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 19th, the 170th day of the year. There are 195 days until the end of the year.
On Saturday, the South African cricket team finally won a World Cup. Before the match, I planned to use the Proteas as an example of ergodicity in this letter. A system is ergodic when a sample from a population looks exactly like the population.
Since readmission, every generation of Proteas team has had the opportunity to win but has not been able to do so. As a result, the Proteas came to be known as chokers.
The current team, under Temba Bavuma, changed all that on Saturday. This team is different to the previous teams. This team has made the Proteas cricket team’s history non-ergodic.
Ergodicity may be one of the most consequential yet least well-understood concepts, not just in investing but also in business and life. Luca Dellanna wrote a book about it: Ergodicity: How Irreversible Outcomes Affect Long-Term Performance.
In the book, there’s a story that explains the concept neatly.
It’s about Dellanna’s cousin, a good skier. At a young age, he makes it to the World Championship in his age bracket. But then he suffers a series of leg injuries – quite common for skiers – and has to give up his dream of professional skiing.
The lesson? It’s not the fastest skier who wins the race, but the fastest among those who make it to the finish line.
Here’s the math: imagine a ski championship consisting of ten races. A great skier has a 20% chance of winning each race. However, because he takes a lot of risks, he also has a 20% chance of breaking his leg in each race.
How many races is he expected to win in a championship of ten races?
Most people would say two races – 20% of 10 races is two. However, the real number is less than 1, because if the skier breaks his leg during the first race, not only does he lose that race, but he also loses the possibility of participating in future races. He only has an 80% chance of participating in the second race, a 64% chance of participating in the third race and so on.
In a world where irreversible losses do not have long-term consequences – i.e. in an ergodic world – Dellanna’s cousin wins two races. In the real world, where irreversible losses absorb future gains, his cousin only wins 0.71 races.
This difference, caused by irreversibility, is what ergodicity is about.
Here’s another example: many investment marketing splurges contain the factoid “our team has a combined 100 years of experience.” They are saying they have 20 people, each with 5 years of experience. They want you to believe that 20 X 5 = 1 X 100, which is true mathematically and would be if investment experience had the property of ergodicity.
But it doesn’t.
One person experiencing 100 years of investment history would have seen many, many things – things that would seem surprising to a person experiencing only 5 years of investment history. And 20 people experiencing the same 5 years would have accumulated exactly zero of these insights.
In maths, one is equal to the other, but in the real, ergodic world, one is not the same as the other. Investment experience is non-ergodic.
Let’s give ergodicity a formal definition: Ergodicity refers to a property where the outcome of one person performing an activity many times is statistically equivalent to the outcome of many people each performing it once. In other words, in an ergodic activity, the average result over time for an individual matches the average result across a group at a single point in time.
A situation is ergodic if irreversible losses do not have long-term consequences, and you can rely on averages.
- A river is 1 meter deep on average, but has sections that are 5 meters deep. On average, you’ll be fine, but there are sections where you could drown and not make it across. Such a river is not ergodic.
- To win a bike race, you have to take insane risks, which can lead to race-ending crashes. All races have a winner; no one hears about those who could have won but crashed out. Bike races are not ergodic.
- Climbing Mt. Everest is seen as the crowning achievement of mountaineering. Most climbers make it to the top. Yet one out of every 100 climbers dies and irreversibly fails in their attempt. Climbing Mt. Everest is not ergodic.
Investing is non-ergodic. You first have to survive, and only then can you think about thriving. Ergodicity is not just the idea that survival is necessary for long-term success, but that it is the defining constraint.
In practice, surviving in investing means managing the potential downside becomes your primary objective. So, when you are thinking about your portfolio of investments, you should be asking yourself the following types of questions:
- Imagine your broker phones you to tell you that your portfolio is worthless. What could have happened? Is there anything you could have done to prevent it from happening?
- Imagine your best friend, whom you have always held in high regard, gets liquidated. How did that happen? What can you learn from it?
- Imagine gold trades at $ 50,000 an ounce. Why did that happen, and what does your portfolio look like under those circumstances?
And so on.
In investing – as in life – the Lindy effect (first coined by Nicolas Taleb) is a powerful heuristic. It posits that the longer something has existed, the longer it is likely to continue existing. It either possesses certain characteristics that render it immune to decay or destruction, or it forms part of an ergodic system. Either way, such investments are highly sought after.
Investments with ergodic properties are rare, but here are a few examples:
- Government bonds, held to maturity, have predictable returns and no risk of ruin (if the issuer is from a stable country).
- Savings accounts with a AAA-rated bank.
- The most senior tranches of the capital stack of a highly rated creditor.
- Gold has maintained its purchasing power over centuries.
Any well-diversified portfolio should contain a reasonable allocation to such investments. Such a portfolio will always survive, and therefore have a chance to thrive.
Markets
1. Valterra Platinum
Spin-offs are often regarded as prime hunting grounds for finding mispriced investments.
To understand why, let’s take a closer look at them.
A spin-off occurs when a parent company “spins off” one of its unwanted subsidiaries to its shareholders, almost like a dividend. The reasons for doing this vary, but they generally boil down to trying to present a better picture to investors. The subsidiary might be in a struggling industry, overleveraged, or involved in an unpopular business.
The spun-off company is also generally much smaller than the parent company. It also does not have a history of previous performance, as it has not been listed separately before, so no one really knows what it is worth.
Spin-offs sometimes make good investments because the parent company’s shareholders, who receive the shares in the subsidiary company, don’t want to own or don’t want to understand this small business they’ve been saddled with (just like the parent company!). Their natural reaction is to sell the shares.
Price-insensitive selling can turn a bad company into a good investment.
Enter Valterra Platinum, previously known as Anglo Platinum, which was spun off from Anglo American a couple of weeks ago. Its share price has picked up a bit since then, leading many to think it might be a classic spin-off situation:
But it isn’t. Firstly, Anglo only spun off approximately 50% of the business, retaining 20% of its original holding of roughly 70%. Valterra Platinum had also been listed separately for years before the spin-off, allowing the market to price it quite efficiently.
My take: Valterra Platinum is not a typical spin-off, but it might represent something much better: a classic “capital cycle” investment made famous by Marathon Asset Management. We don’t own it – or any other platinum stock – in the MWI Value fund, but we’re working on it. If the platinum sector is indeed subject to a positive capital cycle, it will play out over years, so there is no need to rush into the current excitement.
2. BYD
There are some companies where the rule of thumb is that you never buy the product, but always the shares. Investec, Discovery, Sanlam, Hermès and Ferrari spring to mind here. There’s a reason their shares do so well – their products are expensive. These industries are generally characterised by pricing power from complexity, emotionally driven customers, or sometimes even both.
A corollary to this is that there are certain businesses where the products are excellent, but the industry is highly competitive with almost no pricing power. This is generally a result of overcapacity – i.e. too much supply.
Just about anything “Made in China” falls into this category.
Especially cars. I wrote about BYD earlier this year in “Keep Calm and Carry On.”
Researching them got me looking at their cars, and I decided to buy one from BYD. However, the shoddy service from the local dealership has put my acquisition on the back-burner. If the service I had before actually buying a car is any indication, imagine what it will be like after you’ve bought it!
In China, Chinese companies accounted for about 60% of all passenger vehicle sales in the country last year, according to the CPCA, up from about 35% in 2020. “The Western carmakers slept their way through the pandemic while the Chinese rode the EV revolution,” Andrew Fellows, global head of automotive and mobility at tech consulting firm Star, told Reuters. “They’re going to find it hard to dislodge the local carmakers.”
For a long time, Volkswagen was the top-selling car brand in China until domestic player BYD surpassed it last year. Tesla also saw its China market share dip from around 15% to 9% in the first quarter.
But now, BYD has triggered a sector-wide EV price war in China, with cuts of up to 35%, sparking a sharp sell-off in Chinese auto stocks. This is due to China’s standout feature: manufacturing overcapacity.
So it’s hard to see why the share price is riding as high as it is at the moment:
It is currently trading at less than 40% of its level 10 years ago, barely above Covid levels.
In South Africa, there are four investment options:
- Invest in offshore companies listed on the JSE
- Invest in capital-light, service-oriented businesses
- Invest in businesses with excellent management
- Invest in massively undervalued local industrial companies
We have some world-class offshore businesses (Richemont, Naspers). We have world-class, capital-light local businesses (WeBuyCars, STADIO). We have some businesses with really great management (Capitec, Discovery). We have a host of (mainly small-cap) undervalued industrial companies (Adcorp, Telkom, Tharisa).
My take: Although the JSE is a small market, we are spoilt for choice. Investing here is simple, but not easy: all we need to do is avoid companies exposed to the hollowing out of the economy, or where the valuation doesn’t pay you for the risk of owning them.
3. WPP
For a long time, WPP was recognised as the industry leader, both in terms of reputation and size, within the advertising and communications industry. Its CEO, Sir Martin Sorrell, was regarded as one of the most influential figures in the sector. He built WPP into a global powerhouse, overseeing major acquisitions and expanding its reach to over 200,000 employees across 113 countries.
However, he was kicked out in 2018 after allegations of personal misconduct, which he denied. Investigative findings were never published, so who knows? But power does tend to corrupt…
In any case, WPP has fallen on hard times since he left, as the share price shows:
It’s also worth mentioning that S4 Capital, the business Sorrell started when he left WPP, has not fared very well either:
Sorrell’s successor, Mark Read, is leaving the UK’s largest advertising group as it faces industry-wide upheaval prompted by artificial intelligence. Scott Galloway says, “A new WPP forecast estimates that in 2025, ad revenue from creator-driven platforms such as YouTube, TikTok, and Instagram will surpass the combined ad revenue of traditional media (TV, print, audio, and film) for the first time. Creator-led advertising revenue (brand deals, sponsorships, and platform ads) is expected to grow 20% this year and more than double by 2030.”
At its current market value of £8 billion, WPP is worth less than one day’s fluctuation in Google’s market value. It is spending £300 million this year on AI, compared to Google and Meta, which will spend that amount every day of the year on predominantly AI-related capex.
As Buffett said, “When great management meets a tough business, it’s usually the business’s reputation that stays intact”.
My take: WPP will have to make fundamental changes to its business model to avoid becoming like some of the other erstwhile media powerhouses – newspapers, magazines, radio, and TV. I wouldn’t bet on it succeeding.
4. China and wars
People are justifiably worried about the situation in Asia and the Middle East, first with the Ukraine situation, and now Iran. One of the things that worries them is what would happen if China joined forces with Russia/Iran.
In this regard, I saw a post on X this week that gave a different insight:
It seems that China is happy to supply arms to whoever wants them, not just Russia or Ukraine. Some would call this mercenary, lacking in morals. But Robert Wu from China Translated points out – in my opinion quite correctly: “Between a world where people stuck to their principles kill each other, and a world where people trade with each other in peace, which one will you choose?”
He goes on to say: “I’d argue that the growing conflict and wars around the world are in some way another ‘gift’ for China. As time passes, and as China consciously stays away from conflicts worldwide, more people will start to appreciate the “Iron Bank power” that China truly is.”
And markets are starting to see this. The Hang Seng index is hitting new highs, up 20% year to date:
Increasing numbers of investors are no longer calling China “uninvestable” and the renminbi is gradually strengthening.
My take: I remember reading somewhere that China has never invaded another country. It doesn’t look like they are going to start now, which bodes well for their economy and their stock market over the long term.
In The Media
1. A few questions, by Morgan Housel
My favourite writer has hit the ball out of the park again. In this short piece, he asks (quite) a few rhetorical questions. Put your thinking caps on, and see how you go.
2. Discipline: An Interview with General Stanley McChrystal
Gen. Stanley McChrystal is a retired four-star U.S. Army general, former U.S. and NATO forces commander in Afghanistan, and author. He leads a fascinating discussion on a topic most of us prefer to avoid. We all think we have discipline in our lives, but I know that more would be better in my life.
McCrystal defines character as follows:
Character = conviction * discipline
Character can be developed. Convictions are those things about life-values that you have decided to examine, and upon surviving a thorough examination, accept them as the truth. Then you need the discipline to live truthfully according to those values.
That is the bedrock on which real character is built. McCrystal points out that moral courage is much harder to attain than physical courage.
He also says that when we reach the extremes of any endeavour, the outcomes become unpredictable. Relationships are valuable, as they round us out, file off the sharp edges, and pull us back from the extremes, towards predictability.
You can watch the full interview here.
3. Tears for Fears – Everyone Wants to Rule the World
Remember this ’80s classic?
In the Song Exploder podcast series, Hrishikesh Hirway interviews famous artists about their creative process, focusing on one specific song. I’m always interested in how processes shape outcomes, so it is one of my favourite podcasts. This particular episode was a highlight, as I did not expect such process-related insights from a pop-music band like Tears for Fears.
You can listen to the podcast here.
4. The cricket
Did I mention that the Proteas won the World Test Championship? At the home of cricket, the Lord’s Cricket Ground? Even better, I was there!
It was a fantastic four days of cricket. The vibe in the stands was unbelievable, almost like being at a football match with all the singing and chanting.
I can still hear the chants of “Oooo, Temba Bavuma”
During the match – I think it was after the third day, I posted this on X:
“What a wonderful day of cricket. Just reminded me again why I love the game so much!
Cricket = life. All the ups and downs, long periods of suffering, and the joy of coming through tough periods. Sometimes, you even win.”
And we did end up winning.
After the test, I was able to go cycling in the Norfolk countryside for a couple of days. I also met up with my stepson Zac afterwards, in between his accounting studies.
Here are some pics:
(Zac’s the one with the big hair)
That’s it for an exciting week.
Be very, very, very careful out there!
Piet Viljoen
RECM