Archive 3Q 2019 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.

Dear Shareholder,

A reputation once broken may possibly be repaired, but the world will always keep their eyes on the spot where the crack was. – Joseph Hall

During the third quarter, SaltLight Capital generated a decline in net worth per share of [redacted] vs. the JSE ALSI (with dividends) index decline of -4.57%. Our YTD returns are [redacted] vs. the JSE ALSI TRI +7.09%.

I recently attended a results presentation where the company’s acclaimed CEO, with an extensive track record of building businesses, lamented that institutional investors no longer acted like ‘partners’. Instead, he declared, investors preferred to focus on ‘tick box exercises’ such as corporate governance reports that do not generate ‘real profit’ (he also alluded to something about the market significantly undervaluing his company).

I respect our CEO’s sentiments but also sympathise with our institutional colleague’s inquisitorial aims in validating corporate governance structures. In a recent article penned by Peter Armitage[1], the author catalogued twenty high-profile domestic companies that had significant share price declines in the last two years.

Three of the twenty names (the “terrible three”) had unconscionable levels of impropriety with Steinhoff achieving the accolade of being the second largest corporate fraud ever![2]. Given a 1 in 20 chance one of these stocks are in a domestic portfolio, investors are justifiably twitchy about how domestic companies are being run.

In the case of the ‘terrible three’, time has revealed that the ‘tick box’ corporate governance disclosure requirements were of little help to shareholders. However, there were some common threads that might have prompted more questions:

  • A company run by a ‘halo’ CEO or influential ‘midas touch’ shareholder providing significant credibility that tamed difficult questions being asked;
  • Complex and opaque accounting disclosure and;
  • A quantifiable marker: declining returns on invested capital.

Faced with declining returns on capital, management resorted to accounting manipulation to mould the results to appear rosier. I would argue that some of these unabashed creative accounting techniques would have made even Enron’s accountants blush.

Poor Capital Allocation

In the seventeen other cases, ‘bad luck’ played a role however, without a doubt, there was a common thread of poor capital allocation decisions – particularly in ‘big ticket’ international M&A transactions. Institutional investors should not be the first to cast stones at management on this criticism; much of this offshore M&A was actively cheered (dare I say, prompted) by SA institutional pension funds as a means to increase non-SA exposure[3]. Moreover, what CEO would protest against the prospect of a larger, more internationalised, empire to run?

‘A Market for Lemons’

Our grumbling CEO has indirectly asked a pertinent question: why are investors waiting on the side-lines and still avoiding what is an obviously cheap market? I offer up one possible explanation…

George Akerlof, a Nobel Prize winner for Economics directed his research to attempt to answer the underlying phenomenon. His notable paper titled “The Market for Lemons[4] hypothesised that there is a real ‘economic cost of dishonesty’ for a market. Akerlof uses the case of transaction involving the sale of a used car where the seller usually has more information than the buyer about any potential faults with the vehicle. Naturally, to reduce the risk of uncertainty, the buyer simply discounts the price to account for the prospect of the vehicle being a ‘lemon’. It is a familiar heuristic that as soon as a new car is driven off the dealership floor, it loses a percentage of value. The result is that not only do the ‘bad actors’ pay a cost, but so do the honest actors pay for the bad apple’s mistakes…. “the bad cars tend to drive out the good… in much the same way that bad money drives out the good”.

SA Inc… Permanent Lemon?

SA Business Confidence Index[5]

It is perhaps my greatest fear that, over the long term, South African companies permanently attract a risk discount from market participants in a similar manner that a ‘kleptocracy discount’ is applied to Russian domestic companies.

Many investors allocating capital to Russia are forced to ask some disagreeable questions that are not necessary in developed markets: ‘will I be able to get my money out?‘, ‘can a politically connected actor steal the company from me?‘, ‘can I trust the legal system?‘, ‘are the financial accounts real?‘. I would argue that an investor allocating capital to China and other frontier markets is also required to ask the same unsettling questions.

But are these questions necessary for a domestic or foreign South African investor? In my opinion, over the last century, these questions would have been unwarranted. Our private sector was seen to have excellent management, dependable financial reporting and a reliable government. So… has this all changed?

Warren Buffett famously said: “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently”. The Zuma era certainly shepherded in an unpleasant odour. The stink, however, appeared to dwell when four fateful words were uttered by President Ramaphosa immediately after being elected by his party, ‘land expropriation without compensation’. Even the hint of a challenge to property rights simply increased risk premia across the board. You can draw a line in our results from the point when he uttered these disastrous words in December 2017. Calgro, as an example, has felt the brunt of the property rights uncertainty and has been the largest detractor to portfolio performance. These were ‘five minutes’ that cost billions.

However, since the national election in May this year, the issue appears to have genuinely dried up. The government has indicated land reform is likely to be carried out in a constitutional manner leaving the ‘Zimbabwe risk’ as a remote scenario. Interested readers can read the advisory panel report here[6]. However, the ‘twenty years’ reputation rebuild process now has to restart.

Acknowledging the Problem and Rebuilding Trust

Today, the zeitgeist has thankfully moved onto more mundane challenges such as State-Owned Enterprises reform and fiscal budget management. If you have recently visited South Africa, one would quickly observe that across the domestic airwaves, the Ramaphosa administration has been exposing the nation to commissions of inquiry on a range of issues[7]. In the business press, companies engaging in improper behaviour have been vociferously exposed. Company Boards have become steelier with contentious management being swiftly removed.

Many, however, feel that the dramatic revelations imply that the entire system has become somewhat damaged. However, our feelings differ. We believe that the fact that the public are becoming aware of improprieties is a good thing. These processes have been a cathartic adjustment to the political and economic system to build up trust again and, hopefully, remove Akerlof’s ‘economic cost of dishonesty’. Until this happens, Mr Market will justifiably discount South African prices.

Making Lemonade

How does SaltLight, in light of this context, deploy capital to generate investment returns?

A few years ago, I picked up a book called “The Score Takes Care of Itself” by Bill Walsh. Walsh was an iconic NFL football coach that had a management philosophy that I readily identified with. As a South African, I must admit that I don’t always understand the American Football terms and personally prefer the game of rugby (why do NFL players need all those pads?). What I do appreciate is Walsh’s idea that if you create an organisational culture with a focus on processes with high performance standards – the score will eventually take care of itself.

SaltLight’s investment process can be painfully slow. It is not uncommon to take one to two years of research before executing a position. This has meant that I’ve occasionally committed mistakes in omission for no other reason than not having completed enough work on the investment. On a portfolio basis, this has probably cost us a few basis points of returns, but it has also meant that we have avoided some of those twenty ‘casualties’ that Armitage wrote about. I have researched, in the past, over half the names on Armitage’s list and, thankfully, decided not to deploy our capital into those names.

SaltLight’s process is underpinned by the Russian proverb, trust…but verify. For us, this involves verifying our hypotheses through customer and supplier interviews, independent data verification and importantly, recalibrating financial accounts to their economic essence.

Our fundamental bet is that South Africa will not be a ‘permanent’ lemon; the discounts currently available today are simply unwarranted. I am finding immense value in unloved corners of the market. Many of our investees are growing, despite the economic challenges that have existed over the last five years. These are the times when it is appropriate to diligently deploy capital. It must be remembered that, despite the events of the last five years, South Africa has only had two negative quarters of growth since 2008.

For the patient investor, the market offers an unwarranted discount of a dollar for 70c.


[1] Source: https://anchorcapital.co.za/article/?sas-corporate-meltdown-billions-of-rand-vaporised

[2] US$30bn in lost value with the worst fraud being Enron of US$60bn

[3] A contributing factor was the unforeseen consequence of exchange control regulations: fund regulations limit the offshore exposure of a domestic pension fund to 30%. However, if a SA domestic company went ahead and spent say 50% of their market cap on an offshore acquisition, the rules dictate that exposure would still be counted as a domestic investment.

[4] Source: George Akerlof, The Market for Lemons: Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3, 1970

[5] Source: Bureau of Economic Research, RMB/BER Business Confidence Index

[6] “Final Report of the Presidential Advisory Panel on Land Reform and Agriculture”, https://www.dropbox.com/s/jz0urit3aa94hw4/panelreportlandreform_1.pdf?dl=0

[7] Topics have ranged on state capture, tax administration, the fourth industrial revolution, the administration of the government employee pension fund