Regarding… Vol 2 no 7 – Get Shorty

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 22nd of February, the 53rd day of the year. 313 Days remain until the end of the year.

Yesterday, our finance minister delivered the budget speech in 47 minutes. Today, I am going to spend less than 1 minute analysing it. Here goes: we will pay more tax in the next financial year, and we will get less for it. What we will have more of is load-shedding, port-shedding, rail-shedding, water-shedding and job-shedding. There, that’s it.

Much more importantly – according to Jason Zweig, it was during this week 336 years ago – in 1688 – that the London Gazette published the earliest known reference to “Edward Lloyd’s coffee house,” the birthplace of Lloyd’s of London. Today, Lloyd’s is the world’s specialist insurance and reinsurance market. With expertise earned over centuries, Lloyd’s is the foundation of the global insurance industry. This is a very large industry – Swiss Re estimates that the world generates around $6,8 trillion worth of annual premiums.

Fairfax Financial Holdings (FFH) is the biggest holding of the Merchant West Investments (MWI) Global Value Fund. It is a Canadian-based insurance and investment company run by renowned investor Prem Watsa, famous for his conservative value investing style. Fairfax has been called the Berkshire Hathaway of Canada.

Last week, FFH was the subject of a report by short-selling firm Muddy Waters. Not the American blues singer famous for electrifying the blues. No, this is Muddy Waters Research, founded by Carson Block. Their slogan is “Doing the work Wall Street won’t.”

Short sellers want the price of a company’s shares to decline in future. They do exactly the opposite of buying an asset hoping its price rises; they profit from price declines. They do this by borrowing shares and then selling them into the market. If the stock’s price falls, they book a profit by buying back the shares and returning them to the original lender.

Anyway, back to FFH. Here is a chart of its share price:

The orange line is the share price, which is up by a factor of almost three times since I first bought it in early 2022. The green line is its performance relative to the MSCI World Index – FFH has returned almost double the index return over the past two years.

FFH’s price declined 12% after the Muddy Waters report, hurting the fund’s performance on the day. In the context of its longer-term performance, this is not significant. I have not sold out of the fund’s position, as I think the report lacks substance. Since the report, the share has recovered almost all its losses.

Short sellers are often portrayed negatively, characterised as stock manipulators with poor ethics. In the James Bond film Casino Royale, a private banker named Le Chiffre was cast as the central villain. In the movie, Le Chiffre is implied to have conspired with al-Qaeda in orchestrating the 9/11 attacks, deliberately profiting from the attacks by short-selling airline stocks beforehand.

Why are short sellers so vilified?

Simple: incentives drive behaviour. Most market agents – stockbrokers, portfolio managers and financial advisers – levy fees expressed as a percentage of assets. They make more money from their clients when asset prices go up than when they go down. Unsurprisingly, they actively dislike people who benefit from declining asset prices.

Also, short sellers make money when most others are losing it – that is when stock prices fall. Few things trigger negative emotions more than seeing someone make money while you are losing it.

But short sellers are stock pickers, just like the long-only fund managers the market likes to admire so much. The only difference is that their work is picking stocks that will decline, whether it be because of fraud, mismanagement, changes in market dynamics or any other negative factor their research uncovers. Due to their incentive structures, the street focuses on positive research and thus short sellers “Do the work Wall Street won’t”.

This adds richness and value to the system.

The stock market helps people allocate capital through price signals. Short sellers improve the ability of the market to set prices efficiently. More efficient price setting leads to better capital allocation decisions.

Long live short sellers!

Thungela is a coal mining company that was spun off from Anglo American three years ago at a share price of R30. Amidst panic around the European energy situation, coal prices rocketed and the Thungela share price went up to R370. The holy grail of investing is regarded as having a ten-bagger (an asset that goes up by a factor of 10 times) in your portfolio. Well, Thungela saw your miserly ten-bagger and raised it to a 19-bagger! Unsurprisingly, it became one of the most popular stocks on the market.

This just goes to show how a situation can change rapidly. Since then, two things have happened:

• The coal price has dropped from $400 per ton to $120 – but still 50% higher than the level in 2019.
• South Africa’s ability to transport coal to the Richards Bay terminal has reduced significantly, limiting how much coal Thungela can export.

The net result is a share price more than two-thirds lower than the highs reached in 2022:

My take: Thungela has coal reserves of at least ten years’ worth of production. The coal price is cyclical. A high or low price in any one year doesn’t change the intrinsic value of the business. But the breakdown of rail carrying capacity is of a more permanent nature. As Thungela exports most of its coal, this represents a permanent reduction of the intrinsic value of the business. The MWI Value fund still owns a small position in this stock after acquiring it as part of our spin-off strategy shortly after listing. Most of it was sold in 2022.

Cashbuild is a retailer of building materials and associated products, selling directly to cash-paying customers. The South African consumer is under pressure, so that description explains this price action:

My take: This is not a great environment for a retailer like Cashbuild. Until the government stops its socialist policies and neglect of the country’s infrastructure and starts promoting growth, things will not improve for the likes of Cashbuild. On a 12 P/E, we don’t own this stock. There are better-placed businesses available on 3 and 4 P/Es.

Staying with the theme of problematic local stocks, JSE Ltd rounds out the trifecta. Not the JSE as in the whole market – there are stocks we are bullish on – but the company running the stock exchange. They make most of their money from fees on trading. The value of trading is down 24% on last year, and the number of listed companies has dropped from 601 in 2001 to 286 this year.

This share price action should therefore come as no surprise:

My take: For a business that generates healthy cashflows, it looks cheap on almost every metric. But with fundamentals steadily deteriorating, I think it will be dead money for a long time.

Reinet is a Luxembourg-domiciled investment holding company controlled by Johann Rupert, the scion of one of South Africa’s great entrepreneurial families. It was created because of the restructuring of Richemont when it unbundled its holding in the tobacco company BAT. Legend has it that Mr. Rupert initially started Reinet to show fund managers how to invest properly.

Whatever the truth of that, he has done well – in the 13 years of its existence, in Rand terms, the NAV of Reinet has compounded at almost exactly the rate of the JSE All Share Total Return Index – just over 11% p.a. Not many active fund managers have been able to exceed that. The share price has done slightly worse – 9% p.a., as it started at a small discount to NAV which has widened to almost 40%.

Yet today, the share price is at an all-time high:

Mr Rupert’s key investment action was to use the proceeds from the sale of BAT shares over time to diversify into other investments. He bought a jumble of interests in other third-party fund managers, some of whom have become more successful than others.

But his biggest move was to buy control of the Pension Insurance Corporation Group (PIC), a London-based insurer of pension risk, which now makes up almost 50% of NAV. Insurance companies have done well over the past year or two as pricing has firmed (see FFH above). PIC is no exception.

My take: The market – until recently – had put too large a discount on the company. A discount we took advantage of in the MWI Value fund, where Reinet is one of the top holdings. Reinet has also become one of the “self-help” candidates on the exchange, where they are buying back their own shares instead of relying on a disinterested market to buy their shares. Coupled with a good performance from PIC, the share price has benefitted. It’s still not expensive.

My take: Despite the share price quadrupling in the last four years, the P/E is still only 4, with a 6,3% dividend yield. It just goes to show, you don’t have to join the Nvidia hodlers to make money. There are many ignored great businesses out there – you just have to turn over enough rocks.

The following graph plots the amount of energy Eskom provides to the grid:

For the first six weeks of this year, the EAF was the lowest it has ever been. That is despite firing the previous CEO, De Ruyter, and appointing an actual Minister of Electricity (God knows what he does all day).

Here is a timeline of the efforts of our esteemed leaders to fix the situation:

• December 2014: Cabinet announced that a war room had been set up following the power outages which were impacting the daily lives of South Africans. A certain Mr. Cyril Ramaphosa was appointed to head up this important function. (Note: Mr. Ramaphosa has a long track record of very successfully doing exactly nothing, so the chart above should come as no surprise).
• January 2023: Eskom chair Mr Mpho Makwana sets targets of 60% EAF by 31 March 2023, 65% EAF by 31 March 2024, and 70% by 31 March 2025. (Note: here in February 2024, we are at 52%. Mr. Makwana did the honourable thing and quit in October 2023).
• Also in January 2023: Mineral Resources and Energy Minister Gwede Mantashe said that he could end load shedding in six to 12 months if we pay attention to the issue. (Note: I guess we are not paying attention to the issue, then).
• May 2023: ANC secretary-general Fikile Mbalula said load-shedding will be a thing of the past before the end of 2023. (Note: Mr. Mbalula is a windbag and should never be quoted on anything).

My take: The people overseeing our power crisis are either lying to us, or they are incompetent. Importantly, the problem is not going away soon, and investors and businesspeople should be prepared for that.

17 Jan 2024, Davos, Switzerland: OpenAI’s CEO Sam Altman on Tuesday said an energy breakthrough is necessary for future artificial intelligence (AI), which will consume vastly more power than people have expected.

In light of that comment by one of the “uber” insiders on AI, which would you buy – XLE or Nvidia?

My take: Mr. Altman is a proponent of nuclear energy. He doesn’t mind if it is fission (the existing nuclear technology, that uses uranium as fuel) or fusion (which doesn’t). But fusion is still a long way off, and AI needs cheap energy now. And so does the rest of the developing world. So, for me, the lowest-risk way to play AI is to buy Uranium. The cockroach fund holds uranium via the investment trust, Yellow Cake.

While discussing AI and chips, I should note that Nvidia reported after last night’s close. All I can say is the annual revenue run rate is $80 billion, and the market cap is $1,7 trillion. Both are big numbers, but one number is much bigger than the other one, in the wrong way.

I did enjoy these two posts on X, however:

“How the World Really Works” by Vaclav Smil.

This book will further your understanding of the role fossil fuels play in our lives in a straightforward way. In short, if you think the world will wean itself off fossil fuels in the next 20 years, you are sorely mistaken. And if you think EVs running on wind and sun are the future, you probably live in a very rich country. But not where the other 80% of the world live. The 80% that still needs affordable energy to grow and prosper.

I can highly recommend this book.

Also, Berkshire Hathaway’s 2023 annual report will be released on Saturday morning, along with Warren Buffett’s annual letter. I will be spending some time this weekend reading that.

This week in Doom, #17 – Moles, Meat and Mayhem.

I subscribe to a newsletter on Substack called “Doomberg” (As opposed to Bloomberg – geddit? You can learn more about it here)

In their own words: “Doomberg highlights the fundamentals missing from many economic and policy decisions” and “the content is borne out of our team’s deep experience in heavy industry, private equity, and the hard sciences.”

They did a free podcast in December with Grant Williams, which is worth listening to if you are at all interested in the ongoing debate between the pessimistic Malthusian outlook and the optimistic outlook based on human ingenuity.

You can find it here.

That’s all for this week.

Finally, a big thank you to everyone who donated to the RECM Foundation’s fundraising campaign. We have achieved our target of R50,000. Amanda will therefore be drinking 50 tequilas. As promised, I will report back on the proceedings.

And if anyone wants to further increase the number of tequilas, you are more than welcome to donate here.

Remember – you need to be very, very careful out there. There is only one rule in the market jungle, and that is Caveat Emptor.

Piet Viljoen
RECM