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.
Year-end Letter: 4th quarter for the financial year ended June 2017
SaltLight Capital is an investment holding company that seeks to invest your capital for the long term with the objective of growing net worth[1] per share on a sustainable basis. Capital is allocated to a concentrated selection of my best ideas in wonderful businesses with durable competitive advantages, competent and trustworthy management who run their businesses with sound long-term principles.
SaltLight’s provisional[1] net worth per share grew by [redacted] (or [redacted] in US Dollar terms[2]) for the year. When measured against the JSE/FTSE ALSI index (with dividends) return of +1.69%, our relative outperformance was [redacted].
This marks the second financial year of operation for SaltLight and is reflective of twelve months of operation from July 2016 to June 2017. As a reminder, our financial year-end is June each year.
The last year has been a tough year in South Africa’s history. ‘Grey-haired’ readers will most likely relate the present times to the terrible 1980’s. Business and consumer confidence is at a cyclical low. Political uncertainty is its highest since the democratic elections in 1994. If an investor had purchased an ETF linked to the JSE ALSI index three years ago, the total return over this period would have been +10.63%. The economy is now in a technical recession and the widely expected credit downgrade happened.
Yet, despite the negative data, the currency has appreciated 10% relative to the USD and the JSE’s all share return has not fallen as drastically as many had predicted. Most macro forecasters who predicted these outcomes were correct in their forecast, yet markets have not moved as anticipated. Forecasting the future on headlines, political outcomes and macro events is awfully difficult.
How should an investor traverse this environment? Have a robust investment process, understand the long-term opportunity set, deploy capital in outstanding businesses and remain patient.
We currently hold 11 wonderful businesses and 10% of assets in cash for future opportunities.
I have a sign in my office that whispers to me every day: ”patience, discipline and intellectual honesty”. Part of intellectual honesty is learning from mistakes. At the end of this letter I write about a post-mortem on one of my mistakes during the year.
Accounting rules dictate that we mark our asset values to the current traded price rather than the intrinsic value of the businesses that we own. Therefore, if Mr Market is feeling depressed, we have to mark out valuation to his depressed appraisal of the company’s value. Over time, across his moods, valuations should approximate growth in intrinsic value, however a point in time comparison might yield differing outlooks.
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SaltLight’s investment philosophy
In our 2016, I reflected on how South African markets have endured far worse times than the present environment. Reading the letter again, one year later, it feels as if the same issues remain today. I expressed that SaltLight’s method of operation “sows in times of trouble and reaps in times of plenty”.
Like many ‘value investors’, my investment process is influenced by the writings of Ben Graham where he advocates two key investment concepts: (1) having a ‘margin of safety’ in any investment and (2) thinking about the long term by imagining being a ‘business owner’ – rather than a market trader. In my experience, it is far more fruitful to view opportunities at the business or industry level rather than focusing on macro factors.
As a reminder, my criteria for investments are as follows:
- A quality business that I am able to understand and have a reasonable assessment of long-term staying power;
- A long-term prospect of durable competitive advantages that will continue to grow;
- A competent and ethical management team who operate with all stakeholders in mind;
- A favourable price which is at a discount to intrinsic value.
The South African investment opportunity set
I recently compiled a lengthy document that contains my thoughts about the long-term opportunity set in South Africa. Shareholders may access the full presentation. Whilst not a compendium on every opportunity in the country, there are a few that I really find interesting: (1) housing (2) education (3) transport (4) transactional ability and (5) lifestyle and experience consumption. You will notice that these are rather ‘basic need’ opportunities. Compared to developed-market opportunities in technology and biomedical products, they are rather boring. Yet these are the opportunities, I believe, that are going to continue despite the headlines or who sits in the President’s office. Of course, the short-term economic cycle will determine the pace at which these opportunities unfold. However, over time, many fortunes will be made in solving these very basic needs of South Africans.
I must add a caveat that we do not hold exposure to all of these opportunities. Many of the identified opportunities are well recognised and Mr Market is fully appraised of their existence. Allocating capital to these opportunities is highly dependent on being available at the ‘right price’ (or item 4 on my list above) and a business having the right competitive moat to withstand new entrants.
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Our investments
Despite the poor environment, our investees have done a wonderful job in navigating difficult conditions. The majority of our investees are exposed to the domestic economy. Mr Market’s depressed mood regarding domestic companies has led to earnings to be at cyclical lows and value continues to emerge.
Mr Price (MRP)
Mr Price reported its full year earnings during the last quarter. The results were largely in line with my expectations of a difficult trading year. Earnings were down 12% on the back of some poor fashion decisions, unexpectedly warm weather and heavy discounting from competitors. I often get asked about the increasingly competitive retail sector as well as the threat from ‘digitisation’ of retail:
- The apparel sector is starting to show terminal casualties; most of the pain is starting to emerge in high-end retailers. Stuttafords, the iconic department store, is closing its remaining stores in August and international retailers – Nine West and River Island – are exiting South Africa completely. Local competitors continue to be allured to greener pastures in developed markets by allocating capital at lofty multiples. One South African investment firm has already had to write down their recent European retail investment significantly.
My thesis continues to be that Mr Price has rare capital efficiency and pricing advantages relative to local and offshore competitors (see 2H17 Letter here for more detail). The management team is first class and are simply sticking to their knitting in widening their South African moat. At year-end, our return on capital was +20%.
- There is no doubt that e-commerce, in the long-term, is a threat to physical retailers. Yet, online retailing in South Africa is still a frontier enterprise and only represents 1% of South African retail sales vs. 10% in the US; 13% in China and 5% in Brazil. There are a number of challenges to further penetration: (1) customers are not comfortable with experience (2) most internet usage is via mobile phones where high data costs are a barrier for lower/middle income consumers (3) existing firms are loathed to invest in e-commerce infrastructure and customer acquisition costs and (4) ‘disrupter’ e-commerce retailers are unable to build the necessary scale to have a pricing advantage. So where does Mr Price fit in?
Mr Price is, by far, the farthest down the road for e-commerce disruption having invested significantly over the last few years. Its sales platform is fully omni-channel, has low delivery charge minimums and does not have all the ‘frictional’ elements that its competitors do. Most of all, their pricing is significantly lower than the most established pure-play ecommerce retailers. Disruption headwinds are likely to be a few years away.
Combined Motor Holdings (CMH)
CMH has been an investee of ours since last year. I’m mentioning CMH to illustrate that macro factors often do not dictate investment returns. CMH is a traditional vehicle retailer offering major brands across its dealerships. The vehicle sales market has had an extraordinarily rough time where total sales volumes have not passed levels last seen in 2007. Despite this, CMH’s headline earnings per share has a compounded growth rate of 19% over the last five years. CMH has been a major contributor to Saltlight’s growth in net worth.
CMH has strong owner-managers that run a scaled dealership platform which requires minimal capital to operate. This robust cocktail creates wonderful competitive advantages and a source of cash flow for SaltLight that I reinvest into new opportunities.
- Owners not managers: CMH’s management have significant interests in the business whereas competitor’s managers are employees of divisions in large industrial companies. The CEO, Jebb McIntosh and his team, have applied many lessons learned from the 2008 crisis by diversifying into a car hire business and offering ancillary financial services to their customers. Rather than being ‘brand collectors’, they actively manage their portfolio of brands to ensure returns on capital are maximised.
- Scaled dealership platform: The passenger dealership market has an oligopoly structure with a fringe of small independently-owned dealers who enter and exit depending on the ‘boom’ or ‘bust’ period of the economic cycle. Economies of scale through a national footprint creates a strong position to negotiate with manufacturers. Benefits include generous working capital terms offered by the manufacturers that are not available to smaller independent dealerships. Competition amongst the larger players is limited as brand manufacturers dictate the geographical location where a dealership may operate. The captive customer base allows CMH, in addition to selling new and used vehicles, to create annuity revenue by offering vehicle maintenance services and selling spare parts. On top of this, CMH offers ancillary services such as insurance and extended warranties to customers coming through the door.
- Minimal capital required: Due to favourable working capital requirements, investment needed for growth is limited and therefore management returns capital through frequent buybacks and dividends.
CMH has a ROE[5] of 28% across the cycle. I am expecting growth in vehicle sales for the next few years could be muted as long as consumer confidence remains low, however there are continuing opportunities to grow earnings in ancillary services. Our entry price continues to offer optionality for when the vehicle sales recovery does eventually happen.
A new addition – CalgroM3
Since the beginning on this year, I have been slowly building a position in CalgroM3. Calgro is an affordable housing developer operating in a market that I noted in the SA opportunity set presentation mentioned above. The SA Government estimates that there is a shortage of 2m houses in the affordable housing segment. Roughly 700k households are able to afford their own – if they are available at the right price. Last year, only 40k houses (including affordable houses) were developed – there is a long runway to solving this problem. However, investing in a housing developer can be hazardous business. Developers often run into overstock problems and suffer from high debt loads when the housing market turns. Fundamentally, developers are project-driven and therefore there is little earnings power beyond existing project pipelines.
Calgro has an entrepreneurial management team; a sustainable business model and strong competitive advantages relative to other property developers.
- Management team: The Calgro management team have pioneered a successful business model to create scaled developments in partnership with government. Their developments can run into 10,000 units for buyers across the income spectrum. Management have often proven their ‘conscious capitalist’ tendencies in dealing with the communities that they build in.
- Sustainable business model: Calgro mitigates many of the structural developer risks by buying land cheaply and only developing a unit once it has been sold. The risk in a slowdown remains in land and infrastructure investment however there is unlikely to be a significant inventory of unsellable units. Annuity revenue will grow over time as:
- Undevelopable land is being re-purposed to be sold as burial plots;
- A REIT has been formed in a JV with SA Corp to develop units for the residential rental market.
- Strong competitive advantages: Government has a strong motivation to deliver housing and therefore they are likely to partner with developers who have a proven track record of producing large-scale developments. A strong reputation and availability of capital to fund developments would be a significant barrier to entry.
It is possible that sales over the next few years could be muted if banks tighten lending criteria, however there is a 76,000-unit pipeline which will provide revenue for the next 7-10 years. Our entry price assumes some risk in the short term but over the long term we are happy to be part of this journey.
Post mortem on Extract Group
Our return would have been approximately 1.9% better had it not been a mistake that I should have avoided. Unfortunately, my human misjudgements are likely to be a continuing feature of this business. Thankfully, the ‘cost’ in this case was relatively limited however it’s definitely left a black eye and I’m still nursing it. It now is a strong candidate for my “wall of shame”.
Last year, I purchased a small holding in Eqstra for our Special Situations portfolio. Eqstra was selling at a significant discount to its assets and had two good businesses and one poor mining equipment business called MCC. ENX, another listed industrial company, purchased the two good businesses and recapitalised Eqstra. The remaining Eqstra was renamed Extract Group and resultant size was significantly smaller once the other two businesses had been sold.
A common profitable investment strategy is to buy ‘spin-off’ shares. Often, large institutional shareholders do not want these shares and sell them irrespective of their fundamental value. In this case, the selloff was exactly what happened and if one believed the balance sheet values, Extract was selling at a 50% discount to its already-impaired assets. The hefty discount was a temptation I could not bear and I bought some more.
Six months later, I was covering my head with falling knives. In March, the company released a scarlet letter to shareholders indicating further impairments to its assets; that its CEO was leaving in a hurry and it had arrived at a third iteration of a strategy to create shareholder value. I immediately sold our entire shareholding which unfortunately led to a permanent capital loss of 53%. Fortuitously, however, the position was small due to its potential downside risk. However, I completely misjudged how perilous the downside risk could be.
There are some lessons to be learned:
- Failure to acknowledge the primary assumption could be false: The entire investment thesis held together on the premise that the asset values were correct. I had taken steps to visit the company and view the assets. It was hard to believe that they were worth what the market was valuing them at. Ben Graham in Security Analysis talks about the risks when relying on fixed asset values, “often the accounting value bears no relationship to the figure at which they can be sold”. This turned out to be the case as the assets could not be put to use in this difficult mining climate nor could management find a willing buyer.
- Failure to recognise the effect of more than one negative event happening:Peter Bevelin, in his thought-proving book “Seeking Wisdom” has an interesting question when thinking about downside risks: “what are the consequences if I get two or more negative forces acting in concert against me… what are the consequences if things go from bad to worse”. There were early warning signs that I should have appreciated more. Firstly, in December last year, the company got into a significant dispute with a customer in Botswana which lead to a profitable contract being cancelled. This meant additional idle equipment and a loss of cash flow that could have helped the business. This added financial stress eventually leading to capitulation where management no longer had the energy to fix the business.
- Failure to understand that management were fighting for their life too: the management team was a competent team. Unfortunately, they had not recognised the state of their industry and it was a long shot to turn around the business. I misjudged how dire the mining equipment sector really was.
It is almost a certainty that there will be more mistakes in future. Our special situations investments will always have an element of risk that exceeds our ‘generals’. However, my primary objective is to ensure that the payoffs warrant the risk taken.
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Despite the headlines, I am an optimist on the future of South Africa and its role in the African continent. There is some really interesting value emerging in local businesses with valuations offering pleasing potential future returns.
As a reminder: I have the majority of my liquid assets in SaltLight on the same terms as you and I bear the ups and downs as you do.
I look forward to any questions or comments that shareholders may have. I will be communicating in the next few weeks the relevant dates for the SaltLight Capital AGM as soon as I have some clarity on when the auditors will have completed their audit.
[1] These numbers are provisional and subject to a year-end audit.
[2] Source: Poundsterlinglive.com (ZARUSD R14.50/$1 on 1 July 2016; R13.06/$1 on 30 June 2017)
[3] Link: http://www.saltlight.co.za/wp-content/uploads/2016/07/2016-Investor-Letter.pdf
[4] Link: https://tinyurl.com/y8cep3mb
[5] Return on Equity
[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 (NAV per share) to obtain how much of net worth belongs to each holder of a share. Accounting net worth will differ to intrinsic value.