Portfolio Manager comment Coeli Frontier Markets Fund Q1 2020
The global sell-off in the wake of COVID-19 drove the fund lower in the first quarter of the year. Heavy selling in fund’s holdings in Georgia and Vietnam adversely impacted absolute and relative returns.
As governments across the world started imposing restrictions on the movement of their populations in response to the outbreak of COVID-19, global markets collapsed under the uncertainty of the economic impact. Frontier Markets (FM) were no different in this regard: all the countries we follow have recorded cases of the coronavirus; all have pursued their own form of social distancing in order to prevent the spread of the disease; and all have had large draw-downs in their equities market, circumventing the otherwise expected diversification benefit.
There is a lot that we still do not know about the spread of the virus and while the immediate economic consequences on tourism and service industries are obvious, the second- order economic effects are unclear. Despite this uncertain outlook past crises have taught us that some form of normalcy will eventually return. When it does we suspect that it will accelerate the conversion of consumption in branded goods and through formal / organized channels, increase the importance of digital distribution models and amplify the need to diversify supply chains out of China.
Past crises have also taught us that high quality businesses with strong balance sheets, robust cash flows and nimble management teams will emerge in a stronger market position once the dust settles. Not only do our portfolio companies possess those characteristics but they operate in an environment where their major competitors are informal, unorganised and poorly capitalized. Thus, while it is not possible to know whether short term prices will go up or down from here we are confident that the potential for long term value creation is significant.
How does the onset of coronavirus impact our work with the portfolio? It doesn’t; we continue to look for quality businesses that have the ability to compound earnings at high rates of return on invested capital over the long term.
First quarter return review
With the exception of China, the dispersion of equity market returns in the developing world (EM and FM) was minimal in 1Q20; with the majority of markets falling 25-35%, in USD. It appears that investors – local and foreigners alike – have been indiscriminate sellers in the face of the unprecedented and synchronized uncertainty brought on by a pandemic. Thus, the fund’s disappointing return, was broadly in line with MSCI Emerging Markets, ex. China, which returned -30.6% in the same period. MSCI Frontier Markets (‘MSCI FM’) fared somewhat better, returning -26.6% in 1Q20, with the fund’s investments in Vietnam and Georgia detracting from the relative return.
Liquidity (measured in numbers of shares traded) has been robust during the quarter, however, the material volatility has resulted in a significant widening of the bid/ask spread. Thus, in order to protect investors, the swing pricing on the fund, which takes into actual trading costs and spreads, has been increased to 2.25%, from 1.25% and will remain there as long as the volatility persists.
Vietnam is widely recognized as being a leading light in the prevention of the spread of COVID-19. Its success to date has been based on its preparedness (it set up a steering committee in mid-January, before its first recorded case), speed of action from the onset, for example in closing the boarders, shutting schools and imposing mandatory quarantine for foreign arrivals, and rigorous contact tracing. In addition, there is no doubt that the authority and oversight of the central government and military has been highly beneficial as well. All-in-all this has meant that Vietnam has been able to be more targeted in its social distancing policies, meaning its economy, while slowing markedly, hasn’t ground to a halt (1Q20 GDP up 3.8% YoY), making it better placed to benefit from the eventual recovery.
Furthermore, Vietnam will continue being a key beneficiary from the ongoing diversification of supply chains out of China, a process that we expect to accelerate due to heightened geo-political tensions resulting from this outbreak. Despite these positive attributes, Vietnam was one of the fund’s worst performing markets, falling 44% (in USD) during the first quarter of the year, compared to 31% for MSCI Vietnam.
The large draw down in the fund was led by retailers Mobile World Investment Corp (‘MWG’) and Phu Nhuan Jewelry (‘PNJ’) which fell by 49% and 47%, respectively. In an environment where governments are enforcing strict social distancing measures and shuttering non-essential retail stores the near-term earnings risks are high. Despite this, we do not see any material deterioration in the long-term prospects for these businesses. Indeed, the current crisis will likely strengthen MWG and PNJ’s market positions as their major competitors – informal traders – have very limited resources with which to weather this sudden fall in revenue. Furthermore, the demise of indirect competitors will provide opportunities to acquire attractive store locations, one of the key constraints on growth.
MWG, one of the fund’s largest holdings (8% at 1Q20), has two broad business areas, electronics and food retail. Earnings in its electronics business, under the TGDD and DMX brands, are most at risk due to store closures (they might not be considered essential) and a decline in discretionary spending. After a solid start to the year, the company reported a 10% decline in revenue from this segment in March with weak sales of mobile phones and TVs and strong demand for home appliances, refrigerators and laptops. An increase in sales through online channels, which accounted for 13% of electronics sales in March 2020 (v 7% in March 2019) helped offset some of the store closures and decline in footfall but it will not be a perfect substitution. While we would expect a further deterioration at the start of 2Q 20, restrictions have been eased in Vietnam and 98% of MWG’s electronics stores are open at the time of writing.
MWG’s grocery business, BHX, which had 1,000 stores at the end of 2019, is a key beneficiary of the current crisis. Increased focus on food safety is accelerating the conversion of shopping habits from unhygienic wet markets, which currently account for 95% of Vietnamese grocery sales, to convenient modern retailing. Furthermore, maintaining relative price stability, compared to the more opportunistic market vendors, in a period of high demand helps increase BHX’s brand equity.
In response to consumer demand, BHX has developed new service delivery models including personal shopping – where staff pick goods from existing stores for delivery / pick up – and traditional online sales from a more limited assortment, fulfilled directly from dedicated distribution centers. Thus, BHX recorded 50% month-on-month sales growth in March and 1Q20 sales were 3 x higher than the same period in 2019. MWG plans to open sales growth of 50% month-on- month, with 1Q20 sales being 3 x higher than 1Q19. In light of this opportunity, improved location availability and more reasonable rent levels the company will look at opening 1,000 new stores in 2020, doubling the store count.
MWG is highly cash generative with a return on invested capital (‘ROIC’) of 30%. At March 2020 the company had comfortable debt levels with net debt to equity of 34%, net debt to EBITDA of 0.7 x and interest coverage of 8.8 x. Furthermore, the company has renegotiated its debt facilities: extending maturities; and reducing rates.
Given foreign ownership restrictions the market price for MWG (and PNJ) are set by local investors which have marked the price down by 49% during the first quarter, taking trailing P/E to 7.5 x. While the near-term outlook is impossible to forecast, the strength of the business and improved long- term outlook makes this move look irrational. Indeed, over the same period the price offered by potential foreign buyers is virtually unchanged, meaning that the premium has increased from 30% at the end of 2019 to 65% at the end of Q1 2020. While it might be tempting to take advantage of this premium in the current environment, we believe that long term investors will be much better served by MWG’s compounding of earnings in the coming years.
The impressive reform agenda undertaken by successive governments has turned Georgia into the most open economy in our investment universe. It has cemented its status as a regional trading hub and quality tourist destination. While 99% of the time these are highly attractive attributes, this is not the case in a pandemic. The IMF now forecasts Georgian GDP to contract by 4% in 2020 before increasing by 4.8% in 2021. All this is, of course, guesswork however, the aforementioned reform agenda and prudent economic policies (average budget deficit of 2.7% over the last five years, resulting in a modest public debt to GDP of 50%) does give the government ample room to stimulate the economy and ensure a rapid return to growth as restrictions are eventually loosened.
The sharp slowdown in growth has resulted in TBC Bank and Bank of Georgia falling 48% and 47%, respectively. The slowdown in the economy will impact asset quality and the depreciation of the Lari (down 12% YTD 1Q20) puts pressure on capital levels. In recognizing this the National Bank of Georgia has responded quickly requiring banks to book 3 – 3.5% in general provisions while relaxing capital requirements and providing significant liquidity. These additional provisions mean that TBC’s capital adequacy ratio (CAR) has been reduced to 16.1% while Tier 1 capital is now at 11.5%, both very comfortable levels. The suspension of dividends and the expansion of its tier 2 credit facilities provide additional liquidity.
The fall in prices mean that TBC Bank, the fund’s largest holding in Georgia, currently trades on a P/B multiple of 0.6 x, despite generating an ROE of 22% in 2019. This valuation indicates either a severe deterioration in the long-term return profile or a material dilution to existing shareholders. We do not believe either will eventuate: swift government action, commitment to reform and an open economy will ensure a relatively quick revival of growth; while prudent lending standards and high capital buffers minimize the risk of dilution. Thus, while it is hard to know what the immediate future brings, current prices of Georgian equities appear overly pessimistic.
In addition to the broad-based selling in EM / FM, Nigerian equity prices were also impaired by the collapse in oil prices, which fell 65% during the quarter. The move in oil reflected both a decline in demand as air and road traffic ground to a halt but also nonsensical increases in production by Saudi Arabia and Russia after they failed, initially, to agree production cuts. Nigeria’s current leadership are obsessed with maintaining stability in its currency, the Naira, but oil, which accounts for almost all its foreign exchange receipts, at USD 30 make this impossible. Thus, a significant devaluation and / or a freezing in liquidity of the X market, like 2016, seem inevitable. In the first part of the year we started reducing our Nigerian exposure on growth concerns and absence of ambition on necessary structural reforms, this process was accelerated during the quarter and today our exposure to Nigeria is under 1% of the portfolio.
As regular readers will understand, the unpredictability of oil prices is one of the key reasons we do not hold exposure to oil and gas in the portfolio. We do, however, have indirect
exposure to oil through our holdings in Kazakhstan and Kuwait. While changes in the oil price can have short term influence on assets prices of our holdings in those countries, it is not a key long-term driver of returns.
The one bright light in the portfolio was Al Eqbal Investment, the fund’s Jordanian molasses (shisha) manufacturer that increased 11% in 1Q20 on news that the major shareholders plan to buy out the minorities and take the company private. The offer price is some 17% higher than the company’s quarter end valuation, which should provide around 140 bps to the fund’s absolute return once approved at the upcoming extraordinary shareholder meeting.
2020 earnings a guess; liquidity and solvency in focus
Like so many others we have become armchair epidemiologists overnight, trying to assess the human and economic impact of the virus on our markets and portfolio companies. On the human impact a number of factors are favorable in our markets, compared to more developed countries: the proportion of the population that is aged over 65 years is minimal (for example 7% in Vietnam and 4% in Kenya v 22% in Italy); there are fewer people in transit; and in many cases they were better prepared following recent experiences with SARS in Asia and Ebola in West Africa. Conversely, FMs have less developed healthcare systems; more densely populated cities; and reliability of reported numbers is lower. It is, in other words, impossible to predict whether FMs will be more or less affected by the virus than other countries.
The economic outcome will be determined by the length and restrictiveness of social distancing measures undertaken both locally as well as in countries that are key trading partners as well as those government’s monetary and fiscal response to the crisis. While some of the immediate effects are obvious – for example, the tourism industry will struggle, and online grocers are benefiting – there will be a lot of second round effects that will are extremely difficult foresee today.
Since being sent home we have had the opportunity to speak / video conference with all our portfolio companies. While it was good to get a sense of what remedial action they were taking in light of the changed operating environment, none of them were willing to give guidance for 2020, despite reporting upbeat 1Q20 numbers.
Hence, near term economic and earnings forecasts are even more inaccurate than usual.
With this in mind, our focus turns to liquidity, debt maturity, solvency and general balance sheet strength. Afterall a precondition of benefitting from the changed competitive landscape is surviving. Furthermore, as noted above, dilution is a key risk to intrinsic value, especially when done at the current rock bottom prices.
It should be unsurprising that our portfolio of high quality businesses are both highly cash generative and well capitalised. Thus, the majority, 13 of 21, of the fund’s non- financial holdings reported a net cash position in their most recent accounts. Of those with net debt the Vietnamese retailers (MWG, PNJ and FPT Retail) have seasonally high debt at December year end as they build inventory levels before the important Tet (Lunar New Year) season. As an example MWG reported a 42% fall in net debt at March 2020, compared to December 2019.
The net debt / equity of all the non-financials holdings is a lowly 3%, increasing to 61% for those companies with net debt. On an aggregate basis this net debt represented around 0.7 x last reported EBTIDA, increasing to 1.9 x for companies with net debt. Meanwhile debt servicing requirements are low with interest coverage for our holdings with net debt close to 8 x. Thus, we conclude that the absolute debt levels of our holdings are low and their ability to service their outstanding debts is high.
During a crisis, dilution risks for banks arise due to potential capital erosion as a result of margin compression, rising bad debts and lower growth. In the absence of uniform standards for reporting capital adequacy levels we concentrate leverage using the ratio of equity to assets and return on assets (‘ROA’), which measures a bank’s unlevered earnings. Thus, based on the most recently reported numbers, the overall equity / assets of the portfolio’s financial holdings was a healthy 13.4%, ranging from 10% to 22%, while the ROA coming in at 2.45%, varying from 1.3% to 5.2%. This compares favorably to similar ratio’s for the bank’s making up MSCI’s EM index which generated an ROA of 1.1% and had an equity to assets ratio of 9.8%. Low leverage and strong profitability indicate the portfolio’s financial holdings have decent capacity to absorb higher NPLs and lower margins before negative earnings start destroying capital, possibly leading to dilution.
It is, of course, too early to tell whether our portfolio companies will make it through this period without requiring further equity capital, but our analysis indicates that the starting point is good. The indiscriminate selling seen in 1Q20 shows that this has not been reflected in short term prices, but it does bode well for future returns.
We remain committed to our strategy of being long term holders of high quality businesses which benefit from the structural changes that are ongoing in our markets. Such companies deliver superior long term capital appreciation by compounding earnings at high returns on investment capital over time. Unfortunately, this does not guarantee superior returns in the short term.
It is, therefore, imperative that we view any changes to the portfolio in the lens of altered long-term structural changes impacting our holdings, rather than the short term challenges they might face. Thus, all the work we have done in the first part of the year has been focused on long term opportunities rather than trying to pre-empt short term price movements, which are impossible for us to predict.
We were satisfied with the composition of the portfolio at the start of the year and see the onset of corona as accelerating pre-existing trends including the conversion of consumption to formal channels / branded goods, diversification of supply chains out of china and growing importance of digital channels. Thus, we do not see any reason for wholesale changes to the portfolio.
Notwithstanding, the volatility in the markets has presented opportunities to purchase a few high quality franchises that have been on our focus list for some time at favorable valuations. We are in no way claiming to collect these stocks at the bottom of the market but feel that we have been able to accumulate them at a significant discount to intrinsic value.
FTP Corp, Vietnam’s leading IT company, is a great example of this. It is a company we have been following for the 15 years we have been visiting Vietnam; admiring its ability to compound earnings (10 year CAGR of 11% in USD) at high rates of return (ROIC of 15%). However, we have never been able to justify the 30% premium to market price required to be paid by foreign buyers. During the quarter we were able to acquire a modest position in the company at market prices, which in themselves had fallen 30%. Thus, our purchase price was some 60% below what were would have paid in February.
FPT has three main business areas: 1) technology – software outsourcing for global clients and digital transformation services; 2) telecommunications – it is Vietnam’s second largest provider of fixed line broadband services; and 3) education – with 45,000 students at their technology universities, vocational training centers and K-12 schools. While its first quarter earnings were strong (EPS up 19% yoy) it is reasonable to expect some softness going forward as growth in the order backlog slow due to delays in their customer’s IT spend as well as logistical difficulties in selling internationally. Despite this, the company’s long term growth prospects remain solid. FPT’s software business stands to be a direct beneficiary of the aforementioned structural trends of supply chain diversification and increased digitalization. While its highly profitable education business plans on increasing the number of enrollments to 100,000.
During the quarter we also made an initial investment in Commercial International Bank (‘COMI’), Egypt’s leading private sector bank. In recent years Egyptian government has completed one of the most comprehensive reform packages, globally. While not in focus right now, these reforms give the authorities an excellent platform from which to reflate the economy once things start opening again.
COMI is primarily focused on banking high quality corporate clients, although in recent years it has developed a sound retail offering. It also has Egypt’s strongest deposit taking franchise, which helps generate lower costs of funds (typically 10% lower than other local banks) and plays a large role in it being able to generate high returns – an ROA of 3% and ROE of 30% through the cycle – despite having a capital adequacy ratio in excess of 26%.
Like all banks, globally, near term results will be adversely impacted by lower net interest margins (‘NIMs’) and a deterioration in asset quality. However, COMI’s large holdings of government paper (51% of assets), 60% of which are long-dated actually mean that lower interest rates are net positive for earnings due to the fall in the cost of deposits. Despite the defensive nature of its earnings, COMI fell 30%, in line with global EM, during the quarter taking valuations to levels seen during the global financial crisis and Arab Spring.
Valuations at levels last seen in the Global Financial Crisis
The large draw down in asset prices and strong 2019 earnings growth (EPS up 10% in USD v -13% for MSCI FM and -14% for MSCI EM) make stocks look very cheap on a P/E basis, 8.4 x on a trailing basis for what it is worth. While 2019 earnings are perhaps the best reference point for 2021, the uncertainty of the 2020 earning’s outlook mean that it is more relevant to look at price to book (P/B) multiples as book value is less volatile than earnings.
As can be seen below, the vast majority of the markets that the fund is present in are now trading at the bottom of their 10-year range; at levels last seen in the GFC.
Thus, the fund has never been cheaper, measured on a P/B basis, 1.5 x. This is 46% lower than the median P/B since the inception of the fund, which compares favorably to MSCI FM (15% lower than its long term average) and MSCI EM (20% lower), not to mention the S&P 500, which is actually slightly higher than its 10 year average.
Clearly the near term earnings uncertainty means that prices should be lower, but the question is by how much? To get a better sense of earnings sensitivity we reviewed our models – we prefer residual income model, which reflects our conviction that returns are the driver of long term value. If we assume that our companies do not generate any cash flow in 2020 and 2021 – not a realistic scenario in our humble estimation – then the equity value of our holdings fall 5 – 15%, far less than the collapse in prices we have seen YTD 2020, despite starting the year at a lowly 10 x trailing earnings.
Thus, while we fully appreciate that aggregate valuation multiples are even more difficult to interpret at this point of a crisis than usual it is difficult for us not to conclude that the current prices represent tremendous value.
As a dramatic quarter comes to an end we can summerise our thoughts as follows:
• the synchronized shuttering of economies had a profound impact on asset prices in the first quarter of 2020, FM included;
• amidst the uncertainty it is important to remember that economies will eventually function again;
• in FM we expect the recent events to accelerate existing trends, including the conversion of consumption to formal channels / branded goods, diversification of supply chains out of china and growing importance of digital channels;
• we remain focused on identifying companies that can compound earnings at high rates of return over time to take advantage of these structural developments; and
• on multiple measures assets are inexpensive. It does not mean that they can not become cheaper (we do not guess short term price movements) but the recent drawdown bodes well for long term investor’s future returns.
Hans-Henrik and James
DISCLAIMER. The information provided here does not constitute professional financial advice. Past performance is not a guarantee of future returns. The price of the investment may go up or down and an investor may not get back the amount originally invested. The key investor information document (KIID) and prospectus are available at www.coeli.se.
VIKTIG INFORMATION. Detta material utgör inte investeringsrådgivning. En fonds historiska avkastning är ingen garanti för framtida avkastning. Värdet på fondandelarna kan både öka och minska och det är inte säkert att du får tillbaka hela det insatta kapitalet. Fondens faktablad och informationsbroschyr finns på www.coeli.se och kan även erhållas direkt från Coeli.