Disclaimer: This letter is an archived letter to shareholders of the SaltLight Investment Holding company prior to the formation of the SaltLight SNN Worldwide Flexible Fund. The purpose of this archive to provide a historical narrative of our thinking and how it has evolved over time. We find that writing down our thoughts and allowing the passage of time to judge them are helpful in our learning and improving the art of investing. Results, past investments held and our thinking may have changed.
Breakfast, Burgers and Complexity
Early in March, in what seems like a lifetime ago and days prior to South Africa’s lockdown, we took a trip down to KwaZulu-Natal Coast. A full trip to the coast usually takes around six hours and if one leaves early enough, you can be in time for breakfast at the halfway distance mark. There is famous sanctuary that many of my generation would describe as a Gastronomical Mecca of sorts for the weary traveller. The infamous Harrismith Wimpy that has served a quick breakfast (or an early Burger) to hungry holidaymakers since the 80’s. This particular restaurant is a franchised unit of Famous Brands, the multi-branded QSR franchisor. The operator of this store could easily design a complex vehicle production line with his flair for efficiency and synchronicity.
As you enter the door, staff greet you with mobile tablets on their forearms and show you to a cheerful-red leather-covered booth. Your order is taken promptly, sent to the bustling kitchen and within minutes another waiter appears with your piping hot meal. Tables are turned quickly and you’re back on your way on to navigating up the mountains of the Drakensberg, and then down the escapement to your seaside sojourn.
Our salivating tongues and hunger pangs had been building up for over the 300 km (186 mi) trip as each distance marker ticked downwards as we hurtled towards our pit stop. Sadly, on arrival, we could not have been more disappointed as our Harrismith restaurant was unexpectedly closed and the usually hospitable lights turned off completely. The only open storefront at our travel haven was the restaurant’s take-away area. Despite a full parking lot, the mood was sombre as patrons were weary of getting too close to one another. This Wimpy restaurant usually feels like sixty people work there, now, only a handful were taking orders and cooking the food. Three days later, lockdown regulations required that this takeaway store close too. South Africa has some of the strictest lockdown conditions relative to other countries.
How things have changed…My wife reminded me of this relevant conversation between a young hobbit and a wise old wizard: “I wish it need not have happened in my time”, said Frodo. “So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time given to us.”
First all of all, I am praying you and your families are healthy and safe. Our business of managing investor’s capital can sometimes become abstract to the real difficulties people are facing in their lives. An investor’s musings about long-term business models and our opinions about the future can seem irrelevant in the face of an immediate family emergency. I cannot fathom how different my job is sitting behind the safe confines of a computer screen is to a doctor or nurse risking their lives to save the lives of others.
It is my hope that amongst the many implications of the virus, families would be closer, and societies would be kinder to each other.
I am sure that you are eager to hear the report of your investment in our fund. The positive news is that our strategy outperformed the JSE All Share Index by 3.7% whilst remaining conservative and we have roughly ~17% of cash on hand.
Given the speed at which events are unfolding, what is written today may not age well in the weeks and months to come. As a rule, I prefer writing about matters that have some durability over time. In times of market distress, time horizons shorten exponentially at exactly the time when one should be thinking in the longest possible time horizon.
Around a year ago, I came across a whitepaper written by Brad Slingerland and Brinton Johns entitled “Complexity Investing“. It is fabulously thoughtful document and has masterfully supplemented the mosaic of ideas that I had been accumulating over the last decade around complex adaptive systems and particularly – systems theory. I have alluded to these ideas before over the years in our previous letters. Some of these ‘complexity’ science ideas have been beneficial in recognising the necessary portfolio actions that I’ve taken over the last two months.
Wide Range Of Future Outcomes
What is the outlook for the future? The honest answer is that I don’t know. As of writing, the range of potential outcomes is very wide. Evidence-based investors face a crucial dilemma in these fast-moving markets. High quality data almost always lags the reality on the ground and therefore by the time the data is evident, much of it is already priced in. This leaves the analyst to rely on the rate of change of data and counterbalancing empirical ‘unknowns’ with a wide margin for error.
The other crucial point is that in the world of financial markets, what becomes important is not what is forecasted to happen and then actually transpires, but what is priced in and then what actually transpires.
My aim in this letter is to share some thinking on the potential outcomes, whilst not to overwhelm with technical jargon. I do need to back up a little bit and delve into a little bit of science to provide some context on how we got here. Why has the market taken such a tumble and what could the consequences be?
(For the impatient, if you wish to jump to the portfolio update please do)
There are three ideas from the Complexity Investing paper that I’d like to share that are entirely relevant for this letter:
(1) Extreme events are not only common; they should be anticipated as the norm;
(2) A few improbable events effect the system in a non-linear fashion;
(3) Portfolios should be constructed ‘Resilience’ and ‘Optionality’ as investment pillars.
The events over the last few weeks graphically demonstrate the reality of a complex system like a financial market. We can read about ‘black swan’ events in books. But it’s something else looking at COVID daily case statistics and see just how quickly that they grow. US cases on 21 March were 13,747… US cases on 21 April were 759,086. Many readers, I am sure, were surprised that this extreme event could arise, and more concerning is how unprepared the world was in dealing with it. In the past, the world successfully managed other viral epidemics such as SARS (2003), MERS (2018) etc without some of the resulting declines in financial markets.
Why has COVID-19 been so impactful?
The reality is that shocks to complex systems occur all the time (remember Y2k / trade wars / missile strikes in Iran?). Some shocks are absorbed with little additional impact. In others, the system is overwhelmed such that small shocks compound to become reinforcing larger shocks. To understand why, we need to talk about feedback loops and non-linear/linear outputs.
Scientists differentiate between positive and negative feedback loops.
- Negative feedback loops are self-regulating mechanisms. An example would be an office with a heating thermostat. When the temperature rises above a certain point, the thermostat kicks in and turns the heating off back to a regulated temperature.
Abstractly, the system acts on an input going higher with a ‘self-correcting’ mechanism that results in the output reversing in the opposite direction.
- Positive feedback loops are the impactful ones. These shocks accelerate their impact over time. Think of a tsunami that starts with a small displacement of water that eventually becomes a 30m (100 feet) tidal wave. The impact of self-reinforcing feedback loops is that it adds momentum in whatever direction of change is imposed on it.
Inputs with positive or negative feedback loops have vastly different outcomes. Mathematicians differentiate the outcomes in two classifications: linear and non-linear outcomes:
- Linear outcomes: James Gleick describes linear outcomes as this: “you can take them apart and put them together again“. In essence, the sum equals the parts in any given situation. You could reverse engineer the sum back to parts.
- Non-linear outcomes mean that units cannot be added together with a determinable outcome.
Think about traffic, if you add 1,000 additional vehicles on the highway on-ramp at 10 am, the additional vehicles will have little impact on overall driving speeds for all drivers at that time in the morning. However, add the same 1,000 additional vehicles in home-time traffic and the average speeds can go to zero. Same input, but vastly different outcomes.
To bring it back to circumstances today, the virus shock ostensibly entered the global financial system during peak economic home-time traffic. The result: a non-linear outcome.
For developed markets, the backdrop was classic ‘top-of-the-cycle’ conditions: over-levered market participants, an indifference to a slowing world economy, policymakers focused on political distractions, abundant liquidity and an over-confident prediction of the future.
For South Africa, we were nearing the end of an era political inertia after being in an economic and political malaise for over a decade. Prior to this shock, the future was looking encouragingly positive as government’s early reforms filtered through the economy. From a market perspective, it was a value investor’s dream setup with little positive news priced in. Business confidence at multi-decade lows, many listed companies had repaired their balance sheets and any potential growth was certainly not priced in.
But COVID-19 has dramatically changed everything…
The question that we need grapple with is how detrimental and how long will the economic contraction be. As this is a non-linear shock uncertainty around time, the magnitudes of effects and policymaker responses will result in wide-ranging estimations.
Remember the extraordinary US COVID infection case jump in one month (55x)? As with COVID cases, it is likely that the speed and magnitude of the economic ramifications will also be misjudged. The recent price volatility in US oil markets demonstrates something that would have been unthinkable six months ago. WTI oil contracts have gone from a high of $60/bbl to negative $37/bbl in six months (sellers are effectively paying the buyer to take the oil off their hands). Expect more “first time ever”, “unprecedented”, “unheard of” statements over the next few months.
Some economists are talking about a 20% quarterly drop in SA GDP demand for the second quarter. What comes next in the following quarters after lockdowns are lifted is also very uncertain.
Time is the most uncertain input
Judging the extent of economic contractions is highly dependent on time. My mind is drawn back to our Harrismith Wimpy owner. A two-weeks lockdown: painful but survivable. But two or three months? Individuals and corporates are able to absorb short-term contractions through cash reserves and patient lenders. But as time increases, the number of stressed participants increases exponentially; cash dries up, capital providers take longer to provide liquidity and the ramifications cascade. Few companies can last more than three months with impaired revenue and a continuation of the same expense base.
Policymakers in developed markets have responded with monetary and fiscal measures to substitute the private-sector drop in demand. In aggregate, this is positive but there will be individual ‘winners’ and ‘losers’ based on how that stimulus is transferred through the financial system.
Emerging markets do not have that luxury. In South Africa’s case, last year it was already ‘stimulating’ demand through a 6.6% budget deficit. With the expected sovereign rating downgrade last month and the resultant higher cost of borrowing, there is very little fiscal room to offer assistance other than deferral of obligations. This leaves the private sector, banks and shareholders to absorb the decline in economic output.
Should we react to this uncertainty?
Recessions are to be expected in long-term investing. Markets react to recessions by over-estimating the negative impact and this leaves attractive opportunities for the disciplined long-term investor to take advantage of the panic of others. Quick recoveries are a long-term investor’s ideal scenario to deploy new capital into.
However, the odds in the present situation appear that the chance of a quick economic recovery are small. In fact, there is the stomach churning risk of a ‘fat tail’ event of a protected economic contraction and indeed, the odds of an Armageddon scenario of a depression are not zero.
There are very few historical playbooks on how to manage risk in a portfolio under these uncertain scenarios. We could be too negative, overestimate the impact and miss the quick recovery or we could be too optimistic and underestimate the impact with a significant loss to our portfolio’s value.
How do we adapt our portfolio under these various scenarios?
Portfolio Construction Implications
I’m going to circle around back to Slingerland and Johns’ eloquent paper on Complexity Investing to provide a map to how I’m thinking about navigating our portfolio through this (to save paper, I’m going to shorten references to the authors as ‘SJ’).
The paper’s foundational idea is that future outcomes are unpredictable firstly, because extreme events happen more often than we think and secondly, the effects are exponential non-linear outcomes. We, therefore, should not construct a portfolio to solve for a particular prediction. Rather, they advocate that investors should construct a portfolio with characteristics that absorb non-linear shocks and hopefully benefit from them when they do occur.
SJ crystallises these characteristics in two key heuristics: (1) resilience and (2) optionality. I’m going to shamelessly re-use the simplicity of their ideas and weave them through how our portfolio is constructed and how it has marginally changed over the last few weeks. I should note that SJ’s paper has a technology slant in addressing what constitutes the ‘resilience’ and ‘optionality’ pillars, however the general application is also very useful.
A controversial idea is that fragility to economic systems is actually a positive in aggregate for an economic system. Nassim Taleb has written an entire book about this topic and I encourage shareholders to read it if you have not. Grave instability creates opportunity for new solutions, new business models, new thinking and particularly new technological solutions (how many readers are using more video conferencing software these days?).
Our SA investment universe is somewhat limited to take advantage of direct investments into technology solutions, but we can find indirect opportunities. Nevertheless, the point is worth pondering on what it means to be a ‘resilient’ company in the South African context.
At first thought, most readers would retort that a larger business would be more ‘resilient’ than a smaller one; a sounder balance sheet is better than a debt-laden one. If facing a short-term existential crisis, these are certainly the desired characteristics of a resilience business.
However, in long-term decision making, SJ’s paper makes the point that resilient companies are actually ones that are the most adaptable to change and can evolve into changing conditions. As a result, they are able to quickly recover from and capitalise on these extreme events.
It’s interesting to note that at no point do they refer to share price resilience. Yet, so many of the modern day investment products are constructed with market prices as the key input. As long-term investors, SaltLight’s investment process is entirely focused on the underlying business and not the share price. We see a share price as merely a servant and not our master. For the long-term investor, what creates wealth is how a business earns returns on invested capital.
My contribution in the search for resilience is to also identify what elements won’t change for a business. Structural and enduring advantages are key. Our Harrismith Wimpy restaurant owner will always have that halfway mark location and, of course, the decade-old Wimpy brand. The mom and pop restaurant won’t have these advantages. In the ‘new normal’ of social distancing, our owner will likely have to space out tables lowering the revenue density of his seating area. This might make owning a restaurant comparatively less profitable although our owner has already been preparing for this environment, even though he does not know it. Relative to his competitors, his choreographed ordering methods will enable speedy table turnovers that will dampen – not eliminate – the effect of social distancing. Of course, an individual franchise restaurant unit might not survive a lengthy lockdown. We simply don’t know. But I’m betting that the system, the brand, the distribution, the marketing power, the supplier relationships and the location will outlast the effects of the ‘new normal’. Perhaps the new normal will look like repurposed smaller store formats, home delivery and even higher table turnarounds. We simply don’t know today.
For our portfolio, in many ways, resilience has already been embedded in our investment process from day one. This is predominantly because South Africa has been harsh environment to invest in for a decade already. COVID has simply become an extension of an already challenging setting. For the quarter, some of our portfolio companies have seen dramatic share sell-offs as the market has perceived that they will be directly affected by COVID: Transaction Capital (-40% QTD), Curro (-57% QTD), Discovery (-36% QTD).
But let me escort you around the ‘resilient’ pillars across a few of our portfolio companies:
- Transaction Capital’s inherent resilience is a lack of alternatives (unreliable trains, infrequent busses or expensive private vehicles). Demand for minibus transport by the majority of South Africans will continue in the years to come. However, Transaction Capital’s quality management has created additional resilience through structuring SA Taxi’s funding vehicles to absorb a mass stress event. If borrowers delay payments, funder’s payments are delayed too. Traditional banks don’t have this option.
- School education will also continue in the post-COVID world. Parents will likely have a renewed gratitude and, perhaps, indebtedness to schools and teachers after the lockdown has ended. Curro has been building ‘price point’ resilience into their business model for the last four years. Their aim is to widen the addressable market through making the cost of private education as affordable as possible (and comparable to the cost of public schools.) Its competitors are still holding price points high for the upper end of the market.
- Discovery’s client base is, on average, much younger and more affluent relative to other insurers. Yet, the market is pricing in very high mortality rate on their life book. South African health insurance is always placed in an off-balance sheet medical scheme vehicle and medical claims will have no impact on Discovery’s balance sheet.
However, some of our portfolio businesses will struggle in this ‘new normal’. Sorbet’s customers will be weary to get a facial for some time, Calgro might take longer to build houses and Trellidor will sell fewer blinds. Roughly 10% of the portfolio will struggle in the near-term.
Many of our investees have seen a strong recovery in their share prices from the period-end measure to last week: Transaction Capital (+28%), Curro (+31%), Discovery (+19%).
When I think about the managers running our portfolio businesses. I think about the inherent adaptability that SJ talks about and then I think about the optionality that was not priced in prior to COVID and what is available for free today.
SJ goes on to define ‘optionality’ as “a large potential payoff resulting from a relatively small investment“. One benefit in crashes is that optionality always becomes under-priced, and even better, is often offered for free by Mr Market.
The authors argue that there is a balance to be had. Companies that are only resilient, without growth prospects, often have old ideas, stale management and can eventually fritter shareholder capital away on poor acquisition or new projects. Companies that only have optionality but not resilience (the next low-cost airline?) will have too many questions around survivability when shocks do happen. The optimal portfolio investment should have the appropriate balance of resilience AND optionality.
During the quarter and post-quarter, I have made marginal adjustments to some of the smaller investments that we’ve had. Recognising that the world has fundamentally changed, and new assumptions need to be applied. For over two years, our portfolio has had high quality preference shares serving as a cash buffer. These have provided an attractive yield (average ~12% yield) and ‘optionality’ to redeploy the capital if better opportunities come along. I sold our entire preference share position in late February at a slight discount to par value which means we have ample liquidity to take advantage of obvious mis-pricings. That leaves us with 17% cash to deploy.
Clearly, I’ve been thinking a lot about Wimpy burgers. I am thinking that all I’d like after lockdown is a burger. Our family is tired of cooking at home. We’re not certain about going to a sit-down restaurant (it’s too soon). But I’d like to get a takeaway meal. Watch this Wimpy advertisement to see if you agree with me.
My lust for a burger has some deeper motivation. I’ve been studying the food delivery sector for over two years and late last year I started adding Prosus to our portfolio in the middle of the ‘trade war fears’. Most investors would focus on Prosus’ investment in Tencent trading at a significant discount. However, I’m rather optimistic about their food delivery investments that will benefit in the ‘new normal’ of social distancing. Today, we’re getting this business for free.
Sentiment around developed market food delivery businesses has soured over the last few months. However, Prosus’ investments in Brazil and India have an emerging market angle that puts them in a competitive position that is well-ahead of developed market competitors. It appears that emerging markets are likely to leap-frog the technology cycle in this regard and are moving directly to food delivery with a supply of ‘ghost kitchens’ to service them. I shall offer a deep dive into our thesis in future letters.
I must remind shareholders that we can’t predict future outcomes. We can only plan for them. We may see further share price declines on our portfolio or a swift recovery; I just don’t know. Ultimately, I’ve positioned the portfolio with ‘shock-absorption’ characteristics with the future prospect of long-term returns from optionality. As a reminder, my liquid capital is completely invested on the same terms and same basis as yours.
I hope that you and your loved ones are staying safe and I’ll leave the last words to another dependable hobbit, Samwise Gamgee: “But in the end it’s only a passing thing, this shadow; even darkness must pass.”.
 This includes no exercise outside one’s home, no selling of hot food and no take-way food.
 James Gleick: Author of Chaos: Making A New Science: link
 WTI is the West Texas Intermediate Oil front-month index priced in Cushing, Oklahoma (source: Bloomberg)
 Antifragile: Things That Gain from Disorder, Nassim Nicholas Taleb; link
 Source: Youtube: https://www.youtube.com/watch?v=_pTliNteebA