Can you believe we’re in the last month of 2019? Seems like yesterday Value Hive was born. Oh how time flies …
Anyways, we’re deep in the throes of Holiday season. Lights are up, stockings hung. Here’s what’s in store this week:
- Media investment guides
- Thoughts on South African investing
- Warnings from Brookfield
- White-paper on Margin of Safety
Pause that Christmas classic, Diehard, and dive in.
December 4, 2019
It’s Beginning To Look A Lot Like Spending: Black Friday shoppers spent a record $7.4B in the second-largest online sales day ever. The spending fell a close second to 2018’s Cyber Monday sales. Also, ‘Small Business Saturday’ onlines sales jumped 18% this year.
Here’s the funny part. Shoppers didn’t start spending on Friday. They were busy hitting ‘Buy Now’ while at the Thanksgiving dinner table. Thanksgiving day sales reached $4.2B.
I guess we are a consumer-driven society.
Investor Spotlight: Everything Has a Price … A Media Guide
Andrew Walker’s at it again. In a pre-honeymoon effort, Walker penned his thoughts on all things media investments. As someone whose long a media investment (FOX), I found this post very valuable. Also, congrats to Andrew on getting married!
I’ll cover the highlights, but I encourage you to read the entire piece. This is only the intro post. Andrew’s whipping out a “Part 1” … and I assume at least a Part 2. We’ll make sure to cover those here as they’re released.
Cord-Cutting: The Negative Flywheel Effect
Before diving into specific companies, Andrew discusses cord-cutting. His reason is simple. Many non-media “experts” don’t understand the concept. Here’s Andrew’s first principles definition of cord-cutting:
Cord cutting is, at its most basic, pretty simple: households who used to subscribe to the legacy cable video bundle are increasingly dropping that package and choosing to just buy broadband from their cable provider. For video, they’re choosing some combination of Netflix, free youtube videos, or maybe some other DTC products (like Disney+, HBO Go, etc.).
Andrew created a simple model to explain the negative flywheel effect. He created a world with three channels (sports, news and entertainment). Each channel cost $10/month to subscribe.
Here’s where things get interesting. Different channels have different values, depending on the subscriber. Andrew fleshes this idea out, saying:
So customer 1 values sports at $50/month, news at $12/month, and entertainment at $11/month. In total, the value is worth $73/month to him, yet he only pays $30/month, so he gets $43/month of value from the bundle. In contrast, customer 2 doesn’t care about sports, but he really likes news and entertainment ($26/month).
Using this logic, if the price of the bundle costs more than its value to the customer, they’ll unbundle.
Another Problem: Value & Price Gap
That’s not the only problem. As Andrew shows in his example, subscribers (on average) value sports at $18/month. Yet the sports media charges $10/month. There’s a value gap and sports media will push for increased prices.
This is where the negative flywheel comes in. After raising the prices for sports media, the total package (bundle) now costs more. This leads to more people dropping off as the value is less than the cost.
Andrew says it perfectly: “However, the value delivered to customers of the bundle never changes, so as the overall bundle’s pricing increases it continues to price out marginal subs. Each channel is stuck raising prices just to try to maintain a flat revenue base, which causes the price of the bundle to rise even further and pushes even more people out.”
Some Stocks Mentioned (They’re Cheap!)
Andrew mentioned a few, cheap media stocks: CBS, FOX and LGF.
CBS trades at 5x earnings …
FOX at 14x earnings …
And LGF at 2.5x EBITDA …
Movers and Shakers: Tread With Caution (Brookfield & South African Equities)
This past week we read two reports issuing caution. First, Brookfield Asset Management says their more cautious than they were in 2009. Then, Ashmore Investment Management released a brake-pumping report on South Africa.
But we’re value investors. We’re greedy when others are fearful. We’re not scared! But should we be?
Brookfield Ain’t All Roses and Dandelions
Brookfield CEO, Bruce Flatt made a bold claim this week. He said (emphasis mine), “it’s inevitable there will be a recession in developed markets at some point in time.”
Flatt really went out on a limb with that prediction, didn’t he.
Brookfield’s positioning themselves in reaction to Flatt’s stance. The company’s holding more “dry powder” on their balance sheets than 2009. Remember, Brookfield has $500B in AUM. That’s a lot of dry powder.
Protection with Diversification
Flatt’s a big proponent of diversified assets. He went so far to say that Brookfield’s success, “hinged on being highly diversified”. They’re industry agnostic, not favoring any particular asset class. Flatt notes that if one asset class gets crowded, they can go elsewhere:
“If many people are bidding up infrastructure in a certain country, we just don’t participate. We have 29 other countries we can go to, we have three other businesses. So we can ebb and flow our capital and therefore we’re not forced.”
That’s not the only word of caution we saw this week.
Ashmore: Beware of African Equities
We like to go where others won’t in search of value. One of those places is South Africa. We’ve highlighted Rudi Van Niekark’s South African fund here before. Like Rudi, we’re finding a ton of cheap SA equities.
But should we tread with more caution? Ashmore Investment Management thinks so.
South African markets are cheap, but well behind the rest of the world (ROW). Check out the below figure:
As you can see, African equity markets make up 1% of the global market cap. Yet they account for 14% of the world’s population and 5% of global GDP.
On average, African equities generate 22% ROE, sport 5% dividend yields and trade at 9.1x P/E ratio. Ashmore also dives into the unique youthfulness of the country, using it as a bright spot for future investment. Here’s three consequences of African’s younger markets:
- African stock and bond markets are almost identical in size. This is much different than other, more developed economies where bond markets trounce equities.
- Eurobonds make up larger share of total bonds (23%). This compares to the average emerging market (EM) country’s percentage (18%).
- Corporate bonds make up 30% of total Eurobond market in Africa. This compares to EM average of 72%. Quite the difference.
Holding all else equal, Ashmore thinks investors can expect:
- Faster relative growth in fixed income compared to stock market
- Faster relative growth in local fixed income compared to Eurobonds
- More rapid growth in corporate debt markets than sovereign debt
The Seven Horsemen of African Markets
But there’s a price to pay for this expected faster growth. Ashmore highlights seven issues in African public markets. I call them the Seven Horsemen. Here’s the list:
- Sovereign governance and transparency
- Politics upheavals
- Pension systems
- Macroeconomic management
- Information asymmetries and the illiquidity premium
- Institutional Quality and Market Depth
We’re not going to parse through all seven — that’s why you should read the report! But we’ll highlight one: Information asymmetries and the illiquidity premium.
Misconception About Governance
Many investors are quick to judge African equities. Claim they’re risky ventures where management pays little/no attention to corporate governance.
It’s a popular opinion. But according to Ashmore, it’s wrong. Ashmore flips the script, claiming that South African companies offer better governance than other EM companies (emphasis mine):
“There is a perception that African companies have poor corporate governance and abuse minority shareholders. This is a misconception. The level of corporate disclosure and governance in South Africa is one of the best in the context of emerging markets.”
Ashmore argues that the relative cheapness in African equities (9.1x P/E) isn’t due to governance. It’s the illiquidity and information asymmetry. Here’s their reasoning:
- Liquidity tends to be lower in African stocks
- African companies are generally not as good at keeping their investors information compared to other EM companies
There’s weight to this argument. The lower valuations in Africa aren’t reflected in higher default / corporate bankruptcies, either.
So, African companies reap better ROE and dividend yields for a lower (relative) price:
In other words, it’s akin to the illiquidity premium from Roger Ibbotson’s white-paper. The only difference appears to be a larger effect on price and returns in Africa than US markets.
For those interested in learning more about African equities, here’s an idea. Print out the list of all JSE stocks and go through them one-by-one. It’s tedious, yes. Time consuming, of course. But you’ll get a great feel for the type of valuations in South Africa. And maybe even find a great idea or two along the way.
Resource of The Week: Margin of Safety White-Paper
Redefining Margin of Safety
NZS Capital released their white-paper on margin of safety. The paper dives into “how the nature of growth and adaptability informs investing”.
In short, NZS turned the idea of margin of safety on its head. They don’t think of margin of safety as the cheapest price paid for an asset. Rather they look at margin of safety as ranges of possible outcomes. They explain their stance:
“If the valuation is expensive, then we have to make more narrow (i.e., highly precise) predictions. If the valuation is cheap, then we have a bit more leeway and can make broader (i.e., less precise) predictions about the future.”
At the end of the day, that’s all we as investors can do. Make predictions — poor ones at that — about the future.
Defining Value Traps
NZS Capital argues the rise of ‘value traps’ is due to the failure of old-age businesses to adapt to the Information Age. Relying on mean reversion and intrinsic value is misleading, they claim. NZS shows the four quadrants of companies along the Disruption and Predictions spectrum:
NZS illustrates the cycle most companies fall into in the middle. Companies start off as gambles. Then they gain market share, grow and create asymmetry. After taking more market share the company is now resilient to competitors. Yet, like most things, these businesses deteriorate into value traps. The company then resorts back to gamble-like status at their death.
What’s The Secret Sauce?
According to NZS, there’s three characteristics of investments that maximize margin of safety:
- Adaptable Management Teams
NZS suggests looking for companies that are mission critical to their customers, delivers more value to their customers than they do themselves, and have a flexible management team. These types of companies, “allows for timely innovation, decelerating the game clock so managers can make smart decisions and maintain their lead through adaptation.”
Idea of The Week: Sanken Electric: 6707 (Oasis Management)
We saw earlier a market ripe with opportunity: South Africa. There’s another market as attractive, Japan. This week’s IOTW comes from Oasis Management. Check out their entire bull thesis on Sanken Electric (6707) here.
Sanken Electric operates two business segments:
- Semiconductor Devices (85% of revenue)
- Allegro (US Subsidiary): 46%
- Other: 39%
- Power Systems (15% of revenue)
- Semiconductor Devices (85% of revenue)
The company does around 175bn yen in annual sales, generates 10.5bn yen in operating profits and trades at 6x EBITDA.
The company’s semiconductor business is a much better business than power systems. The semiconductor business generates 96% of the company’s operating income at an 8.5% average margin. Meanwhile, the Power Systems business accounts for 4% of operating income with a meager 2% operating margin.
The Big Takeaway
One large crux of the bull thesis is that Sanken’s holding in Allegro (the US subsidiary) is worth 41% more than the entire market cap of Sanken:
The path to value creation is simple in theory. Oasis argues that Sanken should rid itself of the low-margin, cost-heavy Power Systems business and focus on their semiconductors segment.
So far, Oasis’ plans are working. Here’s what Sanken’s initiated since the Oasis report went public:
Will be interesting to follow along in their progress. I’m finding a lot of interesting Japanese bargains right now. Heck, even Burry likes Japan!
That’s all I got for this week. Shoot me an email if you come across something interesting this week at firstname.lastname@example.org. Have a great Thanksgiving holiday.
Your Value Operator,
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