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Markus Jooste sold what the market wanted

And fooled even the smartest investors in the process, writes RECM’s Piet Viljoen.

In the town of Newmarket in the UK, often referred to as the headquarters of British horseracing, stands a statue of a horse. It might surprise many, given the town’s reputation in horseracing, to find that the sculpture is not that of a racehorse, but of a stallion instead. For although the public is more interested in racing than it is in breeding, it is in breeding that the true money lies. A champion racehorse can earn millions in prize money, but make multiples of that at stud. Horseracing is in fact an adjunct to a multinational, multibillion-dollar breeding industry. The races merely serve as a vehicle to establish which horses are the best to breed from.

Horse owners go to great lengths to identify and develop strong bloodlines. A whole industry around the “science” of performance has developed, with expensive research into the likely genetic composition of a good racehorse easily funded. Owners will spend a great deal of money on so-called “experts” to pick horses for stud purposes. All this science and expertise serves to legitimize certain breeding choices. In short, no money is spared in the pursuit of horses with “good blood” – i.e. a strong bloodline that will produce winning racehorses.

But, in practice, there is no guarantee that great racehorses produce other great racehorses. In fact, a sire is generally deemed to be a success if 6% of his progeny do well at the track. It might as well be a random process. It seems “bad blood” is a lot more prevalent than the “science” would have us believe!

This element of chance, however, means every breeder can dream. The human condition is such that even a small outside chance of great wealth will attract many punters – especially if that chance is dressed up to look like science, backed by the views of experts.

Recently, one of the foremost racehorse owners in South Africa hit the headlines for all the wrong reasons. It turned out that the company he founded and had built up through multiple acquisitions may actually be a fraud. Investors are struggling to reconcile the company they thought they knew and invested in – Steinhoff – with what they are reading in the newspapers today. How could they have been fooled so easily? What happened to all the “science” and the “experts” that helped inform their decision to invest in Steinhoff? Was it “bad blood” all along?

Interestingly, this turn of events coincided with the release of a book by journalist John Carryrou titled “Bad Blood: Secrets and Lies in a Silicon Valley Startup” about the fraud at a Silicon Valley “unicorn” called Theranos. Theranos, under the leadership of founder Elizabeth Holmes, was founded on the technological promise that they had come up with revolutionary handheld devices that could glean vital health information from a small drop of blood. In the end, this turned out to be a lie, carefully covered up with conspiracies and smoke screens. The devices could not back up the hype. The technological promise was a MacGuffin, only there to advance the interests of the conspirators, having no actual substance.

A reading of the book can help us understand what happened at Steinhoff, with some obvious parallels. In the book, Carryrou describes Holmes as “very intelligent, with heaps of charm and charisma”. Also, “Elizabeth’s biggest trick was that she wrapped older men with great reputations around her finger”. She was able to tell investors exactly what they wanted to hear – “we’ve invented a great new thing, which will make you very rich” – and then get them to suspend their disbelief by being very persuasive.

If all this sounds familiar, it corresponds closely to the way Markus Jooste, the founder and ex-CEO of Steinhoff, operated. Like Holmes, Jooste has latterly been described as the ultimate con artist. However, the best conmen understand full well that the trick is to sell what their targets want (or at least what they think they want). What Jooste was selling was many South Africans’ dream – excitement, capital flight, tax arbitrage – all backed up by the MacGuffin of “supply chain excellence”.

This excitement came in the form of a company that made serial acquisitions. Despite decades of evidence that large scale acquisitive activity generally destroys shareholder value, companies that do lots of (large) deals are often regarded as “sexy” by the market. Over the last decade Steinhoff managed to grow its revenue by 22% p.a., and net profit by 25% p.a. This was achieved through an aggressive acquisition strategy, often paying over the odds for their target companies.

This strategy was funded by massive equity and debt issuance. Its equity base increased from R25 billion in 2008 to R254 billion in 2016, an annual growth rate of 33%. Gross debt also grew rapidly from R17 billion to R129 billion, an annual growth rate of almost 30%. The more debt and equity Steinhoff issued, the more the market applauded and asked for more. Instead of the increased levels of due diligence that should normally accompany such frenetic activity, it seems the “excitement of the deal”, coupled with an incessant promotion of their MacGuffin by the protagonists, caused the market to suspend its disbelief and relax its underwriting standards.

Of course, the rapid increase in equity issuance also caused Steinhoff to become a larger part of the index, which in turn created forced buying in itself, but that’s a different story.

Research has proven that South Africans are consistently too negative about South Africa – it’s been proven that we believe things to be worse than they actually are in reality. In Ipsos’s Perils of Perception 2017 survey, South Africa ranked as the most needlessly pessimistic nation out of 38 countries. This unnecessary pessimism regarding our local situation may explain why local investors may systematically relax their underwriting standards when it comes to offshore investments, empowering unscrupulous salespeople to create products which can be sold quickly and easily, with little regard to future investment prospects.

When Steinhoff’s listing was moved to Europe, Jooste effectively took full advantage of this inherent bias, with investors cheering him on. Of course, the fact that these same investors now want to sue the company for “misrepresentation” is somewhat ironic.   

Over the last few years, South Africa has become one of the most heavily taxed countries in the world. Personal income tax rates top out at 45%, while corporates are taxed at a relatively high (by global standards) 28%. CGT has also been ratcheted up over the years to where it is now in excess of 20%. Starting in 2017, dividends have been taxed at 20%. Even VAT was increased to 15% in this year’s budget. It should come as no surprise that South Africans increasingly view minimizing their tax burden as a national sport. Equally, anyone promoting a tax efficient investment vehicle is likely to get a lot of support from the market. Steinhoff provided tax-efficient investing in spades, with its tax rate averaging around 15% for the ten years from 2006.  

It is clear that Jooste played the game very well – he sold what the market wanted, and in the process fooled even the smartest investors. And the worst part of it was that it was incredibly difficult to pick up in the numbers alone. Changing year-ends and listing jurisdictions all served to obfuscate. But in the end, as investors, we need to use the Steinhoff story as a learning opportunity.

We have tried to summarize what we believe to be the main learnings. There are probably more, which even greater reflection will uncover, but for now these are the most pertinent for us:

1.    In the wake of the Steinhoff debacle, accountants, regulators and even fund managers are imposing increasingly Draconian rules and corporate governance standards. At RECM we think it is better to understand why it happened, and learn from that instead. The reason it happened wasn’t a poor regulatory environment. Instead, the alleged fraud happened due to a strong appeal to incentives which caused otherwise smart people to suspend their disbelief. No amount of regulatory intervention will ever be able to eradicate incentive-caused bias.

2.    As analysts, it pays to understand not only the numbers that represent the activities of a business, but also the human beings behind the companies. Who are they, what are their reputations, and what are their incentives? These soft issues are as important – if not more important – than the hard numbers.

3.    Never ignore the outside view. Our tendency as humans is to favour the inside view. The inside view considers a problem by focusing on the specific situation and making predictions based on that narrow and unique set of inputs. The outside view asks if there are similar situations that provide a statistical basis for making a decision, and if so, what happened? If many corporate disasters are preceded by frenetic acquisitive activity, why would this instance be different? If there are red flags being waved that have indicated fraud in other instances, why did we ignore them this time? We tend not to embrace the inside view as it necessitates throwing out our own cherished findings. But we agree with Michael Mouboussin when he says: “The main lesson from the inside-outside view is that while decision makers tend to dwell on uniqueness, the best decisions often derive from sameness…There is a wealth of useful information based on situations that are similar to the ones that we face every day. We ignore that information to our own detriment.” 

Investors can behave like gullible racehorse owners, chasing a dream based on false science or the advice of highly paid “experts” with no skin in the game. Alternatively, they can apply good doses of common sense and judge a situation by the facts at hand – facts that are not shaped by a good story, but by cold hard reality.

To achieve this, it is essential to develop a sensible investment process, and to stick to it.

A good investment process helps distinguish between reality and a rose-tinted representation of what one wants to see. Even the most astute of investors may be blindsided by rogue operators, and suffer losses along the way. A good process will help minimize those losses when (not if) they happen.

Piet Viljoen is executive chairman of RECM.

This document originally featured in RECM’s REFOCUS publication, which serves to describe the company’s thinking behind selected recent portfolio management actions and provides context to current positioning.

COMMENTS   32

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Good comments from Piet Viljoen. Unfortunately for investors the 1st time in a VERY long time.

# 2 is particularly relevant not just for investors iro asset managers but also for political parties. Does any rational human being really believe that a DA party, with members and voters “won” from the anc will be any better than the anc itself?

Look at the individuals behind asset managers and political parties. Look at their attributes and lack thereof.

That is why SA is stuffed.

A very sensible take on the unscrupulous Steinhoff matter by the acclaimed, veteran investment manager, Piet Viljoen from RECM.

In analyzing the contributing factors that caused mega investment value wipe-outs, fraudulent activities or other money scandals, it is also imperative that captains of the financial investment industry recognise that the reference to “the market” or the broad use of the term “investors” is actually very misleading to the average man in the street and readers of such articles.

The underlying investment composition of available investment- or saving alternatives such as unit trusts, ETF offerings, insurance products, retirement funds, tax-free savings wrappers, etc are mostly selected and executed by fund managers of the banking institutions, insurance companies and investment houses on behalf of their unsuspected and mostly uninformed client base (the average man in the street) solely on a trust and proxy basis.

The percentage of investors who are capable to directly select their own investment choices (direct share selection) are rather small in comparison to the magnitude originating from pooled investments where the composition, selection, relative exposure and the hold or release decision-making are all the responsibility of highly educated fund managers on behalf of these unsuspected individuals collectively referred to as “investors”.

The ultimate “investors” and “the market” therefor are actually the elite fund managers and not individual investors, although the average man in the street are the ones suffering the brunt and investment dilution when their proxy and trust were misappropriated by the so-called “investment specialists”.

I don’t see any reference to the auditors in this article. Surely Piet, the one thing that could have saved this situation was an auditor that did its job and forced management to produce financial statements that reflected the truth from the very beginning? How can we learn anything if the auditing profession conspires to be party to the fraud. If financial statements are worth nothing how can we ever make an investment?

Great, cerebral article from Piet. Pity he didn’t apply the same clarity of thought in the management of the RECM Equity fund. With a 5 year annual compound return of 1,1% p.a. (versus the 10% of the JSE) its no wonder this former R1bn fund is down to R50m.

Jooste could have been the best con artist in the world in a thousand years but he wouldn’t have been able to pull wool over everyone’s eyes if the auditors did their jobs properly. If they qualified the AFS, when they should have, then this disaster would never have happened.

Donald Trump is undoubtedly the best con artist in history. He still hasn’t been caught!!

You are naive to compare a self-serving CA with somebody elected by millions of people.

Which are you closest to, a CA or somebody elected by millions of people?

Millions of ignorant, naive people who were easily led. Wait and watch!

Well millions are watching, but he carries more ‘skin in the game’ than CA/fin guru here!

Millions look over his shoulder and he will be booted out quickly if needed.

But watch out for the next idiot CEO running away with 1000s of ordinary peoples money..

and then ask again the same question, where were fin gurus idiots to protect the ordinary people..

We really have an ability to produce con-artists of note. Just like Elizabeth Holmes in the article and her medical device, South Africa’s own Gervan Lubbe once made headlines with his (questionable) APS pain relief machine. He later claimed to have also developed a malaria-detecting watch and in 1998 he received South Africa’s Entrepreneur Award. On 16 January 2012 Magistrate Leon Claassen found Lubbe guilty on 19 counts of fraud and other white collar crimes. He was sentenced to 43 years imprisonment of which he must effectively serve 20 years for fraud. It is understood that he is currently serving his sentence in St Alban’s prison in Port Elizabeth. Perhaps Markus will join him soon?

Hindsight is of course a perfect science .
Not one Investment Manager / Investment House called this – all these experts were complicit in their silence, if in fact they knew what was going in.

Disagree – they were just as in the dark as the man in the street.

Quite a few SA fund managers actually called it and were quite vociferous about their views. That is the reason why Steinhoff traded at single digit PE’s and at a significant discount to the Alsi and global consumers stocks for most of its life.

Find it so ironic that Piet Viljoen are making these comments. Quite a few of his fellow hardline deep value fundamentalists were the ones that were propping up the value of Steinhoff for ages. Stumbling into yet another value trap that they bought on valuation alone without considering the quality of the business. Just because something trades at a discount does not make it cheap! 9 times out of 10 it is cheap for a reason.

That’s a rather tong in cheek comment. Not sure it is appreciated.

A prefect example of why the fin gurus segment of society that is so misplaced/useless and actually dangerous.

Even uncle Buffet called this out in his ‘managed’ bet recently that made this point rather clear.

Like most economists, ‘I am correct when my prediction plays out and I am correct when it doesn’t it isn’t a mistake…’

Yes, absolutely and in 2007 the Alpha Males types in the financial world and the housing world sold the market what they wanted – overinflated lies, and look how that ended up.

Another market correction of 30-40% is feared in the US. How truthful this is, or if it’s just fear mongering, I do not know, but will watch the space intensely for opportunities.

Yawn this is getting so old. Big bad investment bankers are to blame for everything in the world. People living beyond their means and buying houses that they could never afford carry no blame. Bring on more and more regulation to protect people against themselves.

When you shop for clothes nobody puts a gun to your my head telling me that I must buy the expensive branded underpants that costs 5 x more than the housebrand ones. But because there is a life size image of a ripped Cristiano Renaldo I start thinking mmm if I start working out and I have that body I will need sexy underpants to complement my new greek god body, so I get conned into buying it. Should we ban this type of advertising becuase it exploits my gullibility? Should the clothing chain be prosecuted because it knows that a pair of underpants wont turn me into CR17 – yet it sold me that dream?

That is what we call marketing. That is a capitalist society. It thrives on the irrationality of man. Client facing investment bankers are normally called equity sales or credit sales or derivitave sales. Hint there is a clue in their job titles…

The problem is the lack of regulation coupled with gullible investors/buyers of all stuff toxic, which makes greedy investment bankers complicit and culpable.

Fear the bank that fears regulation.

NotWarren : you do know that STAR was found guilty of predatory lending?

That is part of the debt that has been laundered into good assets and false income through Steinhoff with tax benefits for the job insliders.

Under SEC rules this was federal prison

Johan_Buys: I made a broad statement that I believe there is a lack of personal accountability from buyers of financial assets that do not do their homework and that people should realise that it is part and parcel of a market based economy. My response was to an equally broad statement. The specific details of specific transaction are not really relevant to my point.

What I find strange on the MW comments is that when the discussion is about minimum wages, social grants or any policies designed to alleviate poverty everbody extols the virtues of the free market and laissez faire capitalism, but when there is some white collar dodginess going on then that self same crowd is baying for increased regulation and protection against the evils of the market.

So when the discussion relates to the poor (mainly black) then we do not want any state intervention – trickle down economics will do the trick. But when it comes to middle class savings (mainly white) that might be at risk then we want to regulate everything to the hilt and we point fingers to the evil investment bankers and rich businessmen. What about trickle down economics now?

4. Never trust management. They are not running a charity. 99% of them are only working for their own wealth

You sum the game up for ordinary shareholders!!

I am always amazed that these “experts” come up with such eloquent descriptive analysis of a negative situation or event, but fail completely when it comes to the real investment situation.

1. RECM funds hardly shine, and haven’t for a long time.
2. I don’t recall RECM or P. Viljoen noting that Steinhoff were in trouble or that some horse people were unscrupulous. Easy to have perfect hindsight.

True but close to shooting the messenger. Maybe ou Piet had to do a bit of financial forensic soul searching himself. Sucker (me too).

“…fooled even the smartest investors in the process”…..begging the questions, just how smart, if true, are these investors? What qualifies their “smartness”?

Piet a very good read. Hindsight as you know is easy, however foresight is not. Although you refer to “main learnings” I am yet to be convinced as quite frankly your investment performance is, to be frank -appalling. You may well find the an equally edifying article may be written about your organisation.

I started my investment from 2004 with Steinhoff. The only person I recall speaking up against the STEINHOFF circus was JP Verster and not Piet Viljoen or anyone else.Go look at Youtube or google previous articles by Piet Viljoen on Steinhoff before the crash. JP Verster famous short little explanation to Steven Gunnion was that when companies do many deals and create lots of debt on their balance sheet it creates FRAGILITY. He just kept repeating FRAGILITY and said he found STeinhoff to complicated and not interested kept his response short and sweet but he knew what was coming! Unfortunately i was shocked at JP’s comments and thought this cant be but started looking at Markus the man,historically and listening to his interviews and I became more and more concerned.I was not impressed with Markus “the D00$” Jooste. Unfortunately having such a long period of investment I was hesitant to sell out….but i never did because i was concerned about the SARS/TAX consequences and I had backed steinhoff in the past for over a decade. Unfortunately this ended badly.

Sorry buddy – not all investors were fooled. Some of us have seen this before and stayed away this time around.
It’s easy to recognize corporate greed – the major shareholders in decision making positions start spending money on lavish lifestyles – multimillion Rand houses, wine farms, private aircraft, racehorse strings – and whose money are they spending like drunken ?? investors money, that who? Look around you at current similarities and learn!

W.r.t. #2 – in the end there is no substitute for uncomprisingly ethical behaviour, no matter how tempting the “super” profits or growth promised by the superstar may look. The moment you start thinking along the “… yes, but …” lines on this, rest assured that you will regret it. And, trust your gut!

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