Regarding… Vol 2 no 8 – Squeeze Play

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 29th of February, the 60th day of the year. 306 Days remain until the end of the year. Today is your bonus day for the year. You only get it every four years, so use it well.

Today, in 1896, Indian politician Morarji Desai was born. He was the first prime minister of India not to represent the long-ruling Indian National Congress party. Since then, India has gone from strength to strength.  Let’s hope the elections this year mark the end of the hopelessly inept African National Congress’ rule here in South Africa as well.

Before I get into the meat of this week’s letter, I want to share some good news with you.

Yesterday, I went to Somerset West to do due diligence on a business which we are looking at buying into. I met three of the most enterprising young people I have ever encountered. They have built a business from scratch by solving a problem for ordinary South Africans.

Speaking to other investors in small businesses leaves me highly encouraged about possibilities here in SA. On the stock market, we are faced with huge negativity daily, but out there in the real world, there are people doing it for themselves, creating profits, jobs and growth.

I am excited.

With that said, on to some market commentary:

Nvidia Nvidia Nvidia Nvidia Nvidia Nvidia Nvidia. And more Nvidia. Oh yes, Nvidia, too. And more Nvidia. Did I mention Nvidia?

When I was at university, I spent most of my time in the cafeteria playing bridge. My studies suffered, but I became a pretty good player. One of the more exciting plays in bridge is called a “Squeeze”, where you force an opponent to play a card he doesn’t want to play. Executing such a play is hard, but most satisfying. It made a day spent in the cafeteria – and not in the classroom – worthwhile.

I think something like that is happening in markets right now.

Here is a chart of Nvidia’s market value over the past five years:

It’s up from around $100 billion in 2019 to almost $2 trillion today. That’s a twenty-bagger in 5 years; the stuff dreams are made of.

Nvidia is the poster child for the magnificent 7. And the magnificent 7 are the poster child of the whole market. And the market has vast FOMO.

The other six have shown similar gains, albeit not to the same extent. But they have all done very well. Their earnings have grown, and the multiple on their earnings has also expanded. For investors, growing earnings coupled with an expanding multiple is Nvidia. Sorry, Nirvana.

In 2015, Microsoft was on a P/E of 15, while as recently as 2016, Apple was trading on a P/E of less than 10. Nobody wanted to own them – they were seen as dinosaurs. The iPhone changed Apple’s fortunes for the better, while the cloud and AI have radically improved Microsoft’s. But if you looked at any analyst report on those companies predating these products – they did not mention them at all. The product’s success was not predictable. At the time, the future looked bleak.

Today, the magnificent 7 – Apple, Microsoft, Nvidia and the rest of the gang trade on an average P/E of 48. They are seen as must-haves in any portfolio, and analysts all forecast a very bright future for them.

There are two questions you must ask yourself when thinking about these stocks: why were the analysts wrong in 2015? And are they right today?

The answer is simply that no one knows what the future holds, so when you pay a high price for a stock, you are assuming – no, demanding – a rosy future. You might find it comfortable to do so, given all the analysts are predicting exactly that. But I’m not sure their predictions are worth much more than a comfort blanket.

But it is not only the valuation levels the big stocks are fighting against – long term; size is an enemy of returns. And these stocks are big.

Over the past ten years, the ten biggest stocks in the S&P500 have outperformed an equally weighted index of the other 490. Just like in the ten years leading up to 2001 and the eight years leading up to 1973. But over the whole 70-year period since 1957, they have done poorly.

What’s going on? Is the market irrational? In Jason Zweig’s classic book “The Devil’s Financial Dictionary”, he defines irrational as “A word you use to describe any investor other than yourself.” So let’s not go there.

No, what I think is happening is a massive squeeze play, or “short squeeze”, as it’s known in the market.

I discussed the shorting of stocks last week. A “short squeeze” is when investors are forced to buy to cover their losses due to the price of the stock they are short of going up.

This is a chart of the share price of a company called Gamestop:

Gamestop was the original “meme stock” – it had terrible fundamentals, so many investors had shorted it. Some “activist” investors noticed this and started buying the share aggressively, driving the price up. This caused some of the shorts to buy in to cover their position, driving the share price up even further, in turn causing even more shorts to cover. Ultimately, most of the shorts were “squeezed” into the stock due to the incessant buying pressure.

As a result, the share price went parabolic – from $2 to $120. When the last short was covered, the share price collapsed. Of course.

Active managers as a group are, relative to the market index, effectively long smaller, undervalued stocks and short, big growth companies. Patrick Palfrey of UBS says active large-cap managers have “a natural propensity to underweight the biggest stocks”.

For the past few years, investors have switched from actively managed portfolios to indexing or passive portfolios.  As money flows out of active portfolios, their portfolio managers are forced to sell what they own, which differs from the market. And as the money flows into passive products, the big stocks – which are under-owned by the active guys, get bigger.

As a result of their positioning, active managers’ relative performance has suffered to the extent where they are being forced to buy the big growth stocks – the magnificent 7 – to keep from getting fired by their clients.

With both indices and active managers being forced to buy these stocks, a classic squeeze play, or short squeeze, is on, resulting in the parabolic share price increases we have seen recently with the magnificent seven and their ilk.

The problem is, if I am right, the squeeze can carry on for much longer than one would think –  as long as the narrative holds.

I would not try to time this.

Warner Bros became the first Hollywood conglomerate to turn a full-year streaming profit ($103 million).  But it hit a new low on the news. This is not good. If seemingly good news is taken as negative by the market, I think it shows there are deeper underlying problems.

My take: This price action possibly indicates that Netflix has won the “streaming wars” I discussed the situation in Vol 2 No 4, which you can find here.

This is the Consumer Staple sector relative to the S&P 500, which hit a new low this week.

This index includes stalwarts such as Wal-Mart, Costco, Coca-Cola, Proctor and Gamble, Colgate and Philip Morris. it also includes Monster Beverage, the second best-performing stock in the S&P500 over the past 20 years.

However, the index is performing quite poorly despite the inherent quality of its components.

Right now, the market doesn’t care about defensive earnings. It wants the rocket ship called Nvidia. Also, valuation matters.  Despite its poor performance, the sector is sitting on a historically high P/E ratio:

My take: I would continue to be very selective in this sector.

The benchmark index for the Tokyo Stock Exchange finished at an all-time high on Tuesday. It’s the third straight session that the Nikkei 225 has hit a record level. After peaking in 1990, it spent 34 years in the wilderness:

Even better news is that value investing is working in Japan. I guess stocks must get really cheap before value investing can work its magic. Cheap places – the UK, South Africa and Japan. Not cheap places: the USA.

My take: Both the MWI Global Value fund and the MWI Worldwide Flexible fund have more than their fair share of Japanese exposure. In the long term, I think Japanese equities (and, ultimately, the Yen) are well positioned to take advantage of the inevitable financial repression that will be imposed on Japanese investors.

Just like Japan, the MWI Worldwide Flexible fund – or the cockroach, as I affectionately call it – hit a new all-time high this week. You can read my quarterly comment (about 4Q23) here.

My take: I’m happy with the returns generated by the fund since I changed the investment process in August 2020. Since then, the team at MWI and I have been managing it with a US$ mindset. This changes how one thinks about the world in interesting ways.

Not only in South Africa, but in many, many countries. In fact, half of the world’s population will be voting this year.

My take: Charlie Chaplin said: “I know one thing, and one thing only, and that is to be a clown. And that puts me on a higher plane than a politician.” Be prepared for a circus this year.

Here is a list of CEOs of big American corporations, with a flag of their country of origin: (source: @stats_feed)

Notice anything?

India is flexing its muscles on the global stage. For many years, India championed anti-colonial diplomacy and provided strong backing for the Non-Aligned Movement, but its influence progressively waned due to a weak economy and a largely passive foreign policy. But things have changed under new leadership. Could this be a pointer for South Africa, or is that too much to wish for? In any case, I believe India’s people and its economy have more potential for investors than China over the next decade or two.

My take: I’m so sorry if you sent your poor kids to learn Mandarin. Hindi is the language of the future.

As a kid – and I know this will date me – I remember lying on the floor of our TV den in New York, watching the first moon landing in 1969. It was such an exciting time!

This week, space exploration company Intuitive Machines (ticker $LUNR) rose sharply after becoming the first privately developed spacecraft to land on the lunar surface. Its moon lander promptly tipped over on its side.

My take: Despite reaching a tipping point (I know, bad dad joke), I think this is a significant achievement. It used to be only governments did this sort of thing. Why is no one talking about it?

GMO – your active managers are more competent than they look

As an active manager, I know I’m talking my book here, but still…this article does resonate. And gives me a very good excuse not to go chasing the hot stocks of the day. If you are in charge of hiring and firing fund managers – for yourself or as a fiduciary responsibility – it’s worth contemplating this.

The Semper Augustus Annual Letter

Given that the Berkshire Hathaway annual results were released over the weekend, it’s worth reading one of my favourite annual investment letters. That of Chris Bloomstran of Semper Augustus, who is the absolute expert on all things Buffett and Berkshire. It’s 144 pages of wisdom, the last 60 of which comprise his valuation work on Berkshire. TLDR? – it’s still not expensive. His chapter on China might also be of interest.

Jimmy Buffett

Seeing it’s Berkshire Hathaway’s annual report time, we should all be listening to Buffett. Jimmy Buffett.

In the 1980s, Jimmy became friends with Warren Buffett.  Although they weren’t related, they called each other “Cousin Jimmy” and “Uncle Warren”. Jimmy Buffet became very wealthy by building a big business around his music career, and by owning Berkshire stock for a very long period of time.

Favourite track? Any one of “Why don’t we get drunk”, “Margaritaville”, or “Cheeseburgers in Paradise” will do. Cheesy, but in a good way. But here’s a “best of” playlist in Spotify so you can see for yourself.

That’s all for this week. Next week, this time, we will be on our bikes somewhere between Jeffreys Bay and Cape Town. Can’t wait!

And another big thank you for those who donated to our cause – I really do appreciate it. We have exceeded out target, but we’re not stopping! If you forgot to donate, its not too late to donate at this link.

Amanda is cheering you on, one tequila at a time.

We’re going to be careful on the roads next week. Please be careful in the market this week.

Piet Viljoen
RECM