Portfolio Manager comment Coeli Frontier Markets Fund Q4 2019
In 2019 the fund returned 4.0% (in USD; gross of fees) driven by strong returns in Vietnam, Kenya and Kazakhstan, offset by weakness in Bangladesh. On a relative basis the fund’s significant underweight in Kuwait drove a large deviation to MSCI Frontier Markets TR (‘MSCI FM’), which increased 18.0% over the same period.
The fund’s 2019 absolute and relative returns were frustrating but in no way reflect a deterioration in the fundamentals of the portfolio’s holdings. Indeed, the portfolio’s holdings continue generate decent earnings growth (8% in USD at 1H, YoY), at a respectable rate of return (ROE of 32%) while the long-term outlook for these high-quality companies in nascent markets remain solid.
While the 2019 results give rise to many reflections, our conviction that the best way to benefit from the long term structural tail winds in these markets is to be long term holders of high quality companies that can consistently compound high returns on invested capital. This highly active strategy will result in periods of relative under-performance, as seen in 2019, but is the best way to deliver long term returns. Thus, since we started the strategy nine years ago (2011) it has delivered returns of 6.4% p.a. in USD, versus 1.8% p.a. for MSCI EM and 1.4% for MSCI FM.
The combination of strong fundamentals and sub-standard returns has left valuations at very attractive levels, the trailing P/E of the fund, 11.2 x, is at the bottom of the trading range since the strategy started in 2014, while the 27.4% discount to MSCI Emerging Markets (‘MSCI EM’) is well below the average discount of 15.7% over the same period.
These attractive valuation levels come at a time when the investment case for FM is as strong as it ever has been: the global interest rate environment is becoming more accommodative, driving the search for yield; political transitions of power have never been more orderly; FM currencies, on the whole, are close to long-term fair values; and the differential of GDP growth of the developed world to FM is widening. This combination of strong bottom-up characteristics, attractive valuations and sound market characteristics for the asset class make us confident for future returns.
2019 return review
On an absolute basis the returns of the fund were impaired by broad-based outflows in the asset class. While over 75%of the poor result relative to the index, MSCI FM, was due to the fund’s large underweight in Kuwait, which is benefiting from its imminent transition to MSCI EM. A detailed analysis of the best and worst performing markets is provided below.
Kenyan was a stand-out market in 2019, with the fund’s primary holding in the country, Safaricom, increasing 53% (in USD). The performance reflects continued strength in the company’s mobile money platform, M-Pesa, revenue for which increased by 18% on the back of a 24% increase in the value of transactions. Over half of the growth in M-Pesa’s revenue came from new business lines, the most interesting of which has been Fuliza, a short-term (average duration of 4 days) overdraft facility. Revenues from M-Pesa now account for 34% of Safaricom’s revenue, up from 26% just three years ago. Growth in M-Pesa requires virtually no incremental capex meaning that the return on invested capital generated from this growth is nothing short of outstanding.
Halyk Bank, the fund’s sole holding in Kazakhstan, increased 42% in 2019, having delivered exceptional operating performance since the acquisition of KKB in 2018. In the first nine months of the year the company increased net profit by 53%, generating a ROE of 30%, despite having a tier 1 capital adequacy ratio of 20%. The strong result was driven by a 18% increase in consumer lending, improved net interest margins (NIMs) as well as significant cost savings as Halyk began to realise synergies from the aforementioned merger. These results mean that Halyk is still trading at undemanding valuation metrics of 4.6 x P/E and 1 x B/V, despite its strong share price performance. While the current dividend yield, over 8%, is very attractive, it has the potential to increase significantly in the coming periods as management has guided increasing the payout ratio from 0-50% to 50-100% in future financial periods. Finally, the successful completion of secondary offering by the controlling shareholder for 10% of the company (USD 345 m in equity) has improved stock market liquidity.
The fund’s holdings in Vietnam were the largest contributors to the absolute return. It was particularly the fund’s retail holdings that performed well with Mobile World (‘MWG’), a consumer electronics and food retailer, and Phu Nhuan Jewelry (‘PNJ’), increasing by 33% and 26% (in USD), respectively. These moves were inline with earnings growth, meaning that these high quality, high growth companies are just as reasonably priced as they were at the start of the year.
MWG, the fund’s largest holding, recorded earnings growth of 34% for the first 11 months, of the year, compared to the same period in 2018, representing a ROE of 36%. This was driven by a 18% increase in net sales, with sales of white goods and appliances being practically strong, up 30% YoY (year on year) as well as margin improvement from better economies of scale and an improved product mix. Sales at Bach Hoa Xanh, MWG’s grocery retail concept with over 930 locations, were up over 150% and now account for 10% of the group’s total revenue. Finally, MWG’s online platforms performed strongly in 2019 and now account for 13% of sales. In 2020 we expect earnings growth to be in the range of 25-30% and a ROE between 35-40%, fundamentals which are not reflected in its outrageously low trailing P/E of 13.4 x.
Results at PNJ were similarly strong, its earnings increasing 21% YoY first 11 months on 15% revenue growth. Growth has resumed following the ERP / IT issues earlier in the year which interrupted the supply chain and led to inventory shortages. Thus, retail sales were up 35% in the month of November, YoY, up from the 12% increase recorded in 9M 19. During the year the company has opened 29 gold retail stores, taking the total count to 286.
The exception to the rule in Vietnam was FPT Retail (‘FRT’) which fell 65% during the year as its sales of mobile phones slowed and it was forced to recognised some bad debts on its now defunct loyalty program called F. Friends. Thus, profit for the first 10 months of the year was down 11% YoY, despite 12% sales growth. While we recognise the short-term growth restraints that FRT faces until its pharmaceutical retail business builds scale, the stock now trades at an unreasonable 5 x earnings, despite delivering a ROE in excess of 25%.
Ahli United Bank (‘AUB’) in Bahrain was both one of the largest contributors to the fund’s absolute return, contributing 1.2 percentage points having increased 23% after we purchased it, as well as being one of the largest negative contributors to the fund’s relative return, as it increased 60% before we did. AUB is in the process of being purchased by Kuwait Finance House (‘KFH’), one of the largest constituents of MSCI Kuwait. As the transaction is structured as an all-share deal AUB’s share price performance has been driven by KFH’s purchase price as well as the general momentum in Kuwait from the transition to MSCI EM. Even after the re-rating AUB remains attractive in a Kuwaiti context, delivering above average growth (2019 EPS growth of 15%), while generating a higher ROE (17% v 13% for Kuwaiti banks) at cheaper multiples – a trailing P/E of 13 x vs 21 x for KFH.
After a promising start to the year, with the re-election of the Awami League government, returns in Bangladesh were disappointing in 2019, falling 17.1% in USD. The market ignored a strong macro backdrop (GDP growth in excess of 8%) and decent corporate earnings and was adversely affected by continued reports of the telecom regulator’s aggressive pursuit of Bangladesh’s largest listed corporate, Grameenphone, and concerns over liquidity in the banking sector.
These concerns on the banking sector weighed on BRAC Bank’s returns for 2019, which ended 11% lower. As reported in our Q3 2019 note, the bank’s underlying performance continues to be strong with operating income increasing 12% at 9M 19, compared to 9M 18. Consolidated 2019 earnings have been impacted by significant investments in its bKash subsidiary, Bangladesh’s dominant mobile payments solution, following the capital received from Ant Financial at the end of 2018. At the end of 2019 the implied market valuation of BRAC’s banking operations is under 1 x B/V, which represents tremendous value for one of the best banking franchises in the Frontier universe.
BAT Bangladesh also performed poorly, falling 18% in 2019. After a tough start to the year, where volumes were impacted by two successive excise price increases, earnings have increased sequentially and were flat at 9M 19, compared to 9M 18, generating a ROE in excess of 30% in the process. The recovery in earnings was helped by the successful introduction of a new value brand, ‘Royal’, and higher margins from improved product mix (strong sales in the premium segment). As a result, the trailing P/E of the company fell from 21.2 x to 17.7 x, approximately 1 standard deviation below its historical (10 year) average.
Fan Milk in Ghana fell 55% in 2019 as a result of redemption selling by one of the largest unit holders, despite a significant improvement in operating performance. The destruction of value undertaken by the previous management team, Danone’s first since taking over Fan Milk, has been well documented in previous letters. In those same notes we have expressed confidence in the new management team, led by Ziobeieton Yeo who engineered a strong turn-around as the former CEO of Unilever Ghana. It is therefore a pleasure to report that Fan Milk is well on track to restoring its market position through product innovations (new packaging sizes and reformulations) in priority brands FanYogo and FanChoco as well as investments in marketing (TV and digital) and a reorganising of distribution routes for ambient products. Excluding one-off gains from asset disposals in 2018. 9M 19 earnings are up 65%, on the back of accelerating sales growth, which reached 23% in 3Q 19 (vs 3Q 18), as well as margin expansion from improved scale and efficiencies despite investments in branding and the distribution network. Annualising 9M 19 earnings, Fan Milk is trading at P/E of 18 x earnings; not outrageously cheap but undemanding given the company’s growth potential.
International Breweries (‘InterBrew’) in Nigeria was the fund’s worst performing stock, falling 65% in 2019. ABI’s Nigerian subsidiary has been very successful at gaining market share since merging its three Nigerian operations and today it accounts for over 25% of the Nigerian beer market, making it a clear number two. This growth has come at the expense of profitability with InterBrew showing extraordinary price discipline despite increases in input costs, inflation and the introduction of VAT. Clearly this is a key market for ABI and they have long-term plans to increase market share to 50%. As confirmed in recent meetings with local and regional management, the road to profitability requires both price increases on existing SKUs (stock keeping units) and a broadening of the product portfolio to more profitable premium and international premium brands. To this end Interbrew recently (and after many years of waiting) put through a smaller price increase and introduced Budweiser, the world’s bestselling beer, last year. Our discussions with management confirmed that ABI are rationale operators and we remain confident that they can generate substantial returns on their investment in one of the world’s most promising beer markets. We admit that we have been too early here but feel that patience is required.
Kuwait; a headache for relative returns
As detailed in previous notes, the fund’s underweight positions in Kuwait and Bahrain has been the key driver for the fund’s poor relative performance over the last 18 months. On the back of Kuwait’s imminent (May 2020) move to MSCI’s EM index the market increased 38% (in USD) in 2019, making it one of the best performing markets globally. During the year the fund maintained an average underweight of 19.5% in Kuwait, with obvious implications for relative performance.
As noted above, Bahrain’s largest bank, AUB, is in the process of being purchased by KFH, in an all share deal. Thus, this large benchmark holding (average weight in MSCI FM of 3.8% in 2019) has traded in-line with KFH, tracking the upgrade trade. Thus the combined moves in MSCI Kuwait and AUB account for more than 75% of the fund’s total under-performance versus the benchmark.
With 2019 earnings for MSCI Kuwait underperforming the fund, increasing only 7% in USD, most of the returns have been driven by multiple expansion. Thus, the valuation metrics – P/E and P/B – for National Bank of Kuwait (‘NBK’) and KFH, which represent a combined 71% of MSCI Kuwait and 27% of MSCI FM at year end, are over two standard deviations above historical averages.
Clearly at this stage – five months before the upgrade to – fundamental valuation and earnings mean less for the direction of Kuwaiti equities than momentum and positioning. It is, of course, impossible to say how much of the pre-positioning has already occurred. Previous upgrades – including UAE, Pakistan and Saudi Arabia – are a case study in game theory, with markets reaching peak valuations earlier (i.e. further from the date of inclusion) than those before them. So, it remains unpredictable when Kuwait will top (or where it already has); the only thing we can say with any certainty is that the Kuwaiti market will pull back materially post-EM inclusion.
More MSCI madness
MSCI’s unexpected November 2019 decision to increase Kuwait’s weight in its FM index from 29.6% to 35.2% just 6 months before its eventual removal was difficult to understand. In the process MSCI left its common sense at the door by increasing the weight of NBK to over 18% (!?!) of the FM index. A single exposure of 18%, which is 2.5 x Alibaba’s weight in MSCI Asia ex Japan (6.8%), is irresponsible from a portfolio point of view as well as being impossible to implement for all the money following UCITS regulations which limits single exposures to 10%. Thus, the most recent changes to the index seriously impair MSCI FM as a useful benchmark against which to monitor performance until Kuwait is removed in May 2020.
During the quarter we purchased Equity Bank, Kenya’s leading financial institution with a dominant position in the high margin SME and retail sectors. The purchase followed the government’s removal of an interest rate cap, which reduced loans / GDP from 37% to 24%, and further clarity around the capital allocation strategy of the group.
While the rate cap put pressure on net interest margins and halted loan growth, Equity Bank effectively repositioned the bank by developing non-interest income streams from fees, commissions and trading, which now accounts for 44% of operating income. At the same time it has reduced costs significantly, costs/assets fell to 5.5% from over 7% as it increased focus on digital channels and its agency network. This means that Equity Bank is superbly positioned to benefit from higher loan growth and better spreads. We expect that over the three-year period it will take for rate increases to cycle through Equity Bank’s ROA in Kenya can increase from 4% to 5.5%, translating in a ROE of 37%, up from 28% today. With subdued growth in Kenya following the rate cap, Equity Bank has increased its regional footprint over the last few years, with assets outside of Kenya, including Rwanda, Uganda and DRC, now accounting for 26% of total assets with further acquisitions in the pipeline. During the quarter we had the chance to meet with the company’s CEO, James Mwangi, to discuss the company’s rationale and process for allocating capital outside of Kenya. We came away confident in the company’s ability to price the cost of equity appropriately and feel that the company has demonstrated a reasonable track record in delivery decent returns (above their cost of capital) in other markets.
We have been admirers of Equity Bank for over a decade and were forced to divest in 2016 due to the introduction of rate capes. It is great to have it in the portfolio again.
During the quarter we sold our holding in Delice Holdings, Tunisia’s leading dairy company. The investment case was predicated in a return to growth in consumer purchasing power following the political unrest arising from the 2011 Arab Spring, and a liberalization of the dairy industry, which had already been agreed with the IMF and could result in a doubling of milk prices. Unfortunately, politics got in the way and a hung parliament, with the business-friendly, secular, government, Nidaa Tounes, controlling just 37% of the votes in the house of representatives, resulted in total political paralysis. With the recent 2019 parliamentary elections failing to resolve these governability issues and the outlook for further reforms and growth bleak we decide to dispose of our stake.
We disposed of our stake in Sonatel, the pan-West African Senegalese telecom operator, during the quarter. In the absence of growth in data and mobile money in these early stage markets, Sonatel been very successful in growing free cash flow (‘FCF’) by scaling up in smaller markets like Mali and Guinea. However, industry consolidation has increased competition across markets and tax increases have put pressure on margins. Furthermore, FCF has fallen as Sonatel has invested new 4G networks in Senegal and Mali in accordance with its license terms, despite the lack of demand for those services.
Finally, we sold our position in IDLC, Bangladesh’s leading non-bank financial institution. While the structural story for IDLC remains intact we see more potential upside in BRAC Bank, Bangladesh’s leading bank, following its recent sell-off and have reallocated capital accordingly.
Fund flows have not been supportive of absolute returns
Despite ample global liquidity global FM funds experienced USD 2 bn in outflows in 2019. While three large funds accounted for two thirds of the outflow, our analysis suggests that the outflows were broad based.
The relationship between foreign fund flows and short-term market returns is more complicated than one might intuitively believe – for example, 2016 and 2017 produced good returns, despite outflows. Local liquidity is also heavily influenced by local bond yields, government policy, momentum and retail investor appetite. However, it is clear that foreign FM funds, who have allocated a larger part of a shrinking pool of assets to Kuwait, riding the MSCI upgrade wave, have not been margin buyers elsewhere.
Clearly a reverse of these flows or even a cessation of the outflows could result in a sharp correction in FM asset prices as the marginal seller is removed. To this end flows in January have started positively; too early to call it a trend but encouraging none-the-less.
Very attractive valuations
The combination of decent earnings growth and underwhelming absolute returns has resulted in heavily discounted valuations on an absolute and relative basis in all the fund’s key markets. Measured on a trailing P/E basis, the fund, 11.2 x, is trading near the bottom of its historical range, which stands in stark contrast to MSCI EM and the S&P 500, which are near the top of their 10-year ranges.
On an individual country basis, the MSCI indices in the fund’s most important markets are trading well below their long-term averages. Thus Kazakhstan, Nigeria, Romania, Pakistan, Egypt, Sri Lanka and Bangladesh are all near the bottom of their 10-year ranges while MSCI Vietnam is trading well below its historical mean despite perhaps the best macro conditions globally and strong bottom-up growth (incidentally the fund’s Vietnamese holdings trade a 12.8 x, the lowest level since the fund’s inception).
The only exception is Kenya, which is near the top end of its range after the market re-rated following the aforementioned announcement that the interest rate caps in the banking sector would be removed in 2020. This significant market change will have a positive impact on GDP growth and corporate earnings in 2020 and beyond.
At the end of 2019 the fund’s trailing P/E was 11.2 x, which is a 17.9% discount to MSCI FM, despite better long-term growth and returns profiles.
Since we started at Coeli the fund has traded at 15.7% discount to MSCI EM. At the end of 2019 that discount has almost doubled to 27.4%. On a forward P/E basis MSCI EM is trading at close to a 50% premium to the fund.
Although the timing is uncertain we fully expect these unreasonably wide pricing differentials to converge to their historical averages overtime.
As 2019 comes to an end we can summerise our thoughts as follows:
• The relative and absolute returns for 2019 were disappointing;
• However, the attractive structural case presented by FM – high rates of growth from a low base, returns on invested capital far in excess of the cost of capital and low correlations of returns – remain intact;
• We remain committed to our strategy of being long term holders of high-quality companies, which has out-performed MSCI FM and MSCI EM by over 400 bps p.a. over the last 9 years; and
• With valuations at historical lows there is a significant margin of safety at the current juncture.
Have a great 2020,
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.