Description

FULL DISCLOSURE: We obtained the below information independently and not from Protea, nor Riskowitz Capital, nor Midbrook, nor Conduit, nor Snowball, nor any of these entities' affiliates.

When a hedge fund manager that has compounded at 34% net annualized since inception takes over an insurance company to use as his investment vehicle, should one pay attention? What about when, shortly afterwards, another manager that has compounded at 38% annualized decides to join this project by merging his entire hedge fund into this same insurance company—should one pay attention then?

The South African insurance company Conduit Capital was taken over by Sean Riskowitz in 2015. Riskowitz was born in South Africa, but moved to New York where he learned the art of value investing and started a hedge fund to invest in South African equities.

South Africa’s capital markets are well developed, even beating the U.S. on many important metrics:

• #2 in the world for Securities Market Regulation (U.S. ranked 24th)

• #1 for Auditing Standards (U.S. ranked 23rd)

• #8 in Soundness of Banks (U.S. ranked 39th)

• #3 for Efficacy of corporate boards (U.S. ranked 15th)

Source, page 327 on: http://www3.weforum.org/docs/gcr/2015-2016/Global_Competitiveness_Report_2015-2016.pdf

Yet, and with all due respect, the sophistication of investors in South Africa is nowhere on par with that of the U.S. If one should visit and speak with the investment management community in South Africa, one will probably leave with many anecdotes to prove this.

Sean Riskowitz, however, has the benefit of growing up in South Africa which provides him with intimate knowledge of the country, while later moving to New York to pursue his career in investing, which provides him with a sophisticated grounding as an investor. This has allowed Riskowitz to compound capital at 34% net per annum versus negative 7% for the Johannesburg All Share Index (or versus 12% for the S&P 500) over the same time period:

FULL DISCLOSURE: We obtained this information independently and not from Riskowitz Capital nor any of its affiliates.

These results are for Riskowitz’s US-domiciled hedge fund, and are denominated in dollars, making the returns even more impressive considering the significant depreciation of the South African Rand that has occurred over this period. Nor is this the only evidence we have. Riskowitz’s track record goes back to 2007 in a South African vehicle that became known as Midbrook Lane. While that entity’s results are not audited prior to 2011, the IRR (this time in Rand) from inception through the end of 2015 was 34.7% in a period that includes the global financial crisis.

Think Buffett circa the time he took over Berkshire Hathaway, when value investing was not prominent and there was little competition from other trained value investors. A seemingly similar parallel is currently being created with Conduit Capital.

Riskowitz Capital recently closed to new capital after receiving a large investment from a sophisticated institution. Now, investing in the insurance company that Sean Riskowitz recently took over is currently the only way to benefit from his capital compounding abilities.

And developments at Conduit Capital became more interesting recently. Leo Chou is one of the other top investors in South Africa, also schooled in value investing. Chou’s fund, Snowball, has compounded at 38.4% since inception:

FULL DISCLOSURE: We obtained this information independently and not from Snowball nor any of its affiliates.

Last month, Chou also decided to merge his entire hedge fund, Snowball, into Conduit Capital. In August 2016, Conduit announced the acquisition of Snowball Wealth and Midbrook Lane’s stock portfolios in exchange for Conduit share consideration of ~R465 million and ~R168 million, respectively.

Last month, Chou explained his reasoning on why he decided to merge his hedge fund with Sean Riskowitz’s Conduit Capital in a letter to LPs, which clearly illustrates the potential for Conduit Capital. The letter can be found uploaded to this link:

https://www.dropbox.com/s/7b8l1vc1h8v6als/Letter%202016-08%20Snowball.pdf?dl=0

We encourage giving it a read, as it aptly portrays what is possible for Conduit Capital. These top South African stock pickers both thought they could improve their already extraordinary rate of compounding wealth through the use of Conduit Capital.

We are excited that Leo Chou decided to merge his fund (with its startling track record) and the majority of his own net worth over to Conduit Capital.  Conduit’s goal is to now utilize these newly acquired equity assets to support the insurance business, given the large amount of opportunities available for growth. Over time, this should prove to be a powerful model—as the insurance business grows, so should underwriting profit and float, which should give Conduit more assets to invest. This should provide a self-financed leveraged investment vehicle managed by two of the top South African investors.

What kind of insurer have Riskowitz and Chou hitched their wagons to? It appears to us to be an attractive one. As Chou points out in his letter, Conduit’s insurance operations have produced an average combined ratio of 96.2% since 2008. Better-than-free float is valuable on its own. But put that in the hands of two investors whose funds have achieved around 40% gross annualized returns going back almost a decade—that’s how you unleash powerful economics.

Conduit’s historically impressive underwriting results have been produced, in the main, by Robert Shaw, who has run Conduit’s insurance division and who has been active in the insurance industry since the 1970s. Given Shaw’s track record and his continued leadership of the insurance division, we are comfortable that Conduit will perform at least as well as the average South African insurer under Shaw’s leadership, but with much more room to grow. Today, Conduit’s share of the South African insurance market stands at less than 1% of gross written premiums. There is plenty of space for Conduit to expand its business at above-average rates for a long time to come.

One should also note that the South African insurance market is consistently a very profitable industry. These are the average ROEs of the top South African insurers and the multiples of tangible book value at which they trade:

Conduit should have a significant competitive advantage over the average South African insurer by focusing on higher return niche insurance businesses. On the investment side, Conduit is the only insurer using a high percentage of its float to invest in equities, and thus Conduit should generate ROE’s above the South African industry average.

Yet if Conduit merely earns the industry average ROE of 20.8% over the next five years, it’s TBV would grow to R4.93/share. If it were to trade at the average TBV multiple of 2.8x, the stock would be worth R13.58/share. That’s a 36% IRR from today’s R2.98 share price.

Or a simpler way of looking at it: if Conduit were to trade at the same 2.8x TBV multiple as its larger peers, it would be worth R5.33/share today, which is 79% upside. The upside potential for Sean Riskowitz to create a South African Berkshire Hathaway is so massive, that should you even halve these results, the returns would still be outstanding.

Though the South African insurance market stands as one of the most well-regulated  in the world, much of the country remains unbanked and either uninsured or underinsured. Financial inclusion is still limited, with basic policies like auto or property liability insurance only optional—a rarity in the developing world. This creates a dual opportunity set for Conduit: the potential to grow the size of its insurance book and for two of the best South African investors to allocate its better-than-free float.

Catalyst

• Sean Riskowitz beginning to use this insurance company's free float to compound its capital.
• Growth of the underutilized insurance assets.