Magic Markets #262: Free Cash Flow - Friend or Foe? (with Dagon Sachs of Aylett & Co.)

the markets. We just can't get enough of them. Markets are the drivers of your wealth and investment strategy. Welcome to Magic Markets, with your co-hosts, the Finance Coast and Mahabbat Nullah. Together, we have more than 25 years of combined experience in the markets. Looking to take your market knowledge to the next level, while you are certainly in the right place and you should also check out Magic Markets Premium, our weekly research report and podcast covering global stocks. It is still just 99 random month or 990 round for the year, and features literally a couple of hundred reports and podcasts on international companies. This is an incredible resource for any stock picker, and we are also thrilled to begin a campaign on Magic Markets of welcoming great local boutique asset managers to the platform to come and talk about how they manage money and how they invest. Welcome to episode 262 of Magic Markets, that's a lot of episodes, and we still try and bring you new things along the way. And this is the first episode of something quite exciting that we are doing in 2026, which is to try and expose you as the listener to some of the really good, I would say, boutique asset managers in South Africa, although obviously that is quite an umbrella term, but just some of the really good minds out there who are managing money, allocating capital, and have some great thoughts along the way. And today is the first such example that we will be doing this year. It's by no means the last, and it's going to be a really fun one. So before I introduce our guest, let me at least say hello to Mo, because Mo, you are also here. You are not our great fund manager allocating capital today, but you are here, and thank you for being here, as always, and then I'll say hello to our guest, Degan. Yeah, thanks, Coast. I mean, this week I'm not the brains of the show, and I guess most weeks I'm not the brains of the show. I'm glad we've got Degan on the show here to share his insights from the callface, you know, what they're doing at Alitan Co. And you know, just for some context, I mean, Alitan Co. That's a company I remember from close on 20 years ago, when they launched as an old boutique fund manager, I remember I was at Netbank, you know, early on in my career, and they started up the Netbank Brevata fund or something to that effect, and Walter Alit, who was effectively the founder of the firm, was there on the stage telling us around these ethos. So for me, it's nice to come, you know, full circle. It's very nice to have Degan on the show to take us through, you know, where's the thinking involved, how's it actually played out, and then also to get into some of the nitty gritty around how they're looking at specific sectors and specific stocks. Degan, really excited to have you here on Magic Market. Yeah, thank you. Thank you for having me. And then your memory's correct. I think it's probably 21 years ago that we started that Netbank backed us to run the Brevata fund, and really the whole business has evolved thereafter. And it's been, let's say, a hell of a journey. Yeah, I can well believe it. So that is Degan Sacks from Alitan Co. For those who want to go and find him on LinkedIn, we'll obviously include a link in the show notes. If you like what you hear, then you may want to reach out to go learn about some of the funds at Alit. And today we're going to talk about some really cool stuff around capital allocation, and we're also going to use the hospitality industry as an example. But before we actually get there, I think Degan, it'll be good to maybe just give us a quick lay of the land around Alit's business, essentially the way you guys think. Obviously, as a fund manager, you've got a particular common thread that goes throughout your style and the way that you view the world there at Alit. So maybe let's start there. And for those who aren't as familiar with the Alit brand as Mo, who seems to have some nice core memories there, I'm going to ask you to give us the journey of how the business has evolved since it was started. And since you were there right from the start, might I add, you have been there the whole time. Sure. Yeah, thank you. I mean, the idea was always to build a business that you could implement all the principles that you'd learned over many years in the game. And really what we've tried to build is a business where we are bottom-up asset pickers, probably the best way to put it. We don't try to be macro experts. We don't think that that gives us any real edge. We think our edge is in really spending our time analyzing businesses, really digging deep, visiting the companies and doing thorough, thorough research. Let me just also add, we are not benchmark cognizant. We bought the called benchmark agnostic, which means we're not for everyone. We build up what earlier based on the best ideas we have. And so it doesn't necessarily always follow the markets up or down. It introduces what some people like to call tracking error, but that's the way we do it. We know no other way. We eat our own cooking. There's no PA investing that's allowed in the firm. If you want to invest, you put your money alongside your clients money. We try to keep it very simple in that respect and it's worked really, really well. We've tried very hard to focus on performance and not be acid gatherers as such, rather really just focus on putting our heads down, staying out of the media, working hard and letting the performance speak for itself. And it takes time. It's a slow way to build a business, but we feel like we've got like-minded clients who understand us in the way we think. And we've built a really strong business in that fashion. I laugh about the reference to staying out of the media, because obviously here you are on the Magic Markets podcast, so thank you for trusting us with that, because I know it's actually something that doesn't necessarily come naturally to you guys. So Mo, we've managed to extract them and get them on here, which is quite exciting. Yeah, I think that's so important, because at the end of the day, we've got these fun managers out there, players like Alitan Co that maybe aren't in the media, they're not above the radar. And so a lot of people lose that innovative thinking. A lot of people lose that ability to see a fund manager take on that tracking error, not be afraid to actually move away from the herd. So, you know, they get a lot of what you're saying resonates with me, I think, you know, investing alongside your clients. That's a strong alignment of interest. And again, you know, kudos to fund managers that do that, that eat their own cooking effectively. Now, I don't get too sidetracked. We did indicate to our listeners that we wanted to get into some of the weeds with you, just you know, you're thinking in terms of how you look at companies, and you've indicated that you are a bottom-up house. Now, that is true, but I know that you also manage balance portfolio. So, let's maybe start out with capital allocation 101, because, you know, you obviously are a capital allocator at the end of the day in that balance portfolio. Obviously, as a bottom-up manager, there's a strong equities component that comes through in that. And so, I really want to understand if we actually take that capital allocation thinking a step further, maybe just explain to us why is it important to you as an investor to make sure that when you're investing in an equity in a company that is, you know, in your portfolio, that management is then allocating capital in a way that you are happy with. How do you gauge that? What are some of the metrics that you use to make an assessment of whether management, whether the company you're investing in is actually doing a good capital allocation job themselves? That's a very good question you ask and probably goes right back to the most important thing is when you want to value any asset. The textbooks will tell you that it is only worth the future cash flows discounted back to today to work out what it's worth. Now, you know, that's quite easy. The problem comes in when, okay, let's assume that in that discount, you've already taken care of the maintenance capics needed to keep the business going. So, the free cash flow that it generates, the biggest thing is if that is given back to you as a shareholder, then the maths works. But then what really happens in reality is management often takes some of that cash and they invest it in future projects. Now, when that cash, let's say, a round of cash is taken from you and it is well invested and it creates two round of value. You're very happy as a shareholder. Of course, the reverse is also true when management take that money and invest in projects that ultimately don't return that cash to you and perhaps don't work. So, you know, you can get very complicated when you think about all those sorts of things. But in the end, that is the most important thing as an investor is to sit and say, is the cash, which is really the value of the business being allocated correctly. Now, there's obviously various metrics you can use. You can look at return on invested capital. You know, that's a lovely metric that tells you over time and you can't hide from that. But it doesn't have to be that hard. I mean, you really, your job is to sit every six months and look at the cash that was generated and what was done with it. Was it rational? Does it make sense? And if not, I'll put your valuation is wrong because your DCF is not going to give you the cash that it said it would. Of course, part of the problem is the control over that cash, right? And this is now where you have to trust management. This is where you have to feel like management are going to make good decisions with shareholder money. And of course, one of the big challenges we face on the market is the alignment of shareholder interests and management interests. So where you have managers who maybe are not necessarily big shareholders, but are potentially big bonus earners, they are essentially being incentivized to swing for the fences with your money. Whereas if you have managers who are big shareholders alongside you in the business, I think you stand a better chance. As opposed to them swinging for the fences, they might go and say, well, you know, we stand to lose here in the equity stack as well. So maybe we're going to make slightly more sensible decisions. So it really is an interesting conundrum at the end of the day. And that's why certain management teams, I guess, attract evaluations that they do. They do it because they've built the trust in the market, whereas other management teams, when they break the trust in the market and they are, unfortunately, some very recent examples even here on the JSE, you have a scenario where you get a big D rating in the valuation and things can get ugly pretty quickly. And one of the ways that I know investors try to feel good about that is they seek out capital-like businesses, certainly some investors do. And I'm keen to get your views on this, perhaps because if there's just less capital that needs to be reinvested in the business all the time, then maybe the risk of that capital being used incorrectly goes down. Having said that, of course, the risk of big swash-backling acquisitions is always there. Maybe it's even worse in a capital-like business, actually. I don't know, keen to get your views here. How do you look at it in terms of capital-like versus capital-like heavy businesses? Does that affect, you know, do you have a preference for either one or do you kind of treat each one on its merits along with the management team? maybe just something that you said earlier just rang true for me. I mean, I think it was Charlie Mungo who said show me the incentives and I'll show you the outcome. And so we try not get too involved as major shareholders if we are in a business and how to run the business. That's not our job, but we do look at making sure that management are incentivised correctly to allocate the capital in the best way possible. I think that is vital. And it's not for us to stand on the back benches and throw stones and say you see you shouldn't have done that or you should run the business this way. But where we can get involved is helping to sort of set the framework for what is rational in terms of the capital allocation, the money that's taken from us as shareholders and what it's done with it. But getting to your question, I mean, look, I think there's no doubt Navarna is a capital like business with huge growth prospects. You've got a long runway of growth and it's going to take no money to do it. But to some extent that's often a unicorn. And if you do find it's on 50 times earnings or whatever the story is. So I think in reality, particularly if you're investing on the JSC where your choice is limited, you're constantly weighing up on a scale the degree of capital like versus capital heavy, the degree of growth that's available to you. And trying to put those two together to get a sense of valuation. I would say to you that sometimes perhaps a capital like business has greater risk of those cash flows being misused because you can imagine, you know, this business generates all that cash and then it just keeps going off to shareholders. I'm sure it's very tempting to just hang on but we can do something better with that. Where sometimes with capital heavy businesses, there isn't as much free cash being thrown off. When you have to think hard about spending a billion around, you're going to think very carefully about making sure that you've dotted the eyes and cross the teeth. I guess the other risk is share buybacks at any price, right? You have a situation where a business is capitalised and they don't necessarily want to pay everything as a dividend in cash. So then they inevitably start using share buybacks. But that thing will often trade at a big premium valuation, as you say, and you end up with share buybacks that just get baked in at any price. That is the US tech story, right? With the additional layer where half the time, they're basically just offsetting stock-based compensation with those share buybacks. Correct. And I mean, try to think, imagine that you owned this whole business and it wasn't listed. What would be the rational thing to do? And you can kind of go through a very easy decision tree of. Once you've paid all, you've used all the money you need to maintain the business. Now there's extra cash. What opportunities are available? Compare those to buying back your own shares where you don't need to do a due diligence, you know your business. But of course it's valuation dependent. And also comparing that to saying realistically, if I don't have ideas, will they pay out the cash? Assuming your balance sheet is really strong of course first. And we try and think about it like that because I think the challenge in the listed space is that once you start paying a dividend, you expect it to continue paying a dividend. And maybe there are times when the rational thing to do is to stop paying a dividend and pay down your debt. Or buyback shares. There's many reasons and incentives in the markets that make it quite difficult to do that. Yeah, I like that very rational approach. I think you've used that word quite a bit. And I want to maybe hone you on that. It's, you know, what's the rational thing to do? Because sometimes it's share buybacks. Sometimes it's paying down the debt. And I mean, we've spoken about, you've mentioned, you know, you're looking at the JSC and maybe your subset is quite limited there. If you widen that lens internationally, I mean, one of the most egregious examples of, you know, just throwing your cash flow into CapEx and becoming a CapEx heavy business has been the tech space. I mean, if you just look at how they burning through hundreds of billions of dollars worth of capital, you know, that again is a bit of a risk flag. And maybe I get a little bit sidetracked. I don't want to go into the tech space here. I mean, we mentioned something here in terms of the hospitality space because that's a great example where we've seen businesses effectively migrate from, you know, these traditional capital heavy businesses into capital light businesses. And so I want to maybe use that as an international test case because we've seen those groups go on, they build these strong brands. And then in that initial phase, like I say, they use their own capital, they build the hotels. And then after that, they almost pivot and they then use that brand strength and enter that franchise phase, which is effectively the capital light model that comes through. And that's where they almost become the unicorn that you're speaking about. Maybe they do, maybe they don't. And that's when they start growing through other people's money. I mean, that's something that goes and I love talking about on the show. Now, we are going with this question is, have you actually observed a trend in the hospitality space, maybe even in other sectors where you see these companies, they're good, they have sound businesses, they're generating the cash flows, then they reach that inflection point and then it just unlocks that massive runway of growth. And what are your thoughts on that from an investment perspective? I mean, you you described it as Nirvana, right? How hard is it to actually find those? And in which sectors do you think you'd find those most easily? Because all been about tech over the last while, but that's not necessarily where the best investment subset lies. That's a very complex question. I mean, I think probably the oldest debate we've had in this business is this debate around upcode, prop code. Does it make sense to own your assets to be acid heavy in the hospitality space? Does it make sense to not be? And it's always come out that it depends is the answer. It's not black and white. And your comments on the international hotel groups are actually quite fascinating because what you've had there is developed market groups that as you say initially were acid heavy, they owned all their hotels and they created a brand and they were able to market that brand really, really well. And then what you have is business and it's called it leisure travelers from the developed market, starting to travel to other parts of the world. And let's take a very random example that you're an executive in a in the US. You want to come visit Cape Town and you say, look, I don't know who city lodge is. I don't know who southern sun is, but I know merit is, this book me into a merit. And you can see how that model has really worked as those groups have now been able to take that model and expand it through the world based on that brand and of course the loyalty schemes and very clever things they've done as well. But you know, we've often looked at it the other way around and said, can that work in reverse? And certainly it appears as though it doesn't. So you take southern sun which own pretty much all of their assets. There isn't that big group of people traveling from South Africa to the US saying or to Paris saying find me a southern sun. That's not the way they think about it. The franchise model is very interesting. If you would look at spur famous brands, perhaps less so, but spur is very asset light. They both that business match on the same basis so you can look at a number of the international players there that do similar things. And those are good examples I think. You know, the big issue if I go back to the hospitality that you brought up is, you know, you've got to look at each place in its own little niche and you know, southern sun for example, controlling most of the hotel stock in the key places that you want to be. So they're not beholden to the OTAs. They're not beholden to needing to have a brand that someone else can send you away. I mean, they sit in the position saying, well, we own, you know, the Beverly Hills hotel. If you want to come and stand in Beverly Hills and tell you coming to us, that's the difference really. And you have to look at a piece by piece. Yeah, it's fascinating. I remember the first time I was really exposed to that international hospitality approach. It was when I think we covered Hyatt in Magic Market Premium and you can really just see it coming through now. They talk about how it's a boost to return on equity because they're now starting to earn franchise fees where they're not having to apply their own capital, for example. It's something that storage has started doing in the property space as well. Trying to generate more and more of those fees by actually managing properties for people as opposed to always applying their own money. Lots of good examples of that. That prop code, opcode debate that you've raised there. That's a classic one. MTN going the other way at the moment with their deal to acquire IHS is pretty interesting. They want to own the towers in Africa as opposed to actually just being the opcode. So that's something that kind of bucks the trend that we tend to see in that space. It's actually cool that you raised famous brands versus spur because famous brands might be a good example there of the danger when there's cash lying around that can be used for transactions, right? Because that is technically a capital-like franchise model, but they've unfortunately done some deals that really hurt shareholders along the way. So like you said earlier, capital-like may be not a guarantee of success, actually. Versus CapEx Heavy, it really depends on what happens with the money. But Southern Sun locally, really impressive business. I think it's a great management team. I hosted them or co-hosted them on unlock the stock towards the end of last year, really cool management team. I love the way they think. So that's something that you've raised as a goodie in the local market. A city lodge, that's something that I've bought into. Pretty interesting business. I like what they did with the food and beverage side. So maybe this is a good opportunity to understand more about your investment thesis. You've mentioned some of it there already, which is how Southern Sun owns these properties. And my understanding is you have it as one of your core holdings in the funds. Maybe just walk us through why that's the case. What do you like about it so much beyond just these cool properties that they have? Because there's other stuff to it, right? It's evaluation. It's the management. It's all those important characteristics, right? Yeah, I mean, sure. It's been a very long road. We've walked with them. And there was a split of the casino group and the hotel group at one point. And that's really what gave us an opportunity to look much more closely at just the hotels. The big thing for us, we looked at it was trying to understand the economics as they stood at the time because it's a very cyclical industry. If you were to take a step back, you say, what happens in hotels? Well, when there's a lot more demand than [BLANK_AUDIO] is hotel room available or room stock available not only do you fill your hotel but you get to be able to charge more per room so you can really get a sort of hockey stick effect on your revenue line and then of course you start earning decent returns on the amount you have invested in the land and buildings but once you sort of get to an excessive level there it starts to become attractive for someone to put a hotel next to you and one of the things you always see in the hotel sector is that eventually someone puts a hotel extra hotel in a region and if inevitably too many hotels go up your occupancy drops it gets harder and harder to fill your rooms you start charging less and you get a double whammy on the downside as well so you have to bear in mind that there is that cyclicality and it's quite regional like what is happening not just in the western Cape but in a specific node and that's what you have to watch very closely. Marcel as you said he's a you can see the rationality of the way he manages that business and he often says the problem is that hotels are attractive assets on the eager so when you talk about ROE it's return on on eager and very often people build hotels people with lots of money because they want to build something that looks nice that they can be proud of and you know the economics don't necessarily stack up if you were to be let's say in a corporate with some quite strict criteria to return on the march you're putting into it so that is what you always up against but I think if you look through the cycle they've turned out to be pretty strong assets it keeps us excited about the business itself is that even though we've gone from 250 a share or even less I think Marcel is reminding me the other day to 10 11 round a share today that doesn't get close to what it would cost you to build those assets now what it would cost to build those assets is largely irrelevant in terms of its current economics no one cares about that but that gives you some idea of what it would cost someone else to put that asset in and until those economics make sense they shouldn't in theory put more hotels in so when we look at southern sun today we worry about new hotels that go up in the western cap because that's clearly the space the tourism space at the moment but if you look around the rest of the country that's really where the opportunity sits because those assets are earning quite a low return relative to let's say what they're worth and what that would cost to build and there's no new capacity coming on in haltingas an example and I think that's with opportunity therefore the rest of the portfolio lies so Moe is our resident bear and I don't doubt he's got a question about risk which I'll let him ask you now but I did want to say that it's just really interesting around replacement costs I've seen those arguments come through before to say oh the replacement cost is I don't know two bucks and the thing is trading at one back just a silly example and you're right that is technically irrelevant and I have always thought that but it's also not that irrelevant in the context of a cyclical business when new stock can come on stream so that's pretty interesting it's a bit of a defensive element to it actually when things are depressed you're not just going to get that new stock coming in it's it's almost like mining actually when commodity prices are down you just don't see the same level of exploration and activity so very interesting and Moe I don't doubt you've got some other thoughts here around risk knowing you as well as I do I was chuckling because you mentioned mining as an analogy and I was thinking the same thing because you know Dagon was talking around the competitive pressures the cyclicality how you know sunk assets effectively give you a bit of a moat in some instances except for your new bulls I thought those insights were very fascinating I also like the aspects of operational leverage and financial leverage that come through in that hospitality sector quite nicely like you say you've got a limited number of beds and then you know if they actually get booked up in this demand you can actually flex the price at all but so those are pretty decent aspects that come through it as Ghost has said you know I'm the resident bear here and so I'm going to ask the question around risk because you know you already mentioned the risk of new supply coming on stream and again with hotels with hospitality it's very location specific it's like finding the right team if we're talking about mining as an analogy you've got to find the right all body and so forth with hospitality it's similar you've got to find the right locations but then there are lots of people with deep pockets out there and specifically in hot markets like in the Western Cape at the moment and that gives you a lot of competitive pressure so we see that as one of the points you've raised but what are some of the other risks which keep you up at night maybe specifically in this hospitality sector but then also more broadly across the rest of the portfolio as your position today well I mean firstly let me say I think your mining analogy is spot on in a sense that if you were to go back to Anglo American for 30 years ago as an example they were unbelievably good at being counter cyclical so when assets were in hot demand they tended to let those assets spin off lots and lots of cash they made no acquisitions they built their balance sheet and they waited for the tough times and when the tough times hit and some of the more marginal mines were struggling they were able to be opportunistic and pick up assets for not next to nothing but clearly a cheap price so that clearly is the way that you want your hotel business to run as well and I think one of the things that we've seen in the way sudden sun has been run is quite similar they have tried to accumulate cash digier their balance sheet wait for those opportunities to hit and then they have the ability to strike and buy those assets cheaply and certainly when they were combined with the gaming group back in the day and it was just this huge cash flow they were very disciplined about what they did and I always kept those assets in top neck much the way Anglo American used to make sure their mines were always well looked after you never to worry about under investment and I'm going back a long time ago when I make that so you know you talk about what worries us management can always change the pressures on management can change from various shareholders you want different things I think those are always possible and you're always going to have the risks around new hotels coming in I think you have to be always concerned if you're in the tourism industry that we as South Africa shoot ourselves before to get and we do something silly because we've seen how quickly that tourism can disappear you know if you're sitting trying to book your room and somewhere there's a headline there Cape Town is out of water well you're just going to go somewhere else all that there's no electricity you're just going to go somewhere else again all perhaps that there's a riot or something that God forbid we don't want to see so those worries but I think that's also why when you invest in that space you always have to be cognizant of the risk and making sure you've got a margin of safety that's why you don't want to have a net debt to EBITDA four times when you're running a hotel group it's not that you can't service us in the good times it's when there's trouble yeah and when that EBITDA comes down in that net debt to EBITDA spikes as we've seen at the likes of Sappy and some other cyclical players so Deagan I'm going to steal one more question with you while we have time we've been slightly cheeky here on time but there is one thing I do really want to ask you which is in terms of your approach do you do something like understand the hotel industry and then say okay locally I can pick southern sun city lodge internationally there's hired there's merit whatever the case maybe or do you look at it and say okay southern sun's a good company I'm prepared to learn about the sector but I'm not actively seeking an international equivalent for example so in other words are you saying I want to own hospitality let me find the stock or are you saying I like the stock let me learn the sector what tends to be your approach yeah I would answer it's a little bit of both and also none of the above the the important thing when you look at South Africa is to accept there's gee at our size we manage 23 odd billion there's about 120 stocks to choose from now if you 10 times our size there's there's very few stocks to choose from it gets very difficult to be able to move so in the South African context there's only these stocks and you look at them and you try and understand it when you're looking overseas you have the comfort or the privilege of being able to look and say I don't really like that industry I'm not even going to look further and you can dig into those business models that you really really like and there's more than enough to find and we always say you want to use your eyes and play your eyes and you want to see if you find something in South Africa that you really like can you find something similar overseas and the reverse and sort of it talks to how we set up our analysts analysts have the freedom to look at whatever they want but they tend to become said to specialists because they get really good at retail or really good at hospitality or gambling or whatever it may be and then you look around the world and you understand what's happening in the various markets and it gives you a much better perspective and context to understand what's really going on let's say for this the stock you look here in South Africa dig and thanks I mean those are all fascinating insights and we really I always feel as though we've only just scratched the surface I mean I look forward to many more detailed discussions with you I do tend to get rained in I know ghost always tells our listeners and this is true I get sidetracked so sometimes it tells me more you go off on a tangent and your questions are too tangential so I have restrained myself but they can hopefully the next time we have you on magic markets let me loose a little bit more than than I am right now and I can ask some of those more tangential questions maybe in the interest of time it's a good thing that I didn't have time to ask those more tangential questions because we are out of time and Moe just wants to talk about macro just wants to talk about macro and that is what this comes down to Moe is missing his macro segments at the start of the show that's what this is all about not always true dig and I really appreciate the bottoms up insights that you've given us here and I certainly look forward to inviting you back on to magic markets in the future but to our listeners we hope you've enjoyed this it's something that we're trying that That is different. a different perspective out there on markets, on how people are analyzing the investments, how they put together the investment these these. So let us know what you thought of the show. Hit us up on social media. It's at Magic Mark. It's part one word at Finance Ghosts and at Muhammad Nala, all on X, all going to finance on LinkedIn, pop us a note on there. And we hope you've enjoyed it until next week. Same time, same place, thanks. And Deegan, thank you so much. Thank you, guys. We really enjoyed that. Yeah, thank you very much, Deegan. We'll include in the show notes. We'll have the links to Elit, go and check out the fans, go and learn more about them, and we very much look forward to having you back, Deegan. Thank you so much, and ciao. The opinions that you have heard on this podcast are those of the person who provided them, the fund manager, Mo, all myself, and none of it should be taken as financial advice. Elit and CoPTY Ltd is an authorized financial services provider license number 20513. Visit elit.co.z for more information.