.a. on their equity over the past 20 years.

My take: If you want gold exposure, buy the physical. Gold mining is not a good business. In the cockroach, where commodities are one of the four cornerstone asset class exposures, 20% of the fund is in either physical gold or in streaming businesses like Wheaton Precious Metals. In the equity funds I am involved with at Merchant West, we have almost no gold equity exposure at all. Every decade or so, there comes a time when the stars align, and it makes sense to own gold shares. It is not yet that time.

The MTN share price is down to pre-Covid levels. The main thing affecting it now is the weak Naira. MTN’s Nigerian business is its largest operating group, with 76,7 million subscribers, more than twice its number in South Africa. Also, the Nigerian Naira, the functional currency of MTN Nigeria, has declined by 65% against the Rand (yes, there are currencies weaker than the Rand!) and 68% against the US$. By destroying the value of the Nigerien unit, it has decimated the intrinsic value of the overall business.

Over ten years, the share price of MTN is not a pretty picture:

Last night, the South African football team (Bafana Bafana) lost to Nigeria in the African Cup semi-final.  As The Finance Ghost said on X, MTN should announce a Bafana Bafana sponsorship this morning. Losing out to Nigeria while focusing on Africa is a perfect brand fit.

My take: For better or for worse, MTN is a play on Africa. So far, it’s for worse. I don’t own the share.

Impala is now trading at similar valuation levels as in 2016, which was a great time to buy. However, there has been a significant change in the market. Over the past 8 years, electric vehicles (EV’s) have become increasingly popular. EVs have no emissions, so don’t use PGM-based (platinum group metals) catalytic converters to reduce emissions. The increasingly obvious realisation that a large part of the PGM market might disappear has driven down the share prices of all platinum-related stocks.

Impala has been the worst:

The EV issue is somewhat of a red herring. Hybrids are becoming more popular than EVs, and Hybrids still need PGMs in their catalytic converters. The real reason behind the precipitous decline in the Impala share price is the “Winners Curse”.  When PGM prices were high a few years ago, Impala followed the institutional imperative and acquired RB Plats. But not after a protracted bidding war with Northam. As with all bidding wars, Impala overpaid. Now, the market is punishing them.

My take: I have been fortunate here – I still have PTSD from buying cheap platinum shares at the previous market bottom almost 10 years ago. This kept me from getting in too early this time around. When – not if – the market for PGMs recovers, Impala should be the preferred play. It is still early days, though.

According to the CSIR, despite a 100% increase in alternative energy production, we are still generating 7% less power than we were 14 years ago:

My take: Until this problem is solved, investors will not take their hands out of their pockets.

As an aside, Germany is facing similar problems. Industrial output in December was down almost 15% below the peak – worse than during the period of post-pandemic input shortages. The “energie-wende” is taking its toll (h/t @DanielKral1)

Unfortunately, only in the USA – the worldwide launch has yet to take place. It has come in for a lot of criticism, with many saying it looks ridiculous. Apple is first and foremost a hardware company, that consistently produces high quality product. I would hesitate to not give them the benefit of the doubt here.

But judge for yourself. Here are two reviews:

The first, by Marques Brownlee, gives a balanced view of its capabilities in a home/office environment.

The second, by Casey Neistadt, takes it on the road for a day.

And here’s an article by Stratechery that goes into significant detail on the product.

My take: The Apple Mac revolutionised the PC, the iPod revolutionised music players, the iPhone revolutionised mobile phones, and air pods revolutionised personal listening. The Vision Pro is likely a platform that will also create a revolution. We need to find out exactly what it will revolutionise, though. And I would not bet against it. Berkshire Hathaway, which holds 915 million shares of Apple stock, is an important holding in both the Cockroach fund and the Merchant West Global Value fund.

Jim O’Shaughnessy had his 200th podcast of “Infinite Loops” last week. In it, the roles were reversed, and he was the interviewee. O’Shaughnessy is my age, so he has a lot of experience, which he generously shares in this podcast. He is also a lot smarter than I am, so he shares it very interestingly.

It’s full of gems; give it a listen.

I’ve just (belatedly) finished Snowcrash, a science fiction novel by Neal Stephenson, published in 1992(!). It plays out in a dystopian world, where a computer virus attacks hackers. Interestingly, a large part of the book plays out in a…. metaverse. Remember, this was written in 1992! As they say, truth is stranger than fiction, however strange the fiction might seem.

I highly recommend the book; it has not dated much and the storyline is compelling.

That’s it for no. 5.

Be careful out there – except when you go to this site; then, you have my full permission to be reckless.

Piet Viljoen
RECM