Dear Fellow Investors and Friends,
Welcome to 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; feel free to drop me a line. It’s great to start conversations.
Today is Thursday, October 2nd, the 268th day of the year. There are 97 days until the end of the year. Time passes quickly: we’re already into double digits.
On this day in 2008, the U.S. Senate voted to pass the Emergency Economic Stabilisation Act of 2008, a massive $700 billion rescue package targeting the financial sector’s mounting losses due to subprime mortgage exposures.
In the preceding 7 years, banks had pushed out the boat in their search for asset growth. Inevitably, it sank, threatening to take the world’s financial markets down with it. Governments were forced to bail out financial institutions that had been managed with reckless abandon.
This abandon was already clearly apparent in the late 1990s and early 2000s, when UBS ran an annual banking conference in New York, which I regularly attended. The conference was held in the last week of May – conveniently, the week before the annual Berkshire Hathaway shareholders meeting. At the time, banking was booming, with high asset growth, extensive M&A activity, and share prices that were discounting rapid growth as far as the eye could see. At the conference, one CEO after another would come to the stage and breathlessly expound on the benefits of cross-selling and the synergies they would extract from their latest merger.
Banking had two heroes at the time: Wells Fargo and Lloyds TSB. Wells Fargo had a story about not really being a bank, and cross-selling as many “products” as possible to its customers, using their many stores (branches). They expanded aggressively, acquiring over 30 banks. Lloyds TSB, on the other hand, was revered for its high ROEs, with an accompanying story about a focus on efficiencies, and boosting non-interest (i.e. fee-based income) through selling more financial products to its clients.
Ultimately, both banks collapsed in the financial crisis of 2007/8. Since then, Wells Fargo has received over 270 fines and regulatory penalties, with cumulative penalties exceeding $27 billion – all stemming from consumer protection violations, sales practice scandals, and other regulatory failures. Lloyds had to be part-nationalised by the UK government to bail it out. Today, its share price is still 90% lower than its peak in 1999.
The lesson? When banks become an exciting sector, it’s time to head for the exit door. Almost no matter how well run or well-regarded, the speculative excesses of any period find their way onto banks’ balance sheets. So, the secret to investing in banks is to steer clear of markets where speculative activity is rife, and head towards markets where activity is rational and relatively subdued.
The way of modern banking is:
- The activities previously undertaken by banks are now carried out by non-bank financial institutions: multi-strategy hedge funds, proprietary trading firms, private credit funds, and so on.
- The banks are happy to lend these institutions the money to do all this stuff.
Bloomberg columnist Matt Levine puts it well (as usual) when he says the banking system is in the process of being “re-tranched”: instead of doing some activity directly, banks take the senior claim on someone else’s activity. Private credit funds lend to companies, and banks lend to those private credit funds. Hedge funds engage in basis trades, and banks lend to those hedge funds.
“Crucially for banks, regulators treat this senior form of financing secured against a client’s assets far more favourably than if banks were engaging in those activities themselves, whether that’s making risky mid-market loans, owning chunky private equity stakes or harbouring large trading exposures on their balance sheets.”
Banks are highly leveraged businesses. In the property business, people become concerned when REITs have debt-to-equity ratios above 40%. Banks typically operate at debt-to-equity ratios of 90%. Sometimes, even more. They can do this because they are highly regulated. Here in South Africa, three bodies are scrutinising the affairs of banks:
- The Prudential Authority, housed within the Reserve Bank, is responsible for the prudential regulation of banks and other financial institutions.
- The Financial Sector Conduct Authority, which is responsible for market conduct regulation and supervision in the financial sector.
- The SARB also monitors compliance with key banking legislation and promotes the soundness of the financial system.
I expect that regulatory oversight is similar, if not more intense, in other countries.
So, one way to think about banks is that they are becoming safer: on top of a tightening regulatory environment and higher capital requirements, instead of engaging in risky trades, they are taking senior claims on these trades, insulating themselves from much of the risk.
Is there a chance they will find new ways to go out on a limb?
History says yes.
Rapid asset growth is the red flag. Systemic risk arises when asset growth, i.e. lending growth, has been high for an extended period. Inevitably, what seems sensible in the beginning becomes ridiculous in the end, with the help of leverage. Just ask Silicon Valley Bank.
But that is not where we are today. In countries with conservative monetary policies, such as most emerging markets, banks are superior investments. In developed markets (DMs), banks’ balance sheets are growing more rapidly but not yet dangerously so. In emerging markets (EMs), activity is positively subdued. There is no excitement.
The difference in behaviour between emerging and developed market banks can best be explained by their different costs of capital. A high cost of capital leads to rational economic activity, while a low cost of capital eventually leads to speculative financial activity.
Here’s a table showing the different situations for emerging vs developed market banks:
Although inflation in EMs is not much above inflation in DMs, interest rates – reflecting the cost of capital – are much higher.
At such high rates, the desire to borrow money is dampened, and banks struggle to grow their loan book. Instead, they take the money clients have deposited with them and lend it to the government by buying government bonds – less risky and thus lower yielding than private sector loans. As a result, their return on equity (RoE) is lower than they would otherwise be.
So, emerging market banks face a triple whammy: their books aren’t growing, their cost of capital is high, and their return on capital in the form of RoE is low.
But here’s the thing – on a forward-looking basis, all three headwinds can turn into tailwinds:
- As interest rates decline, the cost of equity will decline.
- As interest rates decline, business confidence improves, and assets start growing.
- As their books start growing with loans to the private sector, their returns start improving.
In a highly leveraged business like a bank, if the spread between the cost of equity and the return on equity improves, the valuation uplift can be substantial.
In the meantime, the downside is limited, as the quality of their books is good.
- They are not growing rapidly, so bad debts are not a problem.
- They are being “re-tranched”, making them safer.
- Their regulatory oversight is strong, compounding the above.
But what about valuation? Right now, banks are priced by looking through the rearview mirror. The market expects continued sluggish asset growth, high interest rates and lacklustre earnings. At current pricing, there are no positive expectations built in.
With significant potential upside and limited downside, what’s not to like about EM banks?
In The Markets
1. Absa
I’ve picked ABSA, but I could have used just about any bank in South Africa – or other EMs – as an example of the opportunity available in this sector. ABSA is currently on a price-earnings (P/E) ratio of 5.8. Inverted, this means it has an earnings yield of 17.2%. So, even if ABSA doesn’t grow its earnings, which is essentially what the market is discounting, you should earn 17% p.a. on your investment over the next 5 to 10 years.
Here’s ABSA’s historical P/E ratio:
Its rating has basically halved since the financial crisis.
Another way to view the investment opportunity is that ABSA’s dividend yield is currently 8.7%, a higher return than you could earn by depositing money with them. And this dividend has been steadily growing – with the occasional hiccup – by about 7% per year over the past 20 years.
My take: When you buy **insert favourite EM bank name here**, you get a safe, high and growing yield. What’s not to like? Banking shares in emerging markets are among the best risk-reward propositions available today.
Inexplicably, some “investors” prefer to buy properties with yields lower than this. But don’t get me started on that topic.
2. South African interest rates
Interest rates are coming down. Our long bond yields are now down to pre-COVID levels. This is the yield (interest rate) on our long-dated (30-year) government bond:
Around the COVID-19 panic, there was a spike in yields as investors placed a higher risk premium on South African assets. But this risk premium is now being re-evaluated – favourably – by the market. With talk of our grey listing being lifted, there might still be further to go.
With bond yields almost 3% lower than their peak of two years ago, this is good news for all South African assets. A lower discount rate means future cash flows are worth substantially more today – something the equity market has yet to catch on to.
My take: I started my financial career in the bond market. I remember clearly the old bond traders saying that the bond market is much smarter than the equity market. I guess that’s still the case!
Also, bank valuations are pretty sensitive to changes in bond yields.
3. Energy is cheap
Speaking of cheap things, energy is also cheap. Here’s a chart from Gavekal showing exactly how cheap:
The red line in the chart represents the ratio between the S&P 500 price index and the WTI oil price, detrended to account for the post-1900 1.3% growth rate. The detrended ratio is mean reverting: there are times when the market is expensive relative to oil and times when it is cheap, but it always returns to its mean. Right now, energy is too cheap.
As I’ve said many times, energy is life. Cheap and abundant energy makes life easy. Currently, life is easy worldwide, reflected in bull markets in equities across the globe. However, energy is also cyclical due to the capital investment required to extract and produce it. When energy is too cheap, the necessary investment to ensure a constant flow of energy does not occur.
This ultimately leads to energy shortages and increased energy prices. Possibly also lower equity prices, as the cost of doing business goes up with higher energy prices.
This process is inevitable, especially with the massive investment being made in power-hungry data centres at present. But each cycle is different and happens with variable time lags. This one feels like we are waiting for Godot.
In this regard, my friend Anton-Louis Olivier recently sent me a document published by Carlyle called “The New Joule Order”. It discusses the changing global energy landscape and the implications for investors and operators. One of their main takeaways: “Growth in demand for joules is steady, while investment in the supply of joules is inadequate”.
My take: That sentence alone suggests an inevitable upward trend in energy prices over time, considering that joules are effectively fungible, regardless of the source: nuclear, gas, oil, or renewable. An upswing that should arrive before Godot.
4. Truworths
Is Truworths the worst retailer in South Africa? Their market share losses say so:
What isn’t performing poorly is Truworths’ executive remuneration policy.
I’ll leave this table here for you to peruse at your leisure:
Okay, I have one question for you now. Do you want to own Truworths, or do you want to work there? The market has spoken, and it doesn’t want to own the business:
Shockingly, the share price today is not much higher than the price before the financial crisis of 2008.
My take: in 2014, the remuneration report was 8 pages long, making up 7% of the annual report. This year it is 15 pages long, or 15% of the report. 15 pages of completely unintelligible drivel. Drivel that results in the CEO’s pay growing by double digits while shareholders’ returns decline. The remuneration committee should hang their collective head in shame.
It’s easy to single out Truworths – but they are not the only ones. This is a widespread issue on the JSE. A problem partly caused by the poorly designed set of so-called corporate governance best practices, “The King Code”.
5. The cockroach is 5 years old
Immediately after the COVID-19 panic, I experienced an existential crisis regarding my career in money management. My flagship fund, the MWI Worldwide Flexible Fund (formerly known as the RECM Worldwide Flexible Fund), had been going through an extended period of excruciatingly poor performance.
Friends and family were the main investors in the fund, and I needed to take action to change course. After much self-reflection, I devised the “Cockroach” concept and implemented it in August and September 2020.
You can read more about my approach to managing the fund in “The Cockroach” and also in “Ode to the Cockroach”.
TL;DR – I aim to generate returns above inflation in hard currency terms, while keeping the volatility of returns low, so as not to scare anyone.
So, on this 5th anniversary of the cockroach, it’s helpful to review how things have gone.
Here is the fund’s unit price in Rand terms over that period:
It’s earned about 9% per annum in a non-scary way. It also paid around 2% p.a. in dividends, so its total return of around 11% per annum is well ahead of inflation.
More importantly, here is the fund’s unit price in US$:
In US dollars, the fund has grown at approximately 8% per annum, while also providing around 2% per annum in dividends. Once again, the total return significantly exceeds the rate of inflation. There was a scary moment in 2022 when the unit price fell by nearly 10%. At that time, I had made the mistake of holding a disproportionately large position in South African equities, meaning I was not fully diversified globally.
Despite this mistake, the fund has generated returns that are more than satisfactory in US dollars.
My take: Fittingly, the funds’ unit price reached a new all-time high in both Rand and US dollar terms on its 5-year birthday. I love managing this fund. It gives me exactly zero sleepless nights and allows me to trawl the world for good investments.
In The Media
1. Two fantastic articles
I read two super articles this week.
The first was “Welcome to the Continental, We Do Hope You Enjoy Your Stay” by Ben Hunt. In it, he identifies the source of the deepening fissures that threaten to rip societies apart, making debate almost impossible. The source is a constructed world of wrong-headed ideas, propagated primarily by social media. Appropriately, Hunt uses Plato’s allegory of the cave to describe this constructed world.
His advice: only you can talk yourself out of your constructed belief system; it’s impossible to convince someone else. I can’t say it any better than him, so I will quote directly from Hunt’s writing:
“We live as humans with an autonomy of mind.
We step back in order to see the semantic system as puppeteer. And from that vantage point of critical distance, we reapply our disbelief to ALL constructed worlds of declared reality, no matter how appealing to our internal dialogs, no matter how much satisfaction of mind is promised to us.
We celebrate the primacy of lived experience with our family, friends and neighbors. Not just the lived experience of joy and celebration, but the lived experience of pain and loss, too. We share it all and we check in with each other more than we scroll.
We stop arguing truth statements from within any constructed world, no matter how wrong-headed we think it is. We especially stop arguing truth statements with the people we care about the most. Instead, we encourage them to see the system for what it is, and we trust them to reclaim their autonomy of mind on their own, because that’s the only way it can happen.
Our autonomy of mind is our birthright. It is not ladled out to us from some central pot, and it cannot be taken away from us. But we can give it away, sometimes in pieces and sometimes all at once, and that’s what the semantic system encourages us to do.”
The second great piece of writing was by my perennial favourite, Nick Cave in his Red Hand files issue 337. In it, Cave admits he is not really sure where he stands on any of the issues of the day. Not because he doesn’t care or hasn’t thought about it, but because the substance of these issues seems to change all the time, making it hard to pin down precisely what the problem of the day is.
His solution, in his own words: “I have a devotional nature, and I see the world as broken but beautiful, believing that it is our urgent and moral duty to repair it where we can and not to cause further harm, or worse, willfully usher in its destruction.”
That resonates with me.
2. Black Rabbit
Amanda and I watched this series on Netflix this week. Or at least I did, and Amanda kept me company, her anxiety not allowing her to commit. Understandably, as the series is essentially an extended train wreck of people making bad choices, compounding error upon error, with no good outcomes.
You can watch the trailer here, to decide on whether you have the constitution to watch these people fall apart. The one thing I can promise you is that it will keep you glued to your seat. It was the best series I’ve watched for a while.
On a more personal note, some of you have reached out to enquire as to whether I’m okay, given my abrupt departure from X (Twitter) and my role as a director of Astoria.
With respect to X, I think Ben Hunt’s article says it all. My resignation from the Astoria board primarily has to do with my need to write and read more. Additionally, there’s a healthy dose of disillusionment with the listed environment, coupled with growing private interests that require my attention. I retain my significant shareholding in Astoria and have complete faith and trust in Jan to do a good job of looking after it. And I appreciate the interest in my well-being!
I can honestly say I have never been in a better space. Amanda and I are celebrating our 4th wedding anniversary this week, which adds to my joy.
But despite all this warm fuzziness – let’s continue to be careful out there!
And if you are fasting, I wish you an easy and meaningful fast.
Piet Viljoen
RECM