Archive 2Q 2018 Letter

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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.

“Moderation is better than muscle, self-control better than political power”
– Proverbs 16:32

To our partners, this is a half-year review of SaltLight’s investment operations. Despite my best efforts, I haven’t quite worked out the very desirable skill of timing when an investment will yield performance. It is disappointing that SaltLight generated a single digit negative return that is below our hurdle rate. As it would happen, much of the pullback in our returns occurred in the last three weeks of the quarter. At best, the only thing I am able to control is the investment process.

SaltLight has added new partners and therefore, to assist their decision-making needs, I’ve taken a decision to align our reporting with a twelve-month calendar year cycle rather than a financial year cycle ending in June. It has been too confusing to translate this into an apples-with-apples comparison in meetings with new investors. This is the first letter that bears this change. To avoid doubt that I’ve put my accounting training to good use and re-arranged the deck chairs, I provide shareholders in the SaltLight Investment Company a comparative table at the end of this letter[2].  

Year to date[3], SaltLight’s NAV declined by [redacted] vs. the JSE All Share Index (with dividends) growing by +1.42%. Since inception, the fund has turned R1 of investment into [redacted] vs. the JSE All Share Index (with dividends) of R1.19.

Given the skewed distribution of South African indices to a few large names (Naspers) it seems superfluous to spend time thinking about indices. However, I believe that providing such information is useful to afford a sense of what a ‘par’ return is. If one excludes Naspers from the JSE All-Share Index, the local market picture looks rather different, with Rand-based returns of +1.4% CAGR since 2014.

Rest assured, as your manager is remunerated mostly on performance fees, I am as disappointed as you are. Too often we see management being rewarded for ‘performance’ when shareholders have suffered. This is not the case in our fund.  Many of my investment peers earn fees regardless of performance. You may judge who is getting the better deal.

Ben Graham spoke about “profiting from market pendulum swings”. He observed: “there are two possible ways by which he [or she] may try to do this: the way of timing and the way of pricing. By timing, we mean the endeavour to anticipate the action of the stock market”.

Graham goes on to explain that “timing is of great psychological importance to the speculator because he wants to make his profit in a hurry”. Looking over my career, I have never really excelled at ‘timing’ an investment. In fact, I’ve excelled at being a bit too early.  There are a few exceptions where luck played a role however I could never claim an ‘edge’ in timing. My investment process is entirely focused on finding price-driven value.

Looking at our opportunity set, I believe that these are the times to deploy capital reinforced with fortitude and patience.

One of the tell-tale signs for opportunity is often the absence of capital in an opportunity set.  This is most evident in South Africa and I believe that our market is offering a considerable relative-value advantage to other markets and some juicy inefficiencies that should yield a strong return over time. However, measured over this period, we have been found wanting.

“Muddy waters make it easier to catch fish” – Chinese Proverb

It seems fitting to borrow a famous Chinese proverb and bring us back to our South African context. The enthusiasm that I expressed in my last quarterly letter that South Africa had started to turn a corner – appears to be premature.

As is the case when new management takes over, there are always new complications that crop up that weren’t known before. Warren Buffett described the phenomenon well when he said: “there’s never just one cockroach in the kitchen when you start looking around”. Newly-installed, President Ramaphosa, has skilfully begun the process of fumigating the halls of political power. The challenges around the state-owned enterprises, political policies and the upcoming election in 2019 are likely to leave uncertainty to linger for some time (unfortunately an occupational hazard when investing in Emerging Markets).

To readers making domestic vs. international capital allocations over the next year – much caution is advised: headlines and potential policies proposals ahead of the election are likely to be appear so dreadfully capital-destructive that even Donald Trump would have indigestion.

I always pose this thought experiment to potential investors: would you rather allocate a Dollar[4] today to markets that have had a 10-year bull market, with easy credit and participants that are paying for growth well into the future OR a market that has historically low valuations, a catalyst for economic renewal and divergent views about outcomes?

The first opportunity set has performed fantastically well in the past – beyond all expectations since the Global Financial Crisis. It is undoubtedly an ‘easy sell’ to investors. The good times will continue and it’s much easier to push a boulder down a hill.

Candidly, the second opportunity set is difficult to ‘sell’ to prospective investors. It’s human nature and unnatural to invest ‘when the cannons are firing’.  If the price you pay is the largest determinant of future returns – I know where I would like my capital. The reality is, at present, that Mr Market is offering private market multiples for publicly-listed businesses.

SaltLight’s mandate is wide-ranging, my aim is to fish where the odds of success are greatest. The opportunity sets that I tend to fish in are in five areas: (1) transactional ability and financial services, (2) education, (3) experience and lifestyle consumption, (4) transport and (5) housing. Of course, other opportunities do arise from time to time and I would deploy capital where there is a sufficient discount to intrinsic value.

At the time of writing, we are in an enviable position that we have had many opportunities to deploy capital and are currently ~85% invested in 10 businesses.

In this letter, a little more detailed than usual, I talk about Discovery Holdings, Taste Holdings and this year’s awards for the mistakes that I made.

For the technically orientated, I’ve also included in the appendix, some notes on African Phoenix, a good illustration of the inefficiencies in the South African market today.

Investment Activities

Discovery Holdings (DSY)

Discovery Holdings is a two-year research project culminating in a new investment. Briefly, the overarching investment thesis is that Discovery is ‘closing the loop’ as a consumer aggregator in financial services and will continue in enhancing their customer’s lives through digital measurement + behavioural change.

Discovery offers ‘commoditised’ medical, life and P&C insurance products to their 4m domestic and international customers. Within a few months they will be launching a banking platform. Some market participants think this venture is likely to sink the ship in a very competitive banking market.

It is my opinion that Discovery knows more about their customers than any other technology company I can think of – even Google or Facebook.

Let’s compare Google and Discovery: Google has a considerable advantage around knowing who you are and how likely it is that you will click on an advert.

Discovery knows what a customer eats, when they exercise, what their health issues are and is even experimenting with collecting DNA[5].  

It would seem unconscionable that Facebook or Google would have such detailed information about their users. Yet, Discovery’s customers willingly provide their health records, their driving behaviour, their food purchases and, in a short time, a full picture of their spending habits.

It seems that by providing ‘earned’ incentives, customers are less likely to have qualms about privacy.  

Strategically, Discovery has mimicked Apple’s integrated architecture playbook rather successfully. Clayton Christensen notoriously advanced the theory that excess profits are made in an interdependent product architecture[6].

An example would be helpful: Apple has created considerable customer switching costs by designing an integrated product architecture between disparate products (say a watch and a phone) with the addition of a ‘services’ layer (the Apple App Store) on top of their products. The App Store creates network effects that binds third-party developers and multiple devices together with Apple’s customers – continuously growing the value of being an Apple customer as one adds each device and each app.

Discovery similarly integrates and differentiates their products with an ‘incentive’ layer on top.  The incentive layer, called Vitality, interlinks the various financial services products and is the ‘secret sauce’ to lower lapse rates and lower overall insurance claims.

Most insurers are passive observers of their customer’s lifestyle habits. At best, they manage anti-selection risk and avoid ‘sickly’ customers through pricing. Vitality uses modern behavioural finance techniques[7] as a ‘carrot’ and ‘stick’ to actively change behaviour. Customers are incentivised to be more active, drive more carefully and save more for retirement. These activities reduce the insurance claims down the line and Discovery ‘shares’ the saving with their customers.

More beneficially to customers over the long term (if a Vitality member meets their goals on physical activity, routine tests and adherence to programmes) management indicates that those who use the Vitality product are likely to add years to their life[8].

Mortality Bent Curve (by Vitality Status)[9]

A Widening Moat

Discovery has two elements that create a formidable moat: (1) the best ‘marshmallows’ and (2) better data leading to better pricing.

  • The best ‘marshmallows’: Discovery’s insurance products are as much as a ‘grudge purchase’ as any other. In my discussions with customers, there are more than a few that would love to leave Discovery – yet they don’t. “Why not?”, I ask. Customer response: “oh, they give me 30% off flights” and “I’d lose my gym discount”.

Discovery seems to have successfully tapped into the depths of the human psyche by giving customers the best Marshmallows[10](flights, coffee, discounted gym memberships etc) resulting in suppliers (including medical practitioners) being forced to follow them. Discovery currently subsidises 1m flights per year (or 22 planes per day) and 70,000 gym visits per day.

Customers forgive Discovery despite have a reputation of being tight-fisted in paying claims.

Benefits like these are, theoretically, easy to replicate – competitors should simply be able to buy them. However, in reality, competitors are severely disadvantaged. With a 40% share of the private medical insurance market, no competitor has been able to match (on a per unit benefit cost basis) Discover’s benefit range. Discovery has contractually locked up the most-desired consumer-incentive suppliers (airlines, gym brands, coffee chains and healthy gear) by being early but also by providing significant market power.

Therefore, competitors are always at a price and value disadvantage to replicate the same benefits. This has created a positive feedback loop where Discovery directs more customers to a supplier, which means better terms (more transferred value and lower pricing), which, in turn, means more customers.

The result: Discovery’s supplier advantage has forced many competitors to capitulate and rather compete on distribution or other factors.

  • Better data leading to better pricing: If ‘Big Data’ is the new moat, Discovery is years ahead of its one-dimensional competitors. Most life insurers price their life insurance products using standard actuarial life tables with some idiosyncratic adjustments (smoking or demographic factors) to account for an estimated mortality. Discovery has a substantially wider data advantage to pin-point an individual’s life expectancy and other behavioural tendencies with superior accuracy[11].

This ‘commoditised product’ + ‘differentiated layer’ strategy has been rolled out in each product segment that Discovery has entered into (retirement products, short-term insurance and, in the future, banking).

Why go into banking?

The purpose of starting a bank is to (1) know where/how a customer is spending their money and (2) grab more share of a customer’s wallet.

As with health data, Discovery is likely to utilise this data to change a customer’s spending and savings behaviour.

Discovery is already deducting points if a customer puts a chocolate rather than a lettuce in their shopping basket. I speculate a scenario where their app deducts points if you haven’t saved ‘x’ in a particular month?

Discovery’s Banking initiatives come with significant risks as the South African banking sector has extremely high barriers to entry. The ‘benign oligopoly’ that has existed for decades is unlikely to easily allow new entrants. Discovery’s target market is the middle to upper income cohorts – the ‘bread and butter’ of the stodgy oligopolistic incumbents. History has shown that, in the last two decades, the only new entrants that have succeeded have targeted the ‘unbanked’.

So why could Discovery possibly succeed?

Think back to Apple. Apple succeeds because of its integrated product eco-system. The value of a customer’s individual products become more valuable as each new product (Watch, iPad) is added to the platform. The differentiating layer (the App Store) binds these pieces together.

Similarly, Discovery has followed this same process. The medical insurance market in the early 2000s had major incumbents offering a commoditised product. Two decades later and Discovery has 40% market share of the private medical market because they offered a ‘differentiated layer’ (Vitality) on top of a commoditised product.

By creating an integrated solution, customers accumulate more value by moving across to Discovery’s commoditised products. The sum of value is greater than the parts[12].  

Furthermore, given that banking products have a smaller absolute cost than insurance products, it makes strategic sense to use a banking product as a ‘gateway’ product that could be leveraged to encourage non-customers to buy other Discovery products.

These competitive advantages raise my view of their odds of success with a significant ‘market-share grab’ opportunity[13].

It is likely that the bank will target the mass market (12.8m households and $52bn of income) and affluent market ($24bn in income and $115bn in assets). As a share of wallet, Discovery is only grabbing, at most, 20% of a customer’s salary. With banking, Discovery could pick up 0.5%-1.0% of the remaining 80%; ignoring potential optionality on mortgage and mainstay retail banking products.

While Discovery is heavily investing in these initiatives, earnings and margins are likely to be subdued for the next few years but why would an investor argue that management should not invest in widening this kind of moat?

******

Taste Holdings (TAS)

I have been building our investment into Taste Holdings for over a year. To date, if viewed by the share price, I’ve been characteristically too early or simply wrong.  SaltLight is presently sitting with an unrealised loss on this investment. The total portfolio position is 2.7% at the time of writing. From a portfolio perspective this loss has not been material.  There is a significant optionality available that I believe we are getting for a relatively low cost, however it should also be recognised that this might only be the second innings of a long game.

Over the course of the last year, I believe that potential downside scenarios of ‘corporate failure’ have been appreciably reduced. There is yet to be evidence of a ‘moat’– hence the fund’s position is small. However, the well-trodden business model and operating capabilities of these iconic brands offer the potential for a significant moat in the future.

All the major players in the QSR/fast food sector have had some material issue that has depressed the sector’s returns – an untimely mobilisation of capital from new entrants into international brands (and exuberance from local ones) that unfortunately coincided with the economic downturn. Since 2014, Burger King, Pizza Hut, Domino’s, Krispy Kreme, Dunkin Donuts and Starbucks have all entered into the SA market.  Press coverage of the sector, and particularly Taste Holdings, has been appalling. Its predominantly retail investor base has run for higher ground and the market is justifiably concerned about further rights issues.

But first, briefly some background: Taste has two distinct businesses:

  • a Food franchise business that is in early stage development of the master-franchise for Starbucks and Domino’s as well as some mature mass-market local brands (Maxis and Fish & Co); and
  • a Luxury retail business operated as NWJ and Arthur Kaplan Jewellers.

Presently there are 10 Starbucks stores (30-45 stores by FY20[14]) and 72 corporate-owned Domino’s stores (70-90 by FY20).

Here is my back-of-the-envelope calculation of the value that Taste affords:

The market cap of Taste is US$28m.

Conservatively, the Luxury business is worth US$18m-US$20m – if it can be sold in a ‘normalised’ market. This means, Starbucks, Dominos and the local brands are currently valued by the market at c. US$9m. The 82 company-owned stores have a replacement cost of c. US$15m and therefore if purchased today, an investor is buying the food business at ~60c on the Dollar.

The market has correctly penalised Taste. In 2015 it reached a high of R5.00/share and since then has lost 92% of its value.

  • Prior management was too hasty to take on two brands[15]: management rapidly converted their existing local pizza franchisees into Dominos at very generous subsidies; coupled with a significant investment in corporate-owned stores[16].
  • Change in risk profile and capital allocation model: Although Taste has been around for over two decades, with the take-on of the Starbucks and Dominos brands, the risk profile has become decidedly more early stage. The capital allocation model has also changed from a ‘capital-light’ franchise model to a ‘capital-hungry’ corporate-owned store model.

Given its position in the J-curve, the combined business is loss-making. The capital-hungry food business has therefore required serial rights issues to develop enough stores to operate at scale.  It is highly probable that another rights issue will be required in the next 6-12 months (my estimate is another US$10-US$12m)[17].

  • Inability to sell Luxury businesses: Management announced in 2017 that they were looking to dispose the Luxury business and utilise the proceeds for further development of the food brands. However, given the tough economic environment, offers from potential suitors were ‘low-balled’ and Taste opted to keep the business until markets normalise. The risk of further capital raises increases the longer that it takes to sell the Luxury business.

Rumours of its death are greatly exaggerated

It is my view, however, that the market is seeing continued losses and it is not appreciating that the terminal risks have been significantly mitigated over the last six months:

  • Repayment of all long-term debt: All of Taste’s long-term debt has been repaid to align the risks of a start-up funded with equity capital.
  • Newly-installed and better-aligned management: Change at Taste has been significant. In the last six months a new interim CEO, new COO and new food specialist staff have been appointed. It is apparent that the new management is taking more disciplined capital allocation approach[18]. Feedback from my channels checks is that changes have been effective.

But…residual downside risks to the thesis remain:

We might not get to enjoy the upside: Serial rights issues have meant that investor confidence has been stained and therefore rights issues were not well supported by existing shareholders. One particular US-based fund has underwritten much of the injected capital to the extent that they hold c. 64% of the share base.

There are some scenarios where our capital loss becomes more permanent: (1) Taste is taken private at a low price by its major shareholder and we do not recover our unrealised loss or (2) the Luxury business is bought by this fund at a ‘low-ball’ value and it is warehoused for 2-3 years to flip in better times. The implication: we lose our margin of safety.

A structural issue with the South African palate?

A considerable risk is that marketing efforts to convert customers into Dominos-style pizzas does not pay off.

US brands have historically done well in South Africa; however, they have taken years to become entrenched. KFC has been in SA for decades and is the largest (879 outlets). McDonalds entered South Africa over twenty years ago (245 outlets).

Unambiguously, Chicken is the most popular category in South Africa (> 1500 units) with Pizza coming in third (< 1000 units) as a relatively new offering to mass-market consumers.

The South African pizza category has been growing substantially over the last decade. There is an undercurrent of younger African’s desiring western brands which presents a substantial opportunity for Dominos to tailor the menus to the South African palate. Price is the greatest challenge to deeper penetration.

The Dominos brand has faced similar cultural-fit challenges in India where it took menu changes and lower price points to grow into the mass market (from 60 stores to over 500 stores). This, however, took over five years to bear fruit.

What leads me to downplay the risk of a ‘palate’ issue is that pizza does well in geographies that have even more distant food preferences[19].

Is there any good news?

  • Starbucks likely to be successful over the long term and near EBITDA ‘breakeven’ in next two years: The Starbucks brand development has been considerably more tempered. The concept of a ‘third’ place is relatively untapped with casual dining as the dominant coffee occasion. Given management’s FY20 projected store roll-out, revenue is like to be 3-4x from today.  There remains to be low hanging fruit opportunities by opening stores where developed-world travellers flock (airports and tourist sights).
  • Technology-led future needs scale and tech capability: After researching some of the international Starbucks and Dominos organisations, I have come around to the strategy of a typically franchised brand owning its own stores. Primarily because of what differentiates a fast food organisation of the future is: (1) the ability to get food into a customer’s hand with speed and (2) direct digital communications with customers. These functions require expensive technology capabilities and Taste can easily leverage off Domino’s and Starbuck’s international platforms. Local competitors are not as competent in this kind of tech innovation.

There is much opportunity to scale up our position, however, it is prudent to pause and await positive actions by management, and the industry, to deploy further capital. (1) A permanent ‘food’ CEO appointed; (2) More detailed disclosure of unit economics; (3) Reduced head-office overheads by potentially exiting the remaining local brands.

This investment is a small position with outcomes ranging on multiples on our capital to a permanent loss of capital. The Luxury business remains a key source of a margin of safety to give the company some runway to move up the J-Curve. It is my opinion that our expected return is positive with some risks regarding the activities of some of the larger shareholders.

*******

“Enjoy the process along with the proceeds, because the process is where you live”
– possibly Charlie Munger

A Reflection on this Year’s Mistakes

Given my occupation is entirely based on making decisions about an uncertain future, the chance of making several investment mistakes over the next fifty years are highly likely. It serves no purpose to hide these mistakes from shareholders. The best mechanism is to disclose these and use mistakes as a learning feedback loop. I truly hope that my future self in 2028 will not have made the same mistakes.

Gold Award – goes to Master Drilling (MDI)

I wrote extensively in my June 2016 letter about the Master Drilling thesis. The crux of the investment thesis was:

“Master Drilling has (1) pricing power due to specialisation and being a niche product in a small market and (2) high-barriers to entry due to technical know-how, economies of scale and customer captivity”

Over time, it has become apparent that this thesis was wrong. It has taken a severe downturn in mining capex to illustrate that pricing power is only useful when your customer has enough money to spend on your product.

Management has unfortunately changed their tune in the last two years since I wrote my original letter. Despite their customer’s financial difficulties, management has continued to invest in more drilling assets to increase geographic coverage. However, to keep utilisation up they’ve had to sacrifice pricing. The result is that assets have gone up and margins have come down.

Based on my interactions with management, it appears that the primary motivation around capital allocation, namely incremental capital deployed to new machinery, is in anticipation of a ‘supply squeeze’ when commodity company’s need invest in new production. Essentially, management is banking on the multi-year period it takes to build a machine.

Whilst Master Drilling is extremely cheap on many measures, I am concerned about ‘thesis creep’ and so I’ve recently exited this investment. My mistake has unfortunately resulted in a small permanent loss for us.

Bronze Award – Conduit Capital (CND)

Conduit Capital is best characterised as a mini-Berkshire Hathaway or mini-Markel. Warren Buffett has articulated this strategy over the years in his investment letters. It encompasses taking an insurance business that earns ‘float’ through insurance premiums that are received up-front but only paid out in future periods through claims. Whilst this money sits with the insurer, management is able to reinvest it into bonds and shares and consequently profit from investment returns.

If the insurance company earns more premium than it pays out in claims, the cash sitting on its balance sheet does not cost anything. Any other forms of capital would have an inherent cost (interest or required investment returns).  However, if this ‘zero-cost capital’ is reinvested in assets that compound this float over time, it is very possible to become one of the richest men in the world.  

Crucially, this model is highly dependent on the capital allocators making the investment decisions. Berkshire has Warren Buffett and Markel has Tom Gayner. In Conduit’s case, I highly regard the capital allocators who have an excellent track record[20] and have substantially ‘bulked’ up the insurance business with additional lines of insurance (read: more potential float). In the early years, writing new insurance premiums always has a cost until the policies start to season. I have viewed this as an acceptable investment that would yield considerable returns in the future.

Whilst there is a never a perfect business to invest in, I’ve generally looked at the risks on a probabilistic basis and assessed what my expected loss is. If the (1) probability of loss or (2) magnitude of loss is small and there is a sufficient margin of safety to compensate for the expected loss – I’ve tended to go ahead with the investment. 

As part of my investment process, I monitor the underlying businesses that Conduit has invested in. Over the last year, some of these businesses have share prices that have risen substantially and have become a sizable portion of Conduit’s NAV[21]; fortuitously offsetting the losses made in the insurance business.

It is my view that incremental downside risks attached to these businesses have grown substantially and, today, would not pass through our investment process.

Whilst the insurance side of the business remains appealing, it is my opinion that the any upside from insurance is tempered with risk on the downside from the investment portfolio.

I’ve reluctantly decided to sell our investment.

********

Business Matters

SaltLight has a ‘quirk’ in its reporting in that we initially started with an investment holding company structure where our year-end was June. This meant that our ‘annual report’ was at June each year rather than following a calendar year. We have raised capital from new partners outside of this structure which has meant that our reported performance is somewhat misaligned to general practice by working on a June year end.

To align our reporting and annual letter with our partner’s reporting periods, I have decided that all shareholder communications will move to a January to December evaluation window. In the past, I have also followed a quarterly letter cadence. I have found that the quarterly period is too frequent given the slow pace of turnover in our portfolio. Portfolio valuation updates will continue on a quarterly basis however there will be little commentary attached. Hereinafter, I will compile an investor letter every six months

*******

Rest assured, all of my liquid wealth sits alongside your capital in this fund.

As I indicated at the start of this letter, I have little insight into when the value in our portfolio demonstrated in share price appreciation.  Over the long term, the investment strategy of buying a business at a discount to intrinsic has created significant wealth. There is no reason to believe that this will not continue.

A significant ‘edge’ that we have is our partner base. Without your long-term perspective, we would not have the opportunity to take advantage of these opportunities. Thank you for the opportunity to grow your capital alongside mine.

I look forward to providing an update on our investment operations in December.

******

Appendix A

The Need for Solomon’s Wisdom – African Phoenix (AXL/AXLP)

To give you a flavour of some of the special situations in this market, let me talk about African Phoenix. In February 2017, I deployed capital into African Phoenix Investments (AXL) into their ordinary and preference shares. A special situation that, in aggregate, has little downside but a ‘complex’ upside.

AXL is the carcass of the now-defunct African Bank Investments Ltd (ABIL) taken into curatorship in August 2014. ‘old-ABIL’ consisted of a bank that specialised in unsecured lending, a furniture retailer called Ellerines and a very profitable insurance business called Stangen. After a considerable loss to equity shareholders, ABIL underwent a ‘good bank’ and ‘bad bank’ restructuring under its curatorship – with the ‘bad bank’ remaining in Phoenix and Ellerines being written down to zero.

That brings us to today. Much like the Greek myth, African Phoenix is attempting to rise from the ashes into an investment holding company. The business is effectively a cash shell (R1.8bn ($138m)) plus the over-capitalised insurance business. Phoenix has two classes of issued securities: (1) ordinary shares (market cap R941m or $72m) and (2) non-redeemable, non-cumulative preference shares (market cap R311m or $24m). It is debt free and without any residual claims to ABIL debt-holders.  Mathematically-inclined readers will realise that this business is a Dollar of cash trading at 70c – if one sums up the two securities and IF a particular class of shareholder can access the cash. 

Based on my interactions with newly- appointed management, the intended strategy is to create a Private-equity investment holding company by utilising a portion of the cash to build a portfolio of businesses.

Based on this new strategy, it is unlikely that the ordinary shareholders will receive any cash returned in the short term however management has indicated that they are likely to clean up the capital structure (my interpretation: do something with preference shares). This could look like a tender offer for the preference shares or a share-swap exchange for ordinary shares – both at a sizeable premium to our cost. 

The market has indicating that the preference shares are unlikely to see any of the cash (it’s trading at 28% of par) and the ordinary shares are trading at a premium to NAV (inferring that preference shares will obtain less than par). Yet, in aggregate the two instruments are still a 30% discount to cash.

Why the discount?

The question of who gets the cash is complicated. The interests that govern this decision sit with the ordinary shareholders (and the board that works on their behalf). Given that these preference shares are non-redeemable, non-cumulative, non-participating instruments: preference shareholders only receive cash: (1) if a dividend is paid (only paid if a dividend is declared to the ordinary shares); or (2) the prefs are bought back (at premium to incentivise holders to surrender) or (3) winding up (oddly the most lucrative for pref holders, but very remote in this case).

Whilst the 30% discount on cash is attractive, the outcomes surrounding the two classes of shares is relatable to the story of Solomon and the Two Mothers. Luckily, we don’t have to bet on one baby and are able to bet on both outcomes and still have an attractive upside.

The result is that we own both the ordinary shares and preference shares with a ‘skew’ to the ordinary shares. As new information comes in, I’ve adjusted our relative positions accordingly.

Bear in mind, the lower the price that the prefs are bought back – the more cash available to the ordinary shareholders.

Ultimately, this is a unique special situation and is rather complex. Our size allows us to participate in special situations like this. I believe the downside is limited however the outcomes may take some time to play out.


[1] Net Worth or Net Asset Value (NAV) represents assets (investments) plus cash less liabilities and is the best measure of net worth (according to accounting rules) to SaltLight shareholders. The NAV is divided by the number of class A shares outstanding

[2] I will provide a similar table at the end of this year to provide a like-for-like comparison to prior reporting.

[3] For clarity: January 2018 to June 2018. Note that these are unaudited results and may change.

[4] All ZAR/USD conversions have been at ZAR13/US$1

[5] Source: https://www.humanlongevity.com/human-longevity-inc-and-discovery-ltd-to-offer-whole-exome-whole-genome-and-cancer-genome-sequencing-to-discovery-insurance-clients-in-south-africa-and-the-united-kingdom/

[6] Theory of Interdependence and Modularity: The Innovator’s Solution, Clayton Christensen (chapter 5)

[7] Daniel Ariely is a consultant to Discovery (link) and much of his work has been implemented in changing customer behaviour.

[8] Source: Company: After 10 years on Vitality, average reduction in mortality is 16%

[9] Source: Company: The reduction in mortality (actuarially expressed as the probability of death) by age 65 is significant on the highest levels (gold status) of activity. The lower the value on the y-axis, the lower the probability of mortality.

[10] Marshmallow Test: https://en.wikipedia.org/wiki/Stanford_marshmallow_experiment

[11] For example, based on their data, there is a high correlation to indicate that healthier people are a better credit risk (if you’re disciplined enough to go to a gym three times a week, you’re likely to be more disciplined in paying your bills).

[12] For example: A discovery health customer obtains a larger discount on a flight purchase if they use a Discovery Credit Card to pay for it. 

[13] Most banks have their own loyalty products however they are significantly inferior in isolation. Furthermore, they lack the smooth integration that Discovery has.

[14] Based on Starbuck’s traditional densities of a population between 20k-100k per store (or 10-50 units per 1m people), there is a 75-150 store opportunity given the current middle-class size.

[15] A combination of poor incentive alignment and capital discipline: Senior management only owning a small portion of the company. It also seems as if very few questions were asked about capital allocation and this has meant sub-optimal resources allocation.

[16] One can speculate that a few locations are poorly-chosen and there will be onerous lease obligations to close these down.

[17] Management is seeking specific approval to issue up to 30% of the share base each financial year.

[18] A significant portion of the board has been replaced by more experienced directors. There is a skew towards the US-based fund’s choices however I am comforted that, at least, their capital is also at risk. Capital discipline at the store level will go a long way to improving returns over the medium term. 

[19] Yum Brands has 321 Pizza Hut units in South Korea and 231 units in Saudi Arabia!

[20] We also share a similar investment philosophy and, in some cases, have invested in the same businesses.

[21] NAV = Net Asset Value (the most useful metric to understand Conduit’s Intrinsic Value)

[22] Net Worth or Net Asset Value (NAV) represents assets (investments) plus cash less liabilities and is the best measure of net worth (according to accounting rules) to SaltLight shareholders. The NAV is divided by the number of class A shares outstanding