This article by MOI Global instructor Rudi van Niekerk is excerpted from the launch letter of Desert Lion Capital, dated May 2019.
I am grateful and excited to announce the launch of Desert Lion Capital – a South Africa-focused, long-only, unlevered fund that employs a one-man investment committee, bottom-up, fundamental, value investing approach to pursue outsized returns by investing in a concentrated portfolio of asymmetric opportunities in a market containing quality companies that are often mispriced due to structural inefficiencies. The relative inefficiency of the South African equity market makes it easier to gain an investment edge, and my six years of experience running Desert Lion’s predecessor funds support the thesis that we can arbitrage these inefficiencies to extract alpha and generate attractive long-term returns.
In this letter, I wish to convey to you that:
— We believe we have an attractive opportunity set both now and in the long run;
— The focus is not so much South Africa as it is to gain an edge by investing in an equity market where it’s easier to find quality companies, with quality management teams, trading at below-average valuations;
— Investing is my passion and, as a South African citizen with experience, a track record, and local on-the-ground presence, I am positioned to execute our investment approach within my circle of competence, which encompasses South African listed equities, especially small and mid caps;
— We have structured the Fund to have an attractive and fair fee structure, and I believe you’ll find our incentives and interests are aligned with yours as existing or prospective limited partner.
The Omaha Equation
I traveled to New York and Omaha recently and had the privilege of meeting with brilliant fund managers, capital allocators, and mentors over the course of about two weeks. The Berkshire annual meeting has evolved to be more about the networking and engagement surrounding the meeting than the event itself. While in Omaha, I attended a dinner hosted by Columbia Business School. The room was packed with more than 500 people who allocate billions, if not trillions, of dollars. The brain power was immense. There were investors focusing on niches of niches to try to gain an edge. I also attended a Best Ideas conference, which highlighted how picked over and relatively expensive the U.S. markets currently are. Folks were pitching cigar butts at 60c on the dollar and growth companies at 35 times 2020 earnings. It was a long way from the romanticized idea I have of Warren Buffett’s Omaha in the 1960s when he started his first partnership. It seems like the days of jumping on the earliest train to Washington, D.C. on a Saturday morning and knocking on the door of GEICO to be greeted by Lorimer Davidson are gone. The days of picking stocks out of the Moody’s Manuals or gaining an edge through access to filings are gone. The days of buying National American Fire Insurance and Sanborn Map are gone. As I never saw Omaha in the “good old days,” I cannot be sure how much it really changed, but the whole time that I was there, I had a nagging feeling that the South Africa that I invest in today is a lot closer to Omaha in the 1960s than it is to what I saw a few weeks ago. Many of the companies I invest in do not have sell-side research coverage, and it is not uncommon that I am the only attendee at a results presentation or an annual meeting. I can still pick up the phone to call a company and about 75% of the time I’ll be able to make an appointment with the CEO. In South Africa, we don’t have “expert networks” that U.S. funds pay to access current and former employees – we have relationships. Being a local and sharing cultural roots are beneficial. It just blew my mind when I truly realized how much low-hanging fruit we have in the South African equity market. In our portfolio we have high quality companies, with scalable business models and competitive advantages, growing market shares, good management aligned with shareholders, earnings growth over 20% p.a., returns on tangible equity of >30%, trading at less than 5 times after-tax PE multiples.
I came away thinking that my South Africa may be far from perfect, but the environment for stock picking is far better than what I saw in Omaha, and I am grateful to be an ocean away…
Laying the Foundation
My nationality is South African. My passion is investing. I strive to find asymmetric opportunities – well-managed quality companies that we can buy for less than my intrinsic value assessment due to some form of mispricing. When we founded Desert Lion Capital, we didn’t take a macro or top-down view to choose South Africa as a theme. Rather, we have been finding and continue to find that the South African listed equity market is rife with the attractive set-ups we seek.
I was born and raised on a farm in the rural areas of South Africa’s Western Cape Province. Not knowing what career path to pursue, I opted for what seemed to be the default choice and graduated with a Bachelor of Commerce (focusing on Agricultural Economics) degree from Stellenbosch University and got involved in grain trading. It was an interesting time in the South African agricultural commodities market as the country had just deregulated from a single market to free market system. Before, grain boards announced a fixed price ahead of the planting season. With the new free market system, it was chaos as buyers and sellers tried to make sense of price discovery. That was when I first became interested in the concept of markets and where I learned substantially about human psychology and temperament. I was trading both physical commodities and hedging our book using options and futures. For those who have not had a crash course in behavioral sciences and relationship management, try explaining to a capricious, headstrong farmer that the price on his contract is 10% lower today than it was yesterday due to “market forces.” That volatility, and dealing with the intense emotions of a wide audience, taught me a lot about temperament.
My curiosity about markets evolved into an interest in investing, and I pursued further study, obtaining an MBA (University of Stellenbosch) and the CFA charter in 2009. However, the most valuable education came from studying the classic investing texts and learning from “the greats.”
In 2009 I joined Agri-Vie, a private equity firm equity firm focusing on food and agri investments in Africa. It was a period of analyzing businesses deeply, spending ample time with company management, performing due diligence, leading transactions, and playing an active role at board level post investment.
I had been investing on my own for several years at that point and started managing outside capital in 2013, initially through a private partnership for mostly family and friends and later an alternative investment structure called Guscora. I focused on South African listed equities, predominantly in the small and mid cap space. Our returns were more than satisfactory. In recent years, we noticed growing interest from U.S. investors to co-invest, but our structure was not familiar and tax efficient to investors in the United States.
Enter Scott Miller of Greenhaven Road Capital Partners Fund and small cap pioneer Chuck Royce of The Royce Funds. Thanks to their encouragement and support we established Desert Lion Capital with a traditional U.S.-based fund structure to employ the same strategy investing in South African listed equities. Not only did they allow me full autonomy in investment decisions, they also seeded the fund with initial capital. I could not have asked for better partners.
South Africa: Gaining Perspective
I started writing this letter on the 15-hour flight from New York back to South Africa. As I looked down at the vast Atlantic Ocean below, I was struck by the appropriateness of zooming out and writing from a 40,000-foot perspective.
On May 8, I arrived back in Cape Town just in time to cast my vote in our National General Election – an important event as South Africa finds itself at a critical juncture. Over the 15 years stretching from our first democratic general election in 1994, South Africa made formidable progress across most metrics, including economic growth, fiscal consolidation, housing, education, infrastructure, basic services, living standards, GDP per capita, etc. Unfortunately, we also endured the “lost decade” from 2009 to 2018 under Jacob Zuma’s two terms of presidency. As the plane took off, I was reading a special report on South Africa in The Economist. For the most part, it was a fair summation of the challenges facing the country. What The Economist and most people not privy to local nuances fail to appreciate is the new dawn facing South Africa. The democratic election was concluded freely and fairly. The African National Congress (ANC) party won with a level of majority which endorsed President Cyril Ramaphosa as the favored leader of the country. President Ramaphosa is an astute politician and accomplished businessman. In 1999 Ramaphosa was endorsed by Nelson Mandela to follow him up as president, but the ANC elected Thabo Mbeki. Ramaphosa proceeded to build a legitimate business empire and accumulate personal wealth to the tune of about $450m before returning to politics. There is little allure in corruption for a wealthy, self-made man. Like a chess grandmaster, Ramaphosa looks many moves ahead and is deftly patient in positioning before execution. Most people are naturally oriented towards the shorter-term. That’s just how we’re wired from an evolutionary perspective. So, unless we really zoom out and take the 40,000-foot view, it’s difficult to see that the ship that is South Africa is turning. To simply extrapolate South Africa’s recent past linearly would be an error. While it will take time, enough signs are pointing to reform and changing course for the better. I am exceedingly optimistic about the new dawn and the opportunities it brings.
Structurally Attractive Universe
Structurally, the South African equity market is an extremely attractive place to invest. We have about 385 listed equities on the Johannesburg Stock Exchange (JSE). The market is highly institutionalized, there is a high degree of groupthink, the majority are index-focused, and very few venture outside the Top 40 largest and most liquid stocks. That leaves a universe of about 345 companies where price discovery frequently presents opportunity. Considering the continuum of market efficiency of equity markets around the world, the U.S. equity market is certainly on the efficient side of the spectrum. On the other side, we’d find the South African market with a high degree of inefficiency. At last check, we had 1,269 South African-registered mutual funds. Only 10 of those were registered as small and mid cap funds. Beyond these, I am aware of only a few local hedge funds focusing on the small and mid cap space. In Omaha the question surfaced repeatedly: “How many other U.S. funds are available that invest in South African listed equities and are managed by a South African local?”
Less competition = more opportunity to gain an informational edge
as well as more opportunity to buy at attractive valuations.
The Demographic Opportunity is Real
Despite its recent challenges, the demographic opportunity in South Africa is real. There is room for competitive incumbents and disruptive entrants to create value in housing, banking, schooling, electricity, financial services, communication technology, and the IT sector, just to name a few.
Housing: South Africa has a population of 58 million people as well as about 14 million formal houses, with an average household size of 3.3 people. There is a housing backlog of 3.6 million houses, which needs to be tackled. With a growing middle class and increasing urbanization, the opportunity to address lower- and middle-income housing in urban nodes is immense.
Banking and Financial Services: Consider the case of Capitec Bank. Capitec entered the banking sector as an unsecured credit provider and low-fee transaction bank to serve the under- and unbanked. Since listing 2002, Capitec generated a total compound return to shareholders of 52% p.a.
Private Education: Another example is Curro, a private schooling business addressing the growing demand for private education. The 10-year CAGR of Curro since listing 2009 is 48% p.a.
Despite these returns, both Capitec and Curro still have long runways thanks to scalable business models and fairly small market shares in large and growing markets with less competitive incumbents. A Capitec and a Curro has been done elsewhere in the world, but in South Africa there are still opportunities to capitalize on the demographic dynamic.
Over the much longer run, we cannot ignore South Africa’s position vis-à-vis the rest of Africa. As the most developed economy on the African continent, South Africa remains the primary “gateway to Africa.” With a population of 1.4 billion, projected to grow at a higher rate than other continents, Africa is considered the “last economic frontier.” South African businesses are increasingly capitalizing on African growth markets.
So not only do we have an equity market that is less efficient and presents an opportunity to invest in high-quality companies at lower valuations, we also have an economic and demographic set-up conducive to rapid growth in certain sectors. South Africa is not a place where money goes to die. The opportunities are real.
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Disclosures: This letter (the “Letter”) has been prepared solely for use by potential investors in Desert Lion Capital Fund I, LP (the “Fund”), which is managed by Desert Lion Capital Investment Management, LP (together with its affiliates, “Desert Lion Capital”), and shall be maintained in strict confidence. The recipient agrees that the contents of this Letter are confidential, the disclosure of which is likely to cause substantial and irreparable competitive harm to Desert Lion Capital and or its investment vehicles and their respective affiliates. Any reproduction or distribution of this Letter, in whole or in part, or the disclosure of its contents, without the prior written consent of Desert Lion Capital is prohibited. The information set forth herein does not purport to be complete and no obligation to update or otherwise revise such information is being assumed. Other events that were not taken into account may occur and may significantly affect the analysis. Any assumptions should not be construed to be indicative of the actual events that will occur. This Letter shall not constitute an offer to sell or the solicitation of an offer to buy which may be made only at the time a qualified offeree receives a private placement memorandum describing the offering and related subscription agreement. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. All information contained in this Letter is qualified in its entirety by information contained in the Fund’s confidential private placement memorandum. An investor should consider the Fund’s investment objectives, risks, charges and expenses carefully before investing. This and other important information about the Fund can be found in the Fund’s offering memorandum. Please read the confidential private placement memorandum carefully before investing. The information in this Letter is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. No representation or warranty (express or implied) is made or can be given with respect to the accuracy or completeness of the information in the Letter. Some of the statements presented herein may contain constitute forward-looking statements. These forward-looking statements are based on current expectations, estimates and projections. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Although Desert Lion Capital believes the expectations reflected in any forward-looking statements are based on reasonable assumptions, Desert Lion Capital can give no assurance that such expectations will be attained and therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Desert Lion Capital undertakes no duty to update any forward-looking statements appearing in this Letter. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. Diversification does not assure a profit or guarantee against loss in declining markets. Investors should consider their investment objectives, risks, charges and expenses of the underlying funds before investing. The views, opinions, and assumptions expressed in this Letter are as of the date of this Letter, are subject to change without notice, may not come to pass and do not represent a recommendation or offer of any particular security, strategy or investment. The Letter does not purport to contain all of the information that may be required to evaluate the matters discussed therein. It is not intended to be a risk disclosure document. Further, the Letter is not intended to provide recommendations, and should not be relied upon for tax, accounting, legal or business advice. The persons to whom this document has been delivered are encouraged to ask questions of and receive answers from Desert Lion Capital and to obtain any additional information they deem necessary concerning the matters described herein. None of the information contained herein has been filed or will be filed with the Securities and Exchange Commission, any regulator under any state securities laws or any other governmental or self-regulatory authority. No governmental authority has passed or will pass on the merits of this offering or the adequacy of this document. Any representation to the contrary is unlawful.