Archived 3Q 2017 Letter

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 Fellow Shareholders,

This quarter has been a particularly difficult one to digest. As political and economic realities become evident, Mr Market has been in a fearful mood when it comes to South African-focused stocks. Contrast this to the constituents of the large-capitalisation indices that have prominent offshore exposure, and times have never been better[1].

SaltLight’s loss in net worth per share for the quarter was [redacted]. The JSE All-Share Total Return index grew +8.9% for the quarter, a differential of [redacted].

I was reminded of this quote from Charlie Munger when thinking about the market’s vagaries:

“I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” – Charlie Munger

In this letter, I will briefly update you on some of the results from investees and then provide a second instalment on my thoughts about CalgroM3 – an investee I wrote about in June. I have prepared a detailed case study on CalgroM3 which is available on the SaltLight website.

But first, here are some pleasing updates:

Investee updates

  • Trellidor released FY results with our share of earnings growing +27%. I had a lengthy meeting with the CEO Terry Dennison a few weeks ago and I could not be happier with the management team and the business’s future prospects. Trellidor is valued at 8.6x trailing PE.
  • Combined Motor Holdings, our vehicle retailer,announced an interim-results trading update indicating that our share of earnings would increase between 5% and 15%. If one annualises the top-end of the guidance, CMH is trading at a 9.3x trailing PE.

Despite the difficult economic environment, industry-wide vehicle sales are starting to improve. Many customers have simply delayed the inevitable upgrade of their aging vehicles and are starting to return to the dealerships.

  • Master Drilling released their first half results with our share of headline earnings growing 4.8% in USD. The company continues to grow its earnings power through investment in capabilities to offer mechanised horizontal boring.

70% of mining activity is in a horizontal direction and mining methods are stuck in more labour-intensive approaches. Meaningful returns on capital will take some time, however it will be worth the wait. Master Drilling is currently trading at 7.4x trailing PE.

  • Howden Africa released their first-half results growing our share of earnings by 31%. Howden retains 35% of their market cap in cash. When excess cash is stripped out, Howden is trading on a 6.7x trailing PE.

It is apparent that our investees continue to grow despite the difficult environment, yet Mr Market ascribed extremely low valuations to them. In some cases, I have added to our holdings.

CalgroM3 Holdings – Part II

In my last letter, I gushed about Calgro and wrote: “Our entry price assumes some risk in the short term but over the long term we are happy to be part of this journey”. This statement has proven rather foretelling as Calgro’s share price declined 19% this quarter and dampened our overall portfolio result.

It is my experience that contextualising short-term price movements against a long-term investment perspective sanitises the human tendency to panic – price declines always test one’s conviction.

I have included some questions and answers that I think are pertinent to the investment case. The primary risk in investing in property developers is a significant drop in demand due to a housing bubble or economic crisis. The result is that the developer is left with unsold inventory and still has debt obligations outstanding. This usually results in a permanent capital loss for equity investors.  

1) What are the risks of demand drying up over the long-term?

In the insightful book, Capital Returns by Marathon Asset Management, the authors make the point that demand forecasts have “a wide margin of error and are prone to systematic biases. In good times, the demand forecasts tend to be too optimistic and bad times overly pessimistic”. The authors argue that it is more fruitful to focus on supply dynamics rather than demand forecasts. These metrics are less uncertain and distinctly easier to forecast.

  • My research data indicates that supply of affordable housing has been relatively consistent at 40,000 units per year since 2009 – this is 50% lower than the pre-2009 annual supply[3].
  • The ANC-led Government has a significant challenge in providing housing. If the government is to meet the challenge of rising urbanisation and growth of home ownership, the only solution is to develop mega projects (> 1000 units) and contract out the work to large-scale developers such as Calgro.
  • A conservative estimate of nationwide demand is estimated around 700,000 units and Government has gone as far as estimating the need at 2 million units. For perspective, Calgro – the largest developer – is currently producing around 7,000 units and its next largest competitor currently is producing 3,000 units per annum.
  • Even if I haircut the conservative demand estimates by 50% – the addressable market is significant.

It is apparent that there is little evidence of a housing bubble or over-supply to meet one. In fact, competition has reduced in the last few years through the collapse of RBA Holdings[4]. Civil construction competitors also do not seem to be entering into the affordable housing market. 

2) What about competitive advantages and reinvestment dynamics?

  • Cost Advantages: Calgro has focused mainly on the Gauteng and the Western Cape provinces, however it is slowly starting to dip its toe in the Eastern Cape and Kwa-Zulu Natal. An interesting situation is that Kwa-Zulu Natal affordable housing development costs 63% higher than Gauteng and the Western Cape[5].

Encouragingly, in the markets that Calgro operates in, it has managed to curtail affordable housing development costs considerably. This is a significant opportunity for Calgro to bring its scale economics to lower the housing cost for buyers and the public purse.

  • Scale Economics: With mega-developments of this size, an integrated developer such as Calgro is able to produce units at a lower cost than a competitor. Scale economics create a wonderful feedback loop where lower costs are shared with customers (either through lower selling prices or providing neighbourhood-enhancing investments[6]), that in-turn attracts more customers.
  • Reinvestment dynamics: It is apparent that Calgro can continue to deploy capital at high rates of return on each rand re-invested. In the last five years, capital has been redeployed at a 27% return.

3) What are the risks to the long-term thesis?

I believe there are three types of risks that Calgro is facing: (1) cyclical economic risks, (2) structural economic risks and (3) self-inflicted risks.

Cyclical economic risks

Property development is cyclical in nature. In my last letter, I said:

 “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.”

The economic cycle has been a headwind to property demand since 2012. It is normal that economic cycles, particularly credit cycles, will impact housing developers. The recent interest rate cut might alleviate distress on disposable income. However, as I mentioned above, banks are likely to tighten lending if they believe job-losses are imminent. This is a risk in the short term and it could mean that Calgro is not able to execute on its pipeline as rapidly as anticipated.

Cyclical risks are to be expected and we should not be overly concerned if we are deploying capital over a 10-year period. I believe that the existential advantage to Calgro’s business model is that it only starts construction of a unit once it is sold. This prevents unsold inventory ‘sitting on the lot’ and reduces capital at risk. If there is a detrimental slowdown, Calgro could simply ‘mothball’ their projects for a year or two and reboot the system once the economy recovers. Furthermore, if mortgage lenders are cautious to provide loans, these potential buyers could also become tenants to Calgro’s new REIT business.

2) Structural economic risks

Calgro’s primary customer base is the emerging middle-class consumer and government institutions. Through discussion with management, a significant portion of private-sale customers are public-sector employees that work for government or SOEs in some capacity.

Over the last ten years, this market has grown by 600,000 employees[7]. The result is that the civil service has ballooned and the sovereign fiscal position is under strain. Therefore, a significant chunk of Calgro’s earnings power is exposed to the fiscal status of government on the subsidised government units –  as well as the private units.

A ‘Doomsday’ scenario that could be considered is a IMF intervention should the fiscal deterioration get worse. Whilst this scenario, at present, is unlikely; it would be prudent to contemplate how Calgro could be affected and what management could do to mitigate the damage.

It is quite likely that austerity measures would force government to cut the civil service bill and social spending. Given Calgro’s indirect exposure, non-contracted pipeline revenue would be affected.

Calgro has recognised this risk and is slowly transitioning some production to a co-owned REIT fund. This will convert some lumpy revenue into annuity rental income.

3) Self-inflicted risks

History is replete with failed property developers caught out on the wrong side of a property cycle. The usual cause of death is the poison of unsustainable leverage. Despite Calgro’s financial and operating structure, this risk could cause permanent capital loss.

Currently, Calgro’s leverage is moderate and well managed. However, management have indicated that they are seeking to raise international development financial institution (DFI) debt. Whilst in most cases, this type of debt can be advantageous because these lenders have social as well as financial considerations – it is still debt. Currency and refinance risk will have to be carefully managed.

In my discussions with management, they have consistently been considerate about the funding structure of the entire business. It gives me some comfort that management are significant owners of the business and that the CEO was around in the difficult GFC years.

In 2008, Calgro experienced a tumultuous period during the global financial crisis and saw first-hand what a bank-lending freeze can do to business. Management learned many lessons and the most important was to manage operational and financial leverage inherent in the business.

I will assess the loan terms should the DFI loans be taken up and reflect on our risks carefully.


Calgro has some favourable ‘circuit breakers’ should conditions deteriorate significantly. Management has indicated the following actions could be taken in a significant scenario:

  • 60-70% of the cost base could be shut down in 90 days:Employee and sub-contractor agreements all include a 90-day exit clause (including the management team). Staff are paid on the top-end of market remuneration to compensate for this ‘optionality’.
  • Orderly management of debt obligations:  Calgro’s debt is issued in the debt capital markets and is structured as unsecured debt. Whilst this point might be trivial even to the most seasoned banker; in a distressed scenario, it is better for all debt holders and, importantly, for equity shareholders.

Many property developers raise debt from banks on a project-by-project basis and offer their most promising asset as security in return for the lowest interest funding cost.

In the event of financial distress the bank will ‘call’ the loan and if the company is unable to settle the debt, it will take possession of the asset and sell it. This is an advantageous situation for the bank as their risk is mitigated however the situation is disadvantageous for unsecured debtholders and equity shareholders.  They have lost their income-earning property which means that they cannot monetise the property by building and selling off units. 

Calgro’s ‘all unsecured’ debt structure facilitates a group-based recovery process. Funders could participate with Calgro in developing units to be sold which could recover some of the debt owing.

The gap in price and value can last for long periods of time and what really matters is the underlying business performance of the company. Over time, share prices catch up to business performance. Calgro has reported a trading update indicating ‘core earnings’ up 18% for the interim results. I continue to believe that the business has favourable long-term prospects in the context of South Africa’s opportunity set. The conditions for traditional industry-centric risks for property developers such as over-supply, or a housing bubble do not appear to be on the horizon. Most of the downside risk appears to be in significant austerity measures or a self-inflicted misstep.


My next letter is likely to be after the planned ANC-elective conference – if it goes ahead. We will hopefully have a clearer indication of who the likely SA President will be and perhaps some uncertainty will be out of the system.

I am looking forward to seeing all shareholders at our AGM in November. Please do let me know if you wish to invite any guests.

Once again, thank you for your continued support and long-term perspective.

[1] The top five constituents constitute 39% of the index (Naspers, Richemont, British American Tobacco, BHP Billiton and Anglo American)

[2] removed

[3] Source: Statistics SA, Housing units completed for a size less than 80 m2 or 860 ft2

[4] RBA Holdings had a non-integrated business model and acquired already-serviced plots at higher prices.

[5] Source: Statistics SA, in cohort for dwellings completed < 80 m2: Kwa-Zulu Natal has a R9,100/m2 cost vs. Gauteng R4,300/m2 and Western Cape R5,600/m2

[6] Investments such as schools, public parks or libraries

[7] Source: Statistics South Africa