Dear Fellow Investors and Friends,
Welcome to this edition of my newsletter, where I share my efforts to understand markets and the world around me. I do appreciate you taking the time to read this.
Today is Thursday, March 27th, the 86th day of the year. There are 279 days until the end of the year. The first quarter of the year is over. Remember those New Year’s resolutions – if you haven’t started yet, time is running out. Fast.
I got some pushback last week on my assertion that forecasts are not worth the paper they are written on and are mainly used as a marketing tool in financial services. This week, I will explore a practical approach to conducting one’s investment business without relying on forecasts.
Gavekal Research employs an analytical concept known as the 4-quadrant approach. The 4 quadrants are defined by inflation on the vertical axis and economic growth on the horizontal axis. Schematically, it looks like this:
It can be a valuable asset allocation tool – we simply need to identify which quadrant an economy falls into and then allocate to assets that perform well in that environment.
No forecast required.
Let’s see where South Africa sits using this framework.
Horizontal axis – economic growth
Life is the transformation of energy. You take in energy and expend it on being productive and creating things. Economic growth measures how efficiently energy is utilised. Do more goods and services, in a higher state, come out at one end of the pipe than the amount of energy that went in at the other?
If so, you have positive economic growth.
If not, one of two things is holding back growth:
- Not enough energy is coming into the system. South Africa, under load shedding, was a case in point. A similar phenomenon is occurring in Germany, as the country is undergoing a forced transition to lower-efficiency energy sources.
- Energy is not being used productively, i.e. the output value is low. Again, South Africa (and many other African countries) struggles here, relying on low-value primary outputs and an unproductive labour force.
As Gavekal points out, the economy is energy transformed. Therefore, you can use the price of the stock market, expressed in units of energy, as a measure of efficiency on the horizontal axis.
If the stock market, expressed in units of energy, has a low value, it reflects a struggling economy, as energy is not being efficiently transformed into its highest and best use in terms of goods and services. This is an economic “bust” scenario, corresponding to the left-hand side of the chart above. Conversely, if the stock market, expressed in units of energy, has a high value, the economy is transforming energy efficiently into higher-value goods and services. A “boom” scenario corresponds to the right-hand side of the chart.
In South Africa, the price of the stock market (the JSE All-Share), expressed in units of energy, has been declining since 2016. Over the long term, it has been trending sideways. Our economy has been starved of energy and has struggled to generate value-added output. Several factors have contributed to this, but the extraordinary level of mistrust between the private sector and the government lies at the root of this issue, compounded by a government that expropriates a large part of the tiny surplus.
Vertical axis – prices
Here, we examine whether an economy is being managed by the principle of sound money. If money is being printed freely, it will eventually lead to higher inflation. Measuring the value of the stock market in nominal money terms risks being subject to the money illusion. Instead, one can calculate the stock market’s value in terms of gold, one of the few assets that maintains its purchasing power over time.
When the value of the stock market is measured in gold terms and declines, money is debased due to inflation. This corresponds to the top half of the quadrants chart, which represents an inflationary environment. Conversely, when the stock market’s value is increasing in gold terms, you have a sound money or deflationary environment, corresponding to the bottom half of that chart.
In South Africa, the price of the stock market (the JSE All-Share) has been declining, as expressed in gold units.
Putting it all together
Putting this all together helps us recognise and describe the current economic environment. If we overlay asset valuations, it may help us tilt our portfolios in the right direction without needing to make any forecasts.
In the upper half, an inflationary environment, real (hard) assets are king. Unlike financial assets, which derive value from contractual claims, real assets have inherent physical worth. They are tangible investments with intrinsic value due to their physical properties and utility. Examples include commodities, real estate (specifically, land), and possibly some cryptocurrencies. Art and wine might also qualify. However, what exactly to own depends on which “growth” segment applies.
In the upper left quadrant, labelled “inflationary bust,” the type of assets to hold are “anti-fragile ones,” where anti-fragility, as defined by Nicholas Taleb, refers to assets that thrive when things go wrong. Historically, gold has fulfilled this role, unlike land or commodities. The German economy in the 1930s exemplified this quadrant. Argentina has also frequently occupied it, and many African countries are in a perpetual state of inflationary bankruptcy.
Other real assets will thrive in the upper right quadrant, where growth is strong in an inflationary environment. These include commodities and land, as well as assets that benefit from increased nominal prices, such as those with a relatively fixed cost base and short-duration equity investments – specifically, value stocks – will also perform well. South Africa fell into this quadrant in the nineties and noughts.
In the bottom half of the four quadrants – the sound money environment – income-producing assets become increasingly valuable. Nominal assets, such as bonds, are generally a safe bet, as their real value remains intact. Once again, we need to distinguish between the left and right halves here.
In the bottom left quartile – a deflationary bust – anti-fragile assets are once again required. Such an environment would be like what the USA experienced in the 1930s, Japan in the 1990s and 2000s, and what China is currently undergoing. Bonds, in addition to gold, also play an anti-fragile role in this environment.
Finally, in the bottom right quartile – the deflationary boom environment – growth equities tend to do well, along with income-producing assets like bonds. This is the type of environment the USA found itself in until fairly recently.
So, where are we today in South Africa?
South Africa’s economy is energy-starved and struggles to transform what little energy it has efficiently. It falls into the left-hand side of chart 1. If it weren’t for our sound monetary policy, which some would call too strict, we would be on the same path as our fellow African countries – heading toward inflationary bankruptcy. But our economy tends to the deflationary side as a result of high interest rates.
In South Africa, income-producing assets such as bonds and cash, as well as anti-fragile assets like gold, are performing well. Growth stocks are outperforming value stocks. A diversified portfolio consisting of those assets does well in the South African context. Additionally, as always, a healthy allocation to foreign assets would complete the picture.
If the economy were to start growing, the desired portfolio would look different. How different? That would depend on the nature of the growth. In an inflationary growth environment, one would typically sell income-producing assets, such as bonds, and purchase more tangible assets. Value stocks would also likely outperform growth stocks, as nominal earnings growth would be more readily available.
However, if the environment were characterised by healthy deflationary growth, value would underperform growth, income-producing assets would contribute positively, and real assets would be less valuable.
However, the beauty of this approach is that we don’t have to forecast – we can wait until we recognise our environment and then react to the cards we’re dealt. In the meantime, we know what the world looks like around us today.
No forecast required.
Markets
1. Nike – go woke, go broke
The company behind Air Jordans reported that revenue for the three months ending February declined 9% year-over-year. Next quarter, Nike anticipates sales to fall in the mid-teen range. This sent shareholders running:
Nike’s turnaround effort faces challenges, which the company attributes to tariffs and trade wars with Canada and Mexico. However, the bigger problem lies in unsold inventory, which can only be cleared at significant discounts. This inventory bulge is what happens when woke advertising, alienating your traditional market, meets a brand that tried to circumvent its traditional wholesale and retail partners by going direct.
Nike admits as much when it says it is refocusing on sports and rebuilding relationships with retail partners.
Prof. Aswath Damodaran conducted a deep dive into the value of Nike and its brand, which can be read here. The bottom line is that brands provide pricing power, which significantly boosts a business’s value.
My take: Nike has done its best over the past decade to erode its pricing power. At the current price of $68, the market suggests it will recover soon. I’m willing to take the over on that. Hoka, On, and many other shoe brands have quickly filled the space left by Nike.
2. The German stock market – running it hot
The tectonic plates of Europe’s economy are shifting. A few weeks ago, the Bundestag voted through reforms to Germany’s constitutional debt limits, removing constraints on defence spending and creating a €500bn infrastructure investment fund.
The German stock market liked the hint of fiscal expansion:
At the same time, benchmark bond yields increased by 30 basis points (i.e. 0.3%), the biggest jump since reunification in 1990. “There’s no doubt that markets are pricing in a once-in-a-generation policy regime shift,” Deutsche Bank strategist Jim Reid writes. Speaking of Deutsche Bank, I think this is the right way to play the German market:
My take: Governments worldwide are increasingly starting to “run it hot” to kickstart higher economic growth rates. In the longer term, this means both higher equity markets and bond yields.
3. IPOs are back on the table
As if to confirm the bullish outlook for equity markets, a spate of IPOs (Initial Public Offerings) have been announced recently. These include:
- StubHub, which reported a $2.8 million loss on $1.77 billion in revenue for 2024, compared to a $405 million profit on $1.37 billion in revenue for 2023. The difference? Sales and marketing expenses increased to $828 million in 2024 from $518 million the previously. I guess if you’re going to sell equity valued on a sales multiple, you will forgo profit for higher revenues! StubHub is aiming for a valuation of at least $16.5 billion, i.e. 10 times sales.
- eToro – The nexus of financial markets and gambling. eToro is a social trading and multi-asset brokerage platform that enables users to trade, invest, and interact with others in real-time. 96% of its revenue comes from Crypto trading. Its proposed valuation is $4.5bn, down from $10bn when it attempted to go public a few years ago. That’s a P/E of 25, based on – I guess – inflated earnings.
- Klarna, the Swedish fintech company, provides “Buy Now, Pay Later” financing at the checkout counters of online retail sites. It recently signed a deal with DoorDash to fund its clients’ purchases of Big Macs and other items. Klarna’s proposed valuation of $14.5bn is down from a Covid-inflated funding round of $45bn in 2021. It still only has revenue of $2.8bn and net profits of $28mn. Yes, that’s a million with a m.
- CoreWeave, an AI infrastructure play, is looking to IPO at a $35bn valuation. That’s on $2bn of revenue and a $1bn net loss.
My take: Some of these successful businesses may also be succesful investments. But the odds are against you at this sort of pricing. As always, caveat emptor.
4. Momentum has got… momentum
This South African insurance business has been flying under the radar for a few years. But CEO Jeanette Marais and her team have got the ball rolling now. Momentum recently reported Nvidia-like earnings growth of almost 50%. It’s generating a return on equity of 25% and 16% on Embedded Value (an actuarial term that means the present value of all its future profits from existing business, i.e. excluding profits from all new business written in the future).
Momentum is also buying back shares and paying handsome dividends. Its share price is up 95% over the past three years:
For this, you’re paying a P/E of less than 8 and a significant discount to embedded value.
My take: Who says growth is impossible in South Africa? Momentum has a bone to pick with you. It’s a core holding in the MWI Value fund.
5. Xiaomi
This is the best business you’ve never heard of.
Xiaomi is the third-largest seller of smartphones globally, with sales growing by 15%, while Apple and Samsung are in decline.
This chart is from YWR’s blog.
Xiaomi is also the fifth-largest seller of tablets globally, and sales are growing.
Better yet, Xiaomi is gaining market share aggressively in emerging markets, where all the people are:
But that’s not all, folks. It also makes cars. Cool cars:
That’s effectively a Porsche 911 GT3 for R1.3mn.
Additionally, it is gaining global market share in the smart home appliance sector.
It’s no surprise that their share price has gone vertical:
My take: China is the future, and the USA is the past. If you overlook China, you’re missing a massive market with companies that are emerging as global leaders in manufacturing and technology.
In The Media
1. Egypt is getting a new capital
This is what it looks like:
It’s being built 50 km outside of Cairo, complete with Africa’s tallest building (in the foreground) and a high-speed rail link connecting it to Cairo.
Guess who’s funding and building it? Predominantly China.
My take: What has the USA done for us lately? If you’re having sleepless nights about SA’s relationship with the USA, you could start thinking about the positive possibilities for us of moving closer to China/Russia.
2. Interview with Nicholas Nassim Taleb
This is one of the most interesting interviews I’ve seen in a while. Taleb is the author of The Black Swan and other books that explore various types of probabilistic outcomes and how they can help us think about dealing with the world around us.
My take: Taleb can come across as an arrogant pain in the ass. But the guy is brilliant, and his insights are worth thinking about. I guarantee you will have to stop the video occasionally to digest some of his concepts.
The money quote: “In Extremistan, most forecasts are useless. You must always be prepared for extreme events. Most forecasts look good due to survivorship bias.”
3. Adam Singer on Masculinity
This week, Adam Singer published a riff on masculinity in his Hot Takes Substack. I sent it to all three of my sons to read, and I hope they did. If you have a son, share it with them. Even if only 10% of what he says resonates with them, it will give them a tremendous advantage.
The money quote: “A world without masculine virtue devolves into disorder. Weak men breed chaos because they lack the discipline to hold the centre. Strong men maintain civilisation not through oppression but through the quiet, daily enforcement of reality.”
4. Best music of 1990
Continuing my musical journey through the years, I recently finished listening to the music from 1990.
At the time, I was still working for the SARB in Pretoria and sharing a house with a few friends. All of whom are still friends today. My friend Corne owned the house – he was the only one of us who could qualify for a mortgage, so he bought the place, and we rented from him. That was my first lesson in property – never be an owner, always a renter. Corne’s house took a battering from housing a group of young people with limited responsibilities. Maintenance costs, rates, taxes and general DIY jobs ate up most of his rent and time.
Here are the best albums from 1990 on Apple Music.
Here is the long list of the best songs on Apple Music.
The top 20, as chosen by me, are here on Apple Music. Ranked from 20 to number one – just like David Gresham used to do.
And the same top 20 are here on Spotify.
I don’t think it was such a great year for music. But Mazzy Star’s debut stood out, as did Sinead O’Connor’s album, “I Do Not Want What I Have Not Got.” This was peak Sinead – after that, the quality of her output started to decline. The Beautiful South also began to emerge with their wistful songs, which contained quite sharp social commentary. I also discovered Bob Mould, of Husker Du fame – someone I was not familiar with at the time. It was an unexpected pleasure to discover his solo output. And who will forget the year’s anthem – “Sit Down”, by James.
5. The big race
Last Sunday, we did the Cape Town Triathlon as a family, with the youngsters competing as a team against me. The result was close, but everyone ultimately came out as a winner. In the swim leg, Courtney was fearless in a big swell with lots of chop. It was a super challenging swim, so hats off to her! Then Nic blitzed the bike leg, and Daneel ran her heart out to finish the 10km run in under 55 minutes. The team’s time and mine were very close in the end. Here’s a pic of us after the race:
Everyone had a great time, and we’re already planning our next event. Courtney just needs to get over the trauma of her swim! It was a pure joy to share my sport with the family.
That’s it for this week. Please be very, very careful out there.
Piet Viljoen
RECM