Dear Fellow Investors and Friends,
Welcome to another 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. Feedback is welcome; it’s great to start conversations.
Today is Thursday, June 5th, the 156th day of the year. There are 209 days until the end of the year.
The Six-Day War between Israel and neighbouring Arab states started on this day in 1967. The conflict led to concerns about oil supply disruptions, contributing to market volatility and setting the stage for future oil crises. The associated closure of the Suez Canal led to trade disruptions. This and the oil crisis sent an inflationary impulse through the global economy, which lasted for almost 15 years.
History never repeats, but sure does bust a mean rhyme.
Last week, I discussed the appeal of investing in “cash machines”, high-margin businesses that convert revenue into cash at an attractive rate. We then aimed to identify the relevant aspects of various business models that contribute to strong cash generation capabilities (you can read last week’s piece here).
This week, we’ll examine three more classes of cash machines: exchanges (i.e. stock markets), technology companies, and streaming – or royalty-based companies.
To refresh your memory, here’s a table with all the stocks:
ICE stands for Intercontinental Exchange, one of the leading global operators of regulated exchanges and clearing houses. Amongst others, it owns the New York Stock Exchange. The great thing about exchanges is that they act as local monopolies due to the liquidity they provide to traders and investors. Liquidity acts like a flywheel; the more liquidity an exchange has, the narrower the spread between buying and selling prices, the more it attracts new clients, and liquidity increases even further. Because it is a fixed cost business – some software and servers, and that’s about it – when an exchange becomes the dominant player, its margins expand tremendously. The liquidity moat is valuable, so the market places a high value on the earnings of dominant exchanges – ICE trades on a P/E of 35. Most exchanges are local monopolies and not globally scalable, which explains the low market value.
Technology is a catchphrase for many activities these days. However, the two companies I want to highlight represent the broad spectrum of the tech industry. These companies have a great combination of high margins and scalability.
Microsoft. This juggernaut has margins approaching 50%. Importantly, despite a few missteps, Microsoft has been able to adapt – and thrive – to the rapidly changing world of tech over many cycles – from PCs to web to cloud and now AI. There isn’t any other tech company that has been able to do what Microsoft has done. Despite its high margin, it has a lower P/E rating than many other tech companies, probably reflecting the market’s doubts about its ability to adapt to future cycles. However, due to its inherent scalability, it is still one of the most highly valued businesses in the world, with a market value of over $3 trillion.
Nvidia doesn’t even make anything. What it does is design the best GPUs (i.e. the chips that drive computing) in the world. Plus, it writes software (CUDA) that runs on these chips. The actual fabrication of the chips is outsourced, mainly to TSMC. As a result, Nvidia enjoys margins of over 60%. Due to its capital-light business model, it enjoys the highest P/E of the tech companies in this sample. Super high margins and an eminently scalable business model result in a market cap of over $3 trillion.
And then we come to the highest-margin business models in the world: streaming or royalty businesses. These companies employ very little physical capital. They own no physical infrastructure and don’t build, mine, or grow anything. They merely take a little bit “off the top” – a percentage of the revenue of the underlying business.
You can own a royalty or a stream of income in two ways.
The first, more capital-intensive method is to purchase it from a mine, for example. In exchange for financing a new project, the mine promises to pay the royalty company a percentage of the project’s revenues. The royalty business incurs no ongoing maintenance or growth capital costs. If the project expands, it still receives its royalty.
Wheaton is an example of such a “royalty” company. It generates revenues of $1.3 billion and employs fewer than a hundred people. Unsurprisingly, it earns comparable margins to Nvidia, around 60%, and enjoys a similar P/E.
Texas Pacific Land is one of my favourite companies. It’s an example of the second way to earn royalties, which involves being a historical recipient of a land grant. In TPL’s case, they were gifted land by the government over 100 years ago as an incentive to build a railway across Western America. The railroad eventually went bankrupt, but not before the land was spun off into a separate trust, which ultimately became the company Texas Pacific Land. Today, if you wish to drill for oil in the Permian basin, chances are you will be doing so on TPL land, and for that, you must pay them a portion of your revenue. No wonder they earn margins of almost 80%. TPL has half the revenue of Wheaton, but a similar market cap. Why? There is no need for any capex whatsoever.
But the best is yet to come. Sabine Royalty Trust is a passive royalty-based trust that earns royalties from oil production revenues in Texas, Louisiana, and Oklahoma. As a fixed-term trust, it operates with minimal administrative oversight, relying on third-party operators (e.g., ExxonMobil, Chevron) to manage oil and gas production on its royalty properties. It has no employees and incurs no capital costs. It passes its royalties directly to its shareholders. As a result, it enjoys an operating margin of 97%(!) – Sabine Royalty Trust is the closest you can come to a cash machine.
Despite having incredible business models, there is one problem with the royalty-based companies: they are hard to scale. Companies like Wheaton that finance mining projects in exchange for a royalty can expand, but it takes capital. As a result, Wheaton only has a market cap of $34 billion. Despite enjoying higher margins, TPL and Sabine are even smaller, because their earnings power is effectively limited to earning royalties off the land they own.
The upside is that these stocks are not heavily represented in indices because of their size, so they are not subject to the resultant valuation distortions.
In a world where governments aim to run things hot, and inflation risks are increasing, owning growing cash flows that require minimal capex will prove to be a more powerful investment than usual. Companies like these, and others like them, can serve as a good starting point for building a robust or even anti-fragile portfolio of stocks.
Markets
1. Truworths
This is the runt of the South African retail litter. It is a perennial underperformer, consistently losing market share to the other players. Here’s the most recent like-for-like sales growth number, according to Investec Securities:
If you’re doing worse than Woollies FBH, you’re struggling! It’s no wonder the share price has shown almost no gain over the past 10 years:
Shareholders have much to complain about, but not management. They have been well rewarded for poor performance. Here is a table comparing the CEO’s pay with some operating metrics for the business over the past ten years:
The metrics showing how shareholders have done are growing by low single-digit percentages. By contrast, the CEO’s pay has grown by almost 20% p.a. He now takes home nearly 30 basis points of the company’s revenue, compared to 10 basis points ten years ago.
My take: Whoever the company’s shareholders are, they have reneged on their responsibility as owners. Shame on them! As for management, I guess they are just taking what’s there for the taking. Shame on them, too! I would avoid this value trap at all costs.
2. British American Tobacco
In case you haven’t noticed, former market darling British American Tobacco (BTI) has been doing quite well just recently:
And that’s not due to a weak Rand. The Rand has only depreciated by 2.6% p.a. against the Pound over the past five years and is basically flat against the US$. That’s despite the shrill cries of the “take your money offshore now” fear-mongering and asset-gathering crowd.
In any case, things seem to be going well at BTI – earnings and dividends are growing, as they successfully migrate from selling cigarettes to selling vapes. Importantly, their cash flows are growing nicely. My colleague at Merchant West Investments, Josh Viljoen, provided me with this chart comparing free cash flow per share at British American Tobacco to Philip Morris International:
Despite this, BTI is on a single-digit P/E, while PM trades on a P/E of 23 times.
My take: American exceptionalism? The cash flows say no – and so do I. The stark valuation discrepancy between these two stocks shows just how undervalued UK stocks are, and conversely, how overvalued US stocks are. This is a generalisation, but a valid one in my opinion.
3. Kweichow Moutai
I bet you’ve never heard of this company.
Would it surprise you to learn that it is the most valuable alcohol brand in the world, far ahead of second place? In second we find AB InBev, that Frankenstein of the brewing industry, the brewer of Budweiser, Corona, and Castle Lager.
Here’s a table showing the top 10 alcohol brands in the world:
Kweichow Moutai makes a drink called Baiju, a traditional Chinese distilled spirit that is clear and colourless. Its alcohol content ranges from 35% to 60% ABV. Baiju is commonly made from fermented sorghum. Baiju is also an acquired taste for non-Chinese palates.
If you want to try it out, here’s what a bottle looks like – but be prepared to pay around $350 for it.
With the Chinese consumer suffering, the Kweichow Moutai share price has been a poor performer:
My take: With 1.4 billion people and growing purchasing power, the Chinese economy is enormous. Over the next 20 years, it will need to boost consumption at the expense of investment. You could do worse than look at companies like this.
4. Emerging markets are cheap
Over the past three years or so, I have been like a broken record, saying Emerging Markets (EMs) are cheap, and within EMs, South Africa is even cheaper. Putting my money where my mouth is, I have been favouring these assets in the equity portion of the MWI Worldwide Flexible fund (aka “the cockroach”). I have also taken a very public bet with real money that South Africa, as represented by the MWI Value fund, would outperform offshore markets.
It’s starting to pay off. I am well ahead in the bet, and year to date, EMs are outperforming Developed Markets (DMs). South Africa is doing even better. But I think this is only the start of a longer-term trend.
DMs suffer from bloated debt levels and richly priced asset markets, a deadly combination for investors. This chart by Investec Securities shows just how cheap EMs and South Africa are:
My take: As usual, I have been somewhat early with this call. But events over the last couple of years have only strengthened my view.
In The Media
1. A trip around the world, by Rob Vinall
I love a travelogue, especially when combined with some business and investment insights. Rob Vinall, the founder and CEO of RV Capital, wrote an account of his trip around the world in April and May, and it ticks all the boxes for me.
His main takeaways? The Chinese people were united, prepared, and determined to face their challenges. In contrast, politics has fractured American society, with individuals hesitant to express their opinions.
He mentioned many other interesting factoids. You can read the trip account here.
My take: I’m more convinced than ever that China presents a significant investment opportunity.
2. The best music of 1992
My personal trip through music history continues. This month, I listened to the music from 1992. Just to be clear – not the hit songs, but the year’s best albums. I must have listened to over 70 albums to identify the best ones. I re-discovered many I had forgotten about and discovered music I had known about at the time, like the Dutch band Bettie Serveert. I tend to attach memories to music, so it really is a journey down memory lane.
1992 was my second year at Allan Gray Investment Counsel. The business was experiencing a challenging period performance-wise, as all investors do at some stage. However, what I remember most was Gigi van Zyl – my boss at the time – always putting on a brave, smiling face. Looking back now, she must have been under tremendous pressure dealing with upset clients. I was, of course, oblivious to the pressure, being a minion, shielded by her. Respect!
I also had the honour of working with Anet Ahern at the time. She now heads up the best large fund management business in South Africa. Being exposed to Jack Mitchell’s (now sadly passed away) thinking on markets and investing was also a key building block in my career.
The music of 1992 brings back those memories, and many more!
You can listen to the top 10 albums on Apple Music here and on Spotify here.
The long list of top songs from the year is only on Apple Music.
And the distilled list of top 20 songs, on Apple Music here and on Spotify here.
I hope you enjoy the playlists and find something you like, even if it’s just good memories!
3. Series: Mobland
Amanda and I finished watching the series Mobland this week. Guy Ritchie directed it, with his usual punchiness. It’s like Succession, just with more – a lot more – dead people.
It’s about a crime family led by a guy who’s probably past his sell-by date but doesn’t want to recognise it. His wife is a scheming, conniving matriarch who exploits his weaknesses. As a result, the family fixer is, shall we say, overworked.
It’s one of the most riveting series I’ve watched in a while. To top it off, the theme song “Starburster” was one of my favourite songs of 2024 and is by one of my favourite current bands, Fontaines D.C.
4. Coffee with Merchant West Investments
This Friday morning at 9, we will have our monthly webinar “Coffee with Merchant West”. My colleagues, Andre Joubert (on dealing with turbulent markets) and Richard Henwood (on property investing), will present. I will also discuss how the MWI Worldwide Flexible fund (aka “The Cockroach”) is dealing with an uncertain future.
You can register to watch here. Please send through any questions you may have. Question time is the best part of these webinars.
But that’s not all! If you’re a professional, you can earn CPD points for watching.
5. Fatherhood
Here is an excellent essay on the upsides of fatherhood, which nicely counters the pernicious narrative that having kids will make your life worse and is a sacrifice. To be clear, there are hard things about having kids. But the pros far outweigh the cons.
Having a son was the best thing I have ever done. I might not have won any Father of the Year competitions, but I did my best. The joy Nic has (mostly😊) brought into my life is priceless.
Don’t tell him I said this, though, it might go to his head.
Fatherhood has also brought me my one major regret in life: I should have had many, many more kids. I was, however, lucky enough to marry Amanda and add two more wonderful sons to my family, Ben and Zac. So I’ve been fortunate enough to have three. But for all you aspiring parents out there, with the benefit of hindsight, four is a much better number.
This week, I saw a picture encapsulating fatherhood’s ups and downs. Scottie Scheffler, having just won something like $2 million in a golf tournament, was handed his baby boy by his wife – with a distinct poo stain on his back. I can hear her saying: “You’ve been playing golf with your mates all day, while I’ve been looking after him. It’s your turn now, and you can start with a new nappy”.
I had lunch with my good friend Rob van der Valk today. He is not much older than I am. But he is much richer – he has 7 children, 11 grandchildren (so far) and 2 great-grandchildren (so far). Fortunately for him – and his family – he is also fairly well off. He worked out this life equation at a young age:
Kids to the power of x = joy to the power of x
(where x = the number of kids you have)
Rob has a large amount of joy in his life.
And always remember to be careful out there!
Piet Viljoen
RECM