Corospondent January 2018 - January 2018
Notes from my inbox - January 2018
Surely there must be a ‘system overload’ warning on its way!
What a year it has been. Looking back, it is hard to imagine that so many events occurred in 12 months only – it felt like decades had been compressed into shorter and shorter time frames.
Accelerated political and economic change is the only constant at the moment. Isolationism and populism continued to stoke unrest and strain relations between countries. For the first time in many decades, nuclear attack warning systems were tested in the US, as the erratic leader of the free world tweeted his country closer to the brink of nuclear war.
It was a year of profound political crisis, also in SA. At times, news headlines bordered on the surreal as we lived through a number of shocks. Long forgotten is the midnight hour cabinet reshuffle at the end of March which triggered a shock wave of ratings downgrades, the effects of which will be felt for years to come. We lost our investment grade rating, which was secured through great fiscal discipline 17 years ago. This achievement by the first democratically elected government has had a tremendous positive impact on the domestic economy. The negative political events of earlier in the year delivered a major blow to the nascent economic recovery that was widely anticipated.
A culture of patronage and corruption was truly ripping SA apart, which is why the outcome ANC elective conference in December 2017 was such a highly anticipated and important vote.
It has been said that in SA the worst – and the best – never happens. For now, averting the worst may seem like an excellent outcome. Hope for the best has long faded. The election of Cyril Ramaphosa as president of the ANC could bolster SA, depending on how much stomach he has for a fight, and how he and his allies play their cards, as our guest columnist, Steven Friedman, suggests.
SA continues to face many deep-seated structural issues, such as a very uncompetitive labour force, poor education and low productivity. New leadership of the governing party can make a difference to some of the shorter-term issues, but to truly address the long-term issues will take decades, as we detail in our economic overview.
Still, politics matter – because they materially affect and shape the trajectory of business and the economy, changing investment opportunity but also increasing risks and uncertainty. We have seen both positive and negative political outcomes over the past 18 months.
Some of the most significant positive leadership changes in the last few months took place in neighbouring countries Zimbabwe and Angola. Zimbabwe in particular was a watershed moment. It highlighted that there is indeed limits to the abuse of power, even in Zimbabwe. After 37 years of dictatorial rule, Robert Mugabe was ousted as Zimbabwean president. The final overreach of placing his extravagant wife in direct succession while millions of desperate Zimbabweans face starvation unravelled nearly four decades of rule. So we are cautiously optimistic that the winds of change are blowing in the right direction. We know that forecasting the outcome of change and the intention of new roleplayers is tricky. But the people have demonstrated that their tolerance for long-serving dictators is wearing thin. This is a good thing for citizens and investors alike.
Without a doubt, one of the biggest cultural milestones over the past year has been the outpouring of confessions and accusations regarding sexual assault and harassment. The #MeToo movement has reached critical mass, with both Time magazine (‘The Silence Breakers’) and the Financial Times (Susan Fowler, who exposed harassment at Uber) choosing ‘people of the year’ to reflect this. It has galvanised a strong movement that I expect will meaningfully reshape many industries and traditional norms around the world. As Oprah Winfrey recently put it, "a new day is on the horizon …".
No account of the past year would seem complete without mentioning Bitcoin. In our previous edition we articulated our views on blockchain (a revolutionary new technology which we believe has a very positive future) and Bitcoin (a cryptocurrency that we believe is firmly in the midst of the speculative bubble). But the price movement of Bitcoin continues to confound. Bitcoin is an asset perhaps most similar to gold (a historic store of value) – as such it can and will be sustained indefinitely by a pool of willing buyers. However, this ‘currency of the future’ (as heralded by the bulls) has a serious flaw. It is really, really volatile. One of the key attributes of successful currencies has been that they represent reasonable and stable value relative to goods and services. On a single day (22 December 2017), the currency managed to fall by a third, just to retrace all of its losses in less than 24 hours. Notwithstanding the fact that investors have earned outsized gains, this crazy volatility should raise serious doubts over Bitcoin’s adequacy as a currency.
LOOKING AT THE MARKETS
It may seem that someone forgot to tell the markets about the threat of nuclear war.
For the first year since records began, the S&P 500 scored a so-called 'perfect' calendar year – it delivered positive total returns (including dividends) every month of the past year. The Dow Jones Industrial Average, meanwhile, saw 70 fresh closing records in 2017, breaking a record dating back to 1896. The FTSE All-World Index advanced nearly 22% during 2017 and has now enjoyed its longest winning streak on record.
Confounding expectations, global bond markets also enjoyed a remarkable 2017. The Bloomberg Barclays Global Aggregate Bond Index returned more than 7%, its largest annual gain in a decade.
Flows into exchange-traded funds and index trackers hit record highs this year, significantly growing the share of savings assets that are now index linked. This indiscriminate inflow – at a time that the market grows increasingly expensive –seems absurd to me. We have continually written about the risks of index-linked investing (which can never be ‘passive investing’; choosing an index is the ultimate active decision). It will be interesting to watch this investment trend unfold over the coming years.
Despite the increasingly exuberant market levels, we continue to caution that more muted investment returns are to be expected from all asset classes. This makes achieving savings goals far more challenging. As such I emphasise again that in a low return world, the additional, compounded benefit of alpha (excess returns) becomes ever more vital. These excess returns (net of fees) will be crucial to the total returns earned by investors.
Emotion and fear cause massive stock market price volatility and obvious mispricing seems increasingly obscured, given the pace of change in a complex world. The positive here is that markets have not become efficient. Skilled and diligent investors can still earn alpha through detailed analysis and unique insights. New opportunities emerge all the time, often a by-product of over-reaction, fear, greed and the short-term biases of many market participants. In this edition of Corospondent we highlight a number of these opportunities, including Alphabet and the UK retail property giant Hammerson.
LEARNING ENDURING LESSONS - STEINHOFF
Successful long-term investing requires hard work, great patience and strict discipline. There is limitless information available to be sorted, examined and weighed. No one can process it all. We always monitor dissenting views to counterbalance our perspective. It is foolish and arrogant to assume we are always right and others are always wrong. We consistently attempt to learn from our mistakes and draw enduring lessons.
Process is crucially important in investing. Beyond just detailed analysis, there must be a great deal of debate and truth-seeking. As we learn from the counterintuitive and pathbreaking work done by behavioural economists Daniel Kahneman and Amos Tversky, a decision cannot only be judged on its results, whether it turned out to be right or wrong, but also needs to be assessed in terms of the processes and thinking that informed the decision.
It is in this light that we contextualise our investment in Steinhoff. Our stringent investment process has been tested for almost a quarter of a century. Our long-term record of consistent alpha generation is testament to its rigour. However, we still sometimes get it wrong. Steinhoff is a case in point.
This one is hard to stomach, though. The failure of the board and the company’s independent auditors to identify what is at least two years of misstated financial statements is frustrating. It is mystifying that so many smart insiders, who, by definition, had better information than outsiders, were so heavily invested in the company and so blindsided by recent events.
At the time of writing, stakeholders find themselves in an information vacuum. Possible outcomes range from the best-case scenario of tax evasion and inadequate disclosure of related-party transactions to that of sophisticated fraud orchestrated by the CEO. The former would result in a material, albeit manageable, reduction in Steinhoff’s intrinsic value. The latter holds much more serious implications for the long-term future of the company. Until we have a better understanding of the nature and scale of these improprieties, we simply cannot speculate further. Without such information, and an understanding of how the banks are responding to the crisis, it is simply not possible to value the company with any conviction. The stock could just as easily be worth more than the current market price as it could be less. At current prices, we are therefore likely to retain our equity holding in the company until more information has been made available publicly. It is important to highlight that none of our portfolios have exposure to any debt or convertible instruments issued by Steinhoff.
While we were not invested in Steinhoff for many years, this changed with its purchase of the Pepkor group in 2014. We were shareholders in Pepkor at the time of its listing on the JSE in the early 2000s. It is a formidable company, with one of the best track records in SA. It generates lots of free cash and continues to grow strongly despite a demanding base. We were very optimistic about the company’s growth prospects in both SA and Eastern Europe, where the apparel market is large but the opportunity significant for a well-managed value/discount retailer. We believed that Steinhoff had bought Pepkor at a good price and that it had fundamentally changed the quality and prospects of Steinhoff.
We performed extensive due diligence that extended far beyond analysis of the company’s financial statements.
Much of our detailed thinking has been communicated to our clients in a letter from our CIO, Karl Leinberger; as such, I will not repeat all of that information.
Suffice it to say that over the last 15 years, we have constantly challenged quality of earnings, cross-checking margins against competitors for reasonability and cross-referencing management’s assertions with more junior employees of the company, nonexecutive board members and outsiders (typically competitors and suppliers). Although we cannot, for confidentiality reasons, disclose the names of those people, we can confirm that we spoke to at least 82 individuals during that research process (51 of those being outsiders). Our external research on management always reached the same conclusion: Steinhoff was managed by an aggressive and entrepreneurial team, but one that was respectful of the law.
In addition, over time, more and more astute and experienced businesspeople joined the group – many of whom had no history with the company. Most of them stayed with the company right up until the events of December. These included Sean Summers, a former Pick n Pay CEO, who managed some of the group’s UK and Australian retail businesses and Andy Bond, previously the CEO of Asda (the third largest grocer in the UK), who is personally invested in Poundland and currently manages the European general merchandise segment (Poundland and Pep Europe).
Finally, after extensive due diligence over the years we also gained comfort around the company’s quality of earnings, as it dramatically improved its conversion of earnings to cash flow over time. As with all investments, we were very cognisant of the risks inherent in the investment case (a low tax rate, numerous acquisitions, and complex accounting and off-balance-sheet transactions) and duly accounted for them in our valuation. Our investment case was premised on the fact that the company had an extremely undemanding valuation which we felt significantly undervalued the underlying businesses, providing sufficient compensation for the identified risks.
If this turns out to be a case of serious fraud, it would have been highly sophisticated and well concealed. It is highly likely that the audited financial results misrepresented the facts. Somehow Deloitte, which is a top-four audit firm with access to all the internal information it needed to perform those audits, did not pick this up. Even an independent review by a second audit firm that, we understand, was commissioned by the Board to investigate the allegations, came out clean. Finally, David Young, a professor of accounting and control at INSEAD who analysed Steinhoff’s financial statements post the events of December, concluded that these off-balance-sheet structures could not have been uncovered using the group’s annual financial statements or other publicly available information.
It is really only when more information comes to light that we will be able to undertake a more comprehensive study of what went wrong and update our clients accordingly. As much as the loss on Steinhoff is disappointing, we do take comfort from the fact that it is ultimately portfolios, as opposed to single-stock views, that we produce for our clients, and that our portfolios proved resilient in their performance, both through that first week of December and for 2017 as a whole.
OUR COMMITMENT TO YOU
At Coronation, we understand that it is a great privilege to be entrusted to manage your assets. We recognise and value your appreciation of, and alignment with, our long-term investment approach. Without that alignment, our job of creating long-term value for your portfolios would be near impossible. I therefore wish to extend my sincere gratitude for your loyalty and support over the years.
It is because of the trust you place in us that we tirelessly strive to improve and remain steadfast in our commitment to deliver investment excellence for our clients.