Asia Frontier Capital (AFC) - December 2015 Newsletter
"I don’t believe too much in luck.
AFC Asia Frontier Fund (AAFF) USD A-shares gained +3.0% in December 2015. This month the fund outperformed the MSCI Frontier Markets Asia Index (+1.5%), the MSCI Frontier Markets Index (-0.3%), and the MSCI World Index (-1.9%). AFC Asia Frontier Fund A-shares ended the year with a performance of +0.8% versus the MSCI Frontier Asia Index which is down -16.8% for the year. For our investors in Euros, the annual performance this year was +11.0% in EUR, and for Swiss Franc investors the 2015 full year return was +1.2% in CHF. The assets under management in the fund rose to USD 15.5 million.
The AFC Iraq Fund Class D shares returned +0.6% in December 2015, this was an underperformance against the Rabee RSISX USD Index (RSISUSD) which returned +11.1% in USD terms. The fund has performed -22.9% since inception which is in-line with the RSISUSD Index (-22.4%).
The AFC Vietnam Fund gained +0.3% in December, bringing the net return since inception to +41.9%. By comparison, the December performances of the Ho Chi Minh City VN Index and the Hanoi VH Index were +1.1% and -0.7% respectively (in USD terms). In 2015 the AFC Vietnam Fund returned +4.6%, which is an outperformance of 3.7% versus the VN Index (which was up +0.9%) and an outperformance of 12.8% versus the VH Index which was down -8.2% (in USD terms). Since inception, the AFC Vietnam Fund has outperformed the VN and VH Indices by +35.0% and +32.0% respectively (in USD terms).
The year 2016 certainly has started tumultuously with markets across the globe declining. The fall has been led by the Chinese markets which suffered most, losing -14.6% (Shanghai A) and -19.6% (Shenzhen A), despite or perhaps as a result of the flip flop action of Chinese regulators with their circuit breakers that were intended to slow down volatility. While worldwide major markets fell sharply on the back of that, with the Dow Jones falling -5.9% this year up to the 12th of January 2016 afternoon HK time, the Euro Stoxx declining by -7.5%, the Nikkei losing -9.5%, and Hang Seng suffering -10.1%, our portfolio in the AFC Asia Frontier Fund has had hardly any impact with a small loss of -0.9% (estimate as of 12th January 2016 afternoon) providing evidence of the true diversification opportunity this fund offers. The performance of AFC Vietnam Fund was estimated at -2.0% compared with -2.6% for the VN Index.
Last month we announced that we had received recognition from Citywire/Lipper: our CEO/Fund Manager Thomas Hugger was chosen as the #1 top performing Frontier Markets Equity Manager over 3 years. This month, we are pleased to announce that AFC Asia Frontier Fund has been voted the Best Asian Emerging Markets Fund and the Best Asian Frontier Fund (since Inception) by 2016 AI Hedge Fund Awards:
This recognition shows that our efforts to provide solid long term shareholder returns have not gone unnoticed. The tireless work put in by our fund manager and the research team have resulted in a solid overall return with low volatility despite a difficult market environment.
Mr. Ahmed Tabaqchali, CIO of AFC Iraq Fund, will be presenting at the Frontier Exchange Conference in London on the 20th-21st January 2016 where he will speak in the Iraq Country Focus Session on the investment opportunity in Iraqi stocks. Ahmed is an experienced capital markets professional with over 22 years’ experience in the US and MENA markets. Currently a board member of the Credit Bank of Iraq, he is a former Executive Director of NBK Capital, the investment banking arm of the National Bank of Kuwait as Head of Brokerage. Prior to these roles, Ahmed held Institutional Sales and capital markets positions at WR Hambrecht + Co., KeyBanc, Jefferies and Dean Witter and was based in London, New York, and San Francisco. Ahmed has an M. Sc. in Mathematics from Oxford University in the UK, a B.Sc. (Hons, 1st class) in Mathematics from Victoria University in New Zealand and a B.Sc. in Mathematics from Canterbury University in New Zealand. Ahmed is an Iraqi & British national.
If you have an interest in meeting with our team during their travels, please contact Peter de Vries at email@example.com.
AFC Asia Frontier Fund (AAFF) USD A-shares gained +3.0% in December 2015. This month, the fund outperformed the MSCI Frontier Markets Asia Index (+1.5%), the MSCI Frontier Markets Index (-0.3%), and the MSCI World Index (-1.9%). AFC Asia Frontier Fund A-shares ended the year with a performance of +0.8% versus the MSCI Frontier Asia Index which is down -16.8% for the year. For our investors in Euros, the annual performance this year was +11.0% in EUR, and for Swiss Franc investors the 2015 full year return was +1.2% in CHF.
December ended on a positive note for the fund as most Asian frontier markets made positive moves during the month. The fund did better than the index, however, as some of its larger holdings did well. The fund’s largest holding, a Bangladeshi pharmaceutical company, was up +18% as the GDR which the fund holds continues to trade at a big discount to its local listing in Bangladesh. In Pakistan, a cement company which is a Top 10 holding for the fund was up by +16%. Domestic cement dispatches in Pakistan have been growing at double digit growth rates over the past six months due to a pickup in construction activities on the back of historically low interest rates and the outlook for the sector remains positive due to the implementation of the China Pakistan Economic Corridor in the coming year. A large part of the positive performance for the fund came from the fund’s Vietnam holdings, with both small/mid cap and large cap holdings ending the month in the green. The major contributors to positive performance in Vietnam were an agricultural seed company, a consumer food company, and a plastic pipe manufacturer. A rebound in the Iraqi market also helped performance, with a consumer beverage company rallying by +50% during the month. It is this approach of following a benchmark agnostic strategy which helped performance this month and this has been the case for fund performance since inception.
The best performing indices within the AAFF universe in December were Iraq (+10.6%), followed by Mongolia (+3.3%), and Pakistan (+1.7%). The poorest performing markets were Laos (-5.6%) and Cambodia (-4.6%). The top-performing portfolio stocks were a Mongolian construction material company (+52.3%), followed by an Iraqi soft drink bottler (+50.0%), a Vietnamese agricultural product company (+42.5%), and a Mongolian junior gold mining company (+23.1%). Additionally, the fund’s biggest holding – a Bangladeshi pharmaceutical company – was up +17.8% in December 2015.
In December, we added to existing positions in Bangladesh, Laos, Mongolia, Pakistan, Sri Lanka, and Vietnam. We completely exited a construction material company in Sri Lanka and reduced our holding in one company in Sri Lanka. We added a new position to the fund’s portfolio in a construction company in Vietnam.
As of 31st December 2015, the portfolio was invested in 106 companies, 1 fund, and held 5.3% in cash. The two biggest stock positions are a pharmaceutical company in Bangladesh (6.3%) and a Pakistani pharmaceutical company (5.7%). The countries with the largest asset allocation include Vietnam (30.7%), Pakistan (18.7%), and Bangladesh (15.6%). The sectors with the largest allocation of assets are consumer goods (41.1%) and healthcare (16.3%). The estimated weighted average trailing portfolio P/E ratio (only companies with profit) is 15.84x, the estimated weighted average P/B ratio is 1.55 x and the estimated portfolio dividend yield is 3.29%.
For more information about Asia Frontier Capital’s Asia Frontier Fund please click the following links:
2015 was a year which was marked by uncertainty and volatility across global markets. This uncertainty and volatility was caused by both economic and political events. The key issues which impacted global markets were the hike in interest rates by the US Fed for the first time since 2006, the economic slowdown in China, and a fall in the price of commodities like crude oil, coal, and copper. A combination of these factors led to currency depreciation for many emerging and frontier markets and this impacted stock market performance in many of these markets. Developed market currencies such as the Euro also depreciated significantly against the US Dollar due to the continued QE (quantitative easing) by the European Central Bank and due to lower commodity prices which impacted the Australian and Canadian Dollar.
Within the fund’s larger markets in terms of investments, the currencies which performed poorly were the Sri Lankan Rupee, Mongolian Tugrik, and the Vietnamese Dong, which depreciated by 9.9%, 5.5% and 5.1% respectively against the USD. However against the Euro, these currencies appreciated with +1.3%, +5.3%, and +5.9%.The Sri Lankan Rupee was allowed to depreciate by the Central Bank of Sri Lanka as imports of vehicles had increased significantly this year given the drop in fuel prices and the consequent increase in imports was beginning to have an impact on Sri Lanka’s foreign reserves. It was not surprising to see the Mongolian Tugrik remain weak given the slowdown in commodity exports from a country where foreign reserves were already stretched at the beginning of the year. The State Bank of Vietnam devalued its currency immediately after the People’s Bank of China devalued the Yuan in August 2015. This was done primarily to protect Vietnamese exports which are a key economic growth driver for the country.
We are highlighting currencies as the fund does not (or cannot) hedge currency risk but instead focuses on using a top down diversified approach to allocate capital. This diversified approach was instrumental during the past year in successfully managing currency pressure. We estimate that the fund lost ~5% due to the appreciation of the USD against the fund’s currency universe. Having said that, even though currencies were volatile, our stock selection continued to deliver excellent performances which buffered the negative impact of currency depreciation. At the same time, several developed market currencies were weak against the US Dollar (see table below) and so investors with Euro, GBP, or CAD as their base currency enjoyed a net benefit of between around 5% and 15% in their holdings of AFC Asia Frontier Fund as a result of the exchange rate developments in 2015.
Performance of Asian Frontier Market Currencies was not as bad
Developed Market Currencies also were weak against the USD
As can be seen in the tables above, the fund’s major currency exposure did not perform as badly as some of the frontier/emerging market names and developed countries currencies. Most of these emerging markets either had macro-economic issues or political issues or both, which had a significant impact on their currencies, i.e. Argentina, Brazil, Indonesia, Malaysia, Russia and especially Kazakhstan where the Tenge lost about 87% last year. However the fund is also exposed to the Canadian Dollar, which lost 19% last year, due to investments in Mongolian junior miners listed on the Toronto Venture Exchange, but the fund’s exposure to such companies was <5%. More importantly, the fund’s key markets have a fairly stable macro-economic situation compared to some of the countries mentioned above and for this reason their currencies did not see drastic falls.
Crude oil prices more or less continued to fall in 2015 and this was primarily due to a combination of factors such as a slowdown of growth in China, excess supply from countries such as Iraq and Saudi Arabia, a much slower as expected decline of shale oil production in the US, and the possibility of increased supply of crude oil from Iran. Besides crude oil, other major commodities continued to exhibit weakness on the back of weaker demand from China.
A drop in commodity prices is a positive for both macro and micro
Countries which are heavily dependent on resource exports had a difficult year as they saw their currencies depreciate, foreign reserves decrease, and government deficits increase. As a result, countries such as Brazil, Nigeria, Kazakhstan, Iraq, Mongolia, Indonesia, and Australia had a tough year. On the other hand, for countries which are net oil/net commodity importers, the drop in commodity prices was a blessing in disguise.
As mentioned in the 2015 outlook in last year’s newsletter, we had stated that the drop in crude oil prices could be a major positive for most of the fund’s key markets as they are net oil importers. In that outlook, we mentioned that lower crude prices would be positive for inflation, interest rates, input prices, consumer disposable income, and foreign reserves. Over the past year, we have seen inflation levels going down, interest rates being cut, companies’ profit margins expanding, consumer spending increasing, and foreign reserves rising in our key markets of Bangladesh, Pakistan, Sri Lanka, and Vietnam. There has been a visible impact on key metrics such as the gross profit margins of companies which depend on imported commodities and volume growth of cyclical companies in the consumer, industrial, and infrastructure space.
Fall in crude oil and commodity prices has improved
On the political front, the deadlock between the US/NATO and Russia over Syria as well as Ukraine continued to impact events in the Middle East and Eastern Europe as neighbouring countries were brought into this deadlock especially in the Middle East which has now seen the active involvement of Turkey, Iran, and Saudi Arabia over the Syrian crisis. Another important political event during the year was the signing of the nuclear deal between Iran and the P5+1 (Security Council, Germany and the EU). This deal is definitely a positive for the Iranian economy but we need to wait and see how the lifting of sanctions by the EU and US pans out later this year.
These political developments did not have an impact on the fund universe except for Iraq, which saw the onset of ISIS as the conflict in the Iraq-Syria region became more intense. Over the past year the USA, Russia, and Turkey have also entered this quagmire. 2015 was extremely challenging for Iraq with the triple whammy of the increasing cost of war, lower oil prices, and providing aid to displaced persons, straining government spending with the result that the non-oil economy, highly dependent on a government itself highly financed by oil exports, is seen by the IMF to decline by -11.2% in 2015 on the back of a -8.8% decline in 2014. The year, however, ended with the liberation of the city of Ramadi by the Iraqi Security Forces (ISF) allied with local tribal fighters and with Western air support but without the participation of the paramilitary Popular Mobilization Units (PMUs). The liberation of cities such as Ramadi and Tikrit is a significant booster for the unitary Iraqi state and the policies of the moderate leadership of the government.
Since the drop in crude oil and commodity prices was a net positive for the fund’s key markets like Bangladesh, Pakistan, Sri Lanka, and Vietnam, last year’s strategy for the fund was to increase its exposure to companies which benefitted from reduced input prices or raw material prices and increased demand for its products or both.
As a result of weakening commodity prices, interest rates were falling, resulting in a cyclical upturn in markets like Pakistan and Vietnam. For this reason, we increased the fund’s exposure to cyclical companies in the manufacturing, construction, and consumer discretionary sectors in Pakistan and Vietnam.
The allocation to industrial stocks went up from 6.2% at the end of 2014 to 10.0% as of December 2015. We added to the fund’s portfolio cyclical companies in Vietnam such as a construction company, a lighting company, and a commercial vehicle manufacturer. We believe that these names will benefit from the cyclical upturn in Vietnam’s industrial and economic growth. All three of these names have already contributed positively to fund performance in 2015, with the construction company providing the third highest contribution to return and the highest total return for the fund in 2015.
Within the infrastructure space, the fund increased its allocation to a Pakistani cement company, a Vietnamese PVC pipe company, and took a position in a Vietnamese cement company. These allocations were made to take advantage of lower input costs as well as increasing sales volumes for these companies. Over the past few quarters, these three companies have shown both increases in sales volume and an expansion of gross profit margins. All three of these companies have contributed positively to performance with the Vietnamese PVC pipe company and Pakistani cement company being the 5th and 6th biggest contributors to last year’s performance.
This focus of increasing weighting of cyclical companies as well as companies benefitting from lower input prices has played out well for the fund in 2015 as most of these companies have been top performers for the fund in 2015 and are now top 20 fund holdings.
Besides this strategic shift, the fund’s focus on its other core holdings continued, and both value and growth opportunities are present in the fund’s existing top holdings. The fund’s leading two performers were the top 2 holdings, a pharmaceutical company from Bangladesh and a pharmaceutical company from Pakistan. The fund did not add significantly to these two positions in 2015 but already had a high weighting to these two companies in 2014 given their valuation and potential growth and this played out very well for the fund in 2015. Both companies have delivered in terms of performance as the Bangladeshi company received approval from the US FDA for one of its drugs and the Pakistani company has delivered double digit earnings growth for the past five quarters. The fund’s second biggest holding in Bangladesh and its biggest holding in Sri Lanka, both consumer stocks, also did better than their respective markets which again helped overall performance.
The positive performance for the fund, similar to 2014, was driven primarily by the fund’s Top 10 holdings, with 7 out of the top 10 in terms of contribution to performance being part of the Top 10 holdings. This is a reflection of the fund’s proactive strategy as well as its focus on building positions in companies which we believe will deliver longer term value.
To recap, the top 5 contributors to performance (based on gross return contribution) were a Pakistani pharmaceutical company (for the second year in a row), a Bangladeshi pharmaceutical company, a Vietnamese construction company, a Vietnamese stationery company, and a Vietnamese PVC pipe company.
On the negative front, performance was dragged down by companies affected by political and regulatory risk. The biggest drag on performance was a Sri Lankan construction company which was negatively impacted by the change of government in early 2015. Similarly, another infrastructure play on Sri Lanka, a cement company, was a negative for performance for the same reason mentioned above. In Bangladesh, a change in pricing formula for a gas distribution company was expected to negatively impact its future profitability and this impacted its stock price. The fund exited this company fully and used the sales proceeds to increase its weight to consumer and pharmaceutical companies in Bangladesh. Another negative impact on performance was a Laotian bank which saw an increased in NPLs leading to a correction in its stock price, while in Vietnam the threat of Uber and Grab Taxi impacted the growth plans of a taxi company the fund holds.
To recap the negative contributors to performance, the bottom five contributors to gross performance were a Sri Lankan construction company, a Laotian bank, a Bangladeshi gas distribution company, a Mongolian junior copper miner, and a Vietnamese taxi company. Additionally, we decided to completely write off an Iraqi company which has its operations in the conflict zone now occupied by ISIS. This stock has been suspended over the past year and hence we believe it to be prudent to carry out a write off for the time being since the status of the production facility is not exactly known or can be destroyed in the next few months. Fortunately this position has been extremely small for the fund with an exposure of 0.1% of total assets.
Due to the political, regulatory, and governance risks that frontier and emerging markets in general hold, the fund has taken a conscious effort to diversify its holdings and consequently does not have many concentrated positions. This has helped the fund in an overall negative year when there was volatility in markets and when certain unforeseen political and regulatory events took place. Though this approach of having diversified holdings may sound as if the fund does not take focused risk, it is important to point out that the fund’s Top 25 positions account for around 60% of the portfolio. Therefore, we believe in taking positions in companies we are convinced in and this has helped deliver performance not only in 2015 but also since inception.
Also very important was our decision not to invest in or to be massively underweight in certain sectors. The fund has been completely underweight energy stocks in 2015 and obviously rightly so. Energy stocks have been amongst the biggest losers in Pakistan and Vietnam and the fund has avoided them. The fund has only one energy stock in Pakistan as it has a good dividend yield. The fund also did not invest in Bangladeshi, Pakistani, Sri Lankan and Vietnamese banks. Pakistani banks for example underperformed in 2015 due to the worries over declining net interest margins in the coming year as did Bangladeshi banks due to rising non-performing loans. With the benefit of hindsight, the fund could have garnered greater positive performance if it had increased its weighting further to cyclical companies in Pakistan and Vietnam as there is a clear turnaround in those economies. Having said that, 2016 will also continue to offer opportunities in cyclical companies in Pakistan and Vietnam.
Even though it was a year of ups and downs, it was due to the continued proactive benchmark agnostic approach which helped the fund outperform its closest benchmark the MSCI Frontier Markets Asia Index and with a slight positive 2015 performance of +0.8%. This performance came at a time when most other indices had double digit losses in percentage terms. The fund’s benchmark, the MSCI Frontier Markets Asia Index, was down -16.8% during the year while other relevant indices such as the MSCI Frontier Markets Index and MSCI Emerging Markets Index were down -17.3% and -17.0% respectively. The only index which did not see as much of a fall was the MSCI World Index which was down -2.7%. The fund’s strategy of focusing on under-researched names and on the ground visits has also helped deliver this excellent performance. Furthermore, besides performance, the annualised volatility of the fund has been lower than the MSCI World Index over the past year and since inception. This strategy over the year and also since inception reflects the fund’s ability to find undervalued stocks which generate return and at the same time manage overall risk at a below average level.
Though it is a new year, there has not been a significant change in the concerns which are in investors’ minds. The main worries in 2016 will continue to be the rise in US interest rates, the economic slowdown in China, and geopolitics in the Middle East.
Rising US interest rates have been an issue since the summer of 2013. Though many market participants expected the US Fed to raise rates in December 2015, fears over the impact of further rate hikes remain and this continues to dampen investor sentiment. Clearly, rising US rates would be negative for corporates and governments which hold USD debt. Having said that, amongst the fund’s universe, not many or hardly any of the corporates have USD debt and if they do it is a small proportion of their overall debt levels. Further, of the fund’s Top 30 holdings which account for 66% of the portfolio, only a few of the holdings are leveraged and not heavily. Regarding government debt in USD, the countries which could be impacted are Pakistan and Sri Lanka, as their foreign debt as % of GDP is ~21% and ~30% respectively. However, most of these USD debts are long term in nature and are also provided by multi-lateral agencies such as the IMF/ADB. Further, as mentioned previously, soft commodity prices are a big positive which can help negate the impact of rising USD interest payments.
Regarding the slowdown of the growth rate in China, as it was the case in 2015, the economies which depend heavily on exports to China could continue to see their economies being impacted. From the fund universe, Mongolia is heavily dependent on China as it accounts for 80-85% of Mongolia’s total exports with most exports to China being resource related. The fund’s exposure to Mongolian resource stocks is not large and it is currently 3.2% of the fund with the overall exposure to Mongolia being 8.4% of the fund.
Besides hurting exporters, the economic slowdown in China has impacted commodity prices including crude oil. If commodity prices remain weak this will continue to be a positive for the fund’s key markets like Bangladesh, Pakistan, Sri Lanka, and Vietnam. As was seen in 2015, low commodity prices were extremely beneficial for profitability of companies, consumer disposable incomes, inflation, interest rates, and government finances including foreign reserves. This trend of lower commodity prices will continue to have a positive impact on the fund’s holdings as well as on the macro of countries in the first half of 2016 as the fund has positioned itself well to take advantage of lower commodity prices.
What could be a negative for the fund’s markets is currency depreciation, but we do not expect the depreciation to be significant or similar to the depreciation seen in the currencies of resource exporters such as Brazil, Indonesia, Kazakhstan, and Nigeria. Within the fund universe, Iraq, Mongolia, and Papua New Guinea are countries which are dependent on resource exports, but the Mongolian Tugrik and the Iraqi Dinar have been stable of late while the Papua New Guinea Kina has seen the biggest depreciation, but the fund has an exposure of less than 2% to Papua New Guinea. For our key markets such as Bangladesh, Pakistan, Sri Lanka, and Vietnam, we expect the macroeconomic situation to be stable.
We therefore expect market sentiment to remain subdued at least in the early part of 2016 and this may lead to sideways movements in markets. However, sentiment is one thing and fundamentals are another. As mentioned above, lower commodity prices will be beneficial for both companies and government finances in the fund’s key markets which account for 75% of the portfolio. Hence, fundamentally the situation on the ground is better or more stable than what it was 18-24 months ago in our key markets. As mentioned previously, cyclical companies have been showing improving fundamentals in terms of sales growth, profitability, and more healthy balance sheets while consumer spending has been positive in Bangladesh, Pakistan, Sri Lanka, and Vietnam. We expect this trend to continue into the first half of 2016.
We expect to continue to hold onto our top holdings in our key markets due to a relatively stable macro situation and may also further increase our allocations to certain cyclical companies in Vietnam and could also look at banking stocks in Pakistan as they appear to be offering value. We will also look for new ideas which offer either value or growth at reasonable price. We expect this to be backed by our on the ground visits to countries and keeping our ears to the ground.
Sentiment may not have started off on a high note in 2016, but we believe in fundamentals and we want to stick to that as this is what will deliver longer term returns. We expect Asian frontier markets to continue to offer opportunities as they are relatively under-researched compared to emerging markets and these markets continue to have favourable demographics, improving literacy levels, social and economic reform, and offer a base for shifting higher wage jobs from China which all leads at the end to increased consumption which is (and always was) the biggest sector exposure in the fund.
Compared to Developed Markets, the AFC Frontier Universe
Low wages in Asian frontier economies
On the security front, there is definitely an improvement compared to last year as the military continues to take action in the North West of the country and also launched operations in Karachi a few months ago. This has led to significant reduction in the number of security/terror related incidents. Though the security risk remains, the government and the military appear to be taking a tougher stance on this issue. Further, diplomatic relations between India and Pakistan appear to be improving. Improving relations could have longer term economic positives but in the near term any improvement in ties is one less issue for the governments to contend with. Though the diplomatic thaw is delicate we do not believe either side has a choice but to talk given the socio-economic and macro-economic constraints on both economies. Given the favourable macro environment and increase in Chinese investments along with a fine balancing act between the civilian and military leadership over foreign policy, Pakistan can be the dark horse over the next few years.
Papua New Guinea
In the longer term, Vietnam is a key beneficiary of free trade agreements such as the EU-Vietnam Free Trade Agreement, The Korea-Vietnam Free Trade Agreement and the Trans Pacific Partnership. All three of these agreements have the potential to bring in further foreign investment to the country leading to job creation and making Vietnam an even bigger exporter of manufactured goods.
AFC Iraq Fund Class D shares returned +0.6% in December 2015, an underperformance against the Rabee RSISX USD Index (RSISUSD) which returned +11.1% in USD terms. The fund has performed -22.9% since inception which is in-line with the RSISUSD Index (-22.4%).
The RSISUSD’s outstanding performance of +11.1% was almost entirely driven by a 50% gain in its largest component, Baghdad Soft Drinks, with a 28% weighting in the index. The overall market capitalization was down (-6.0%) and almost all sectors were down including banking (-2.7%), telecom (-9.4%), hotels (-4.9%) and services (-0.7%) while industrials gained (+35.4%) driven by Baghdad Soft Drinks which accounts for 71.2% of that sector’s capitalization. Traded value of about USD 14.5 million was higher than the October multi-year lows of USD 9.2 million but lower than the 2015 monthly average of about USD 18 million. The 2015 monthly average is substantially lower than the monthly averages of USD 25 million in 2014 and USD 38 million in 2013. The RSISUSD was down -22.7% in 2015 and -25.4% in 2014 for a total of -42.3% over the two-year period as indicated in the chart below which puts it in deep bear market territory. The declines were kicked-off by violence & political conflict ahead of the parliamentary elections in April 2014, intensified by the ISIS occupation of Mosul & a third of the country in June 2014, and prolonged by the double whammy of the high cost of war and lower oil prices in 2015. Current levels seem exceptionally attractive as the market can start to discount the prospects of recovery with the roll-back of ISIS and the positives of Iran’s re-connection with the world economy.
RSISUSD Index and daily trading volumes
Strains on local liquidity from lower oil prices and the short-term dislocations from the recent political reform package continue to drive prices lower. Net foreign flows, however, as measured by proxy portfolio flows, recovered strongly in December versus the declines of the last two months, and the outflow component of the equation was twice the yearly average. As discussed last month, while liquidity (both foreign institutional & local retail) remains low, the market will continue to witness volatility as the available liquidity moves from stock to stock. This was the case in December with Baghdad Soft Drinks accounting for about 36% of total traded value and for most net foreign portfolio flows, as measured by proxy net portfolio flows. The market’s perennial leading stock fell apart in the summer by 57% while its earnings continued to accelerate in a classic price-valuation disconnect as highlighted in the last two months. Concentrated speculative trading and a 50% gain in December after a 7.7% gain in November shows a revival of the market’s animal spirits.
Looking back at the first 6 months of the fund’s life, the portfolio was constructed with a focus on the long term and we believe that the fund’s holdings are now well-positioned to capture the post-conflict Iraq opportunity. This belief is anchored in the gross performance of the portfolio including commissions and FX, from a cost perspective reflecting both stock selection and timing, which shows that the portfolio had a -18.7% return with the ISX listed portion returning -14.1% vs -22.4% for the RSISUSD and -25.9% for the Iraq Stock Exchange’s ISX60 Index in USD terms since inception. Thus the benchmark, the RSISUSD, is used as a yardstick and not as a monthly comparison tool as Iraq’s nascent market necessitates the creation of highly concentrated or broad based unusable indices. For our benchmark, the top 3 constituents out of 10 account for a 56% weighting. Although the index is a reasonable representation of the largest and most actively traded segment of the market at a specific point in time, it never the less is at odds with the aim of a long term portfolio. The upshot is likely wide disparity between the index and the fund in any given month but over the long term a delta between the two should emerge and give a more meaningful measure of performance.
Net Proxy Portfolio Flows - Outside chart: Oct 13:
The last 6 months confirmed to us the thesis behind the launch of the fund, we are fully confident of capturing the long term opportunity and look forward to sharing its rewards with you.
The liberation of Ramadi was a significant event in that it was carried out by the Iraqi Security Forces (ISF) allied with local tribal fighters and with Western air support without the participation of the paramilitary Popular Mobilization Units (PMUs), giving the ISF its first significant victory after its complete collapse in 2014. It is a huge morale booster for the ISF and bolsters the policies of the moderate leadership of the government to re-integrate the disenfranchised population of the country whose alienation by the prior leadership enabled the rise of ISIS.
Elsewhere in Iraq and in Syria, the combination of military actions by the different anti-ISIS forces is continuing to cut-off the lifelines feeding the overall ISIS structure through the loss of territory with associated supply routes and the curtailment of its oil infrastructure. If this is sustained over the next few months, then the surprise of 2016 could very well be the speed of the crumbling of the ISIS caliphate: recently uncovered ISIS papers show military spending accounts for about 64% of total outlays while oil accounts for 25%, taxes 24%, and confiscations 45% of revenues which is a combination that is impossible to sustain for a long period of time while the intensified military action continues and ISIS is losing territory as opposed to gaining.
Looking at the portfolio, as of 31st December 2015, the AFC Iraq Fund was invested in 14 shares and held 1.2% in cash. As the fund invests in both local and foreign listed companies that have the majority of their business activities in Iraq, the countries with the largest asset allocation were Iraq (93.6%), Norway (4.0%), and the UK (2.4%). The sectors with the largest allocation of assets were financials (45.6%) and consumer staples (27.7%). The estimated weighted average trailing portfolio P/E ratio (only companies with profit) was 14.48x, the estimated weighted average P/B ratio was 1.32x, and the estimated portfolio dividend yield was 2.20%.
For more information about Asia Frontier Capital’s Iraq Fund, please click the following links:
The portfolio was constructed with a focus on the long term to be broadly representative of the sectors leveraged to Iraq’s recovery prospects. The Iraq Stock Exchange (ISX) is not fully representative of the economy, underweighting energy in particular. Iraq is a major energy player with a significant capacity to grow production & exports, given its huge reserves, to be among the super exporter club of Saudi Arabia and Russia. On the ISX, the fund bought into companies in Financials, Consumer Staples, Telecoms, and Healthcare across the full spectrum of market capitalizations and the liquidity profile. In the process avoiding concentration in only the largest capitalization or most liquid stocks, although they are well represented, the portfolio holds small and illiquid stocks as well. Outside the ISX, the fund bought into exploration and production companies who derive the majority of their business from Iraq, and in particular in the Kurdish Region of Iraq (KRI). The thesis being that these companies, while trading at attractive valuation levels, are leveraged to the increased oil production and independent oil sales of the KRI which saw its production rise significantly over the course of 2015 and is set to grow even further in 2016 and beyond to become one of the world’s major exporters on its own right.
The fund’s launch coincided with the ISX, having rallied by 35% over the prior two months, starting a correction just as frontier & emerging markets were about to undergo major corrections/declines driven by the concerns over China in August. These concerns were reflected in the near collapses of prices of major commodities and oil in particular. This was felt through the shrinkage of liquidity within the ISX in which Iraq did not escape the wave of record fund redemptions in frontier & emerging markets, which compounded the local liquidity crunch created by the double whammy of the cost of the ISIS war and lower oil prices.
The portfolio performed relatively well within this environment as reflected in the chart (shown earlier) versus the benchmark, RSISX USD Index (RSISUSD), and while declining with the overall market, it nevertheless avoided the extreme drops, especially in August & November, but by the same token missed out on the relative bounces in the following months.
The fund, moreover, took advantage of the extreme drops in leading names in Communications and Consumer Staples as they underwent declines of more than 50% by increasing holdings meaningfully during these times when valuations and prices go through periods of extreme disconnect as reported in the newsletters over the last few months.
The fund is currently, six months after launch, invested in the following sectors: Financials (45.6%), Consumer Staples (27.7%), Communications (10.4%), Healthcare (8.8%), and Energy (6.4%), and holds 1.2% in cash. We believe that these holdings are now well positioned to capture the long term post-conflict Iraq opportunity.
The new year started with weaknesses in global markets driven by the big drops in China, with oil prices falling to 11 year lows driven by these drops and by fears of weak global growth. However, the outlook for Iraq is brightening with the rollback of ISIS, prospects of return to stability and expectations of option-like benefits from Iran’s forthcoming re-integration with the world both economically and politically. We will continue with the same strategy pursued, adding to positions and taking advantage of the current exceptionally attractive period to acquire positions in quality assets leveraged to the country’s future recovery which was after all the reason behind launching this fund.
The AFC Vietnam Fund gained +0.3% in December, bringing the net return since inception to +41.9%. By comparison, the December performances of the Ho Chi Minh City VN Index and the Hanoi VH Index were +1.1% and -0.7% respectively (in USD terms). Since inception the AFC Vietnam Fund has outperformed the VN and VH Indices by +35.0% and +32.0% respectively (in USD terms).
2015 was certainly a difficult year, particularly for emerging markets, which declined 17%, by far the worst performance in comparison to major stock markets last year. For the first time since 1988, there was a net capital outflow from emerging markets. Considering these facts, the Vietnamese stock markets have held up relatively well, recording a performance of +0.94% for Ho Chi Minh City VN Index and -8.21% for the Hanoi VH Index for the year 2015. The fund outperformed these indices by +3.7% (Ho Chi Minh) and +12.8% (Hanoi), ending the year with a gain of +4.62%.
When we look at countries’ GDP growth in Southeast Asia, which has been the fastest growing region in the world for many years, Vietnam in particular stands out. The economy grew by 6.7% in 2015 in this still young economic cycle, marking the highest GDP growth rate in the region. Valuations remain very attractive on a P/E basis with the Ho Chi Minh City and Hanoi markets having a price-earnings ratio of 11.3x and 9.2x respectively (based on 12 months trailing earnings) leaving considerable upside potential.
The GDP growth rate in 2015 was 6.7%, but for the last quarter it was at a stunning 7.0% – the highest Q4 growth since 2010. Also the inflation rate is well under control with just 0.6%, the lowest since 2001!
Vietnam has concluded by far the most free trade agreements in the region and is therefore uniquely positioned as one of the lowest cost manufacturing countries in the world. It is therefore widely expected that the high level of foreign direct investment and remittances, which were at a record USD 14.5 billion and USD 12 billion respectively in 2015, will continue over the next few years.
Another encouraging indicator was the ANZ-Roy Morgan Vietnam Consumer Confidence Index, which was 2.5 points up in December to a record high of 144.8 points, the highest score in Asia for the first time.
Also the real estate market looks much more promising. Since mid-2014, Vietnam’s residential market has been recovering, firstly in the affordable segment. Entering 2015, the picture has become much clearer and the condominium market is now on a firm path towards recovery. The second quarter of 2015 marked a new record in quarterly absorption rate in the condominium segment, with over 10,000 units sold in both new and previous launches. For the first nine months of last year, condominium sales were close to the whole-year peak seen in 2009 in Hanoi while in Ho Chi Minh City it marked a new record with nearly 25,000 units being sold.
Besides the many positive developments, we also need to have a look at the risks that undoubtedly exist in Vietnam. The dependence on exports is of course a result of the numerous investments by foreign companies in the manufacturing sector in Vietnam. A global slowdown or even a recession in the main export markets would have a considerable negative impact on economic growth. Also Vietnam’s foreign reserves are still relatively low, despite inflows from foreign investments and remittances from overseas Vietnamese. The estimated USD 35 billion foreign reserves in relation to the overall USD 200 billion economy are still very small in comparison with Thailand, for example, where foreign reserves are about at USD 150 billion with a USD 400 billion economy. This can probably partially be explained by the USD hoarding and speculation of banks and private individuals, despite the efforts of the government to prevent this.
In 2015 we also saw a few new key policies for foreigners in Vietnam:
With these positive developments we are very optimistic about Vietnam’s economic outlook, especially if the government keeps on driving economic reforms and labour productivity can be improved. It really looks like Vietnam’s stock market has a prosperous future ahead and will probably continue to outperform other emerging and Asian markets.
In December the fund’s largest positions were: Sam Cuong Material Electrical and Telecom Corp (3.7%) Industrials – a manufacturer of electrical and telecom equipment, Nui Nho Stone JSC (1.9%) – a stone mining company, Net Detergent JSC (1.8%) – a detergent manufacturer, Doan Xa Port JSC (1.8%) – a logistics company, and Thuan An Wood Processing JSC (1.7%) – a wooden furniture manufacturing company.
For more information about Asia Frontier Capital’s Vietnam Fund please click the following links:
I hope you have enjoyed reading this newsletter, especially our 2016 outlook for the Asian Frontier Markets. I just returned from my Christmas holiday in Switzerland where I was surprised to see how many investors, journalists, and even people in the street are extremely negative on China. Even worse, everybody seems to now believe that China = Asia. I agree with the consensus that China’s economic growth is slowing down, there are major problems in the Chinese financial system, and that some sectors of the economy and state and/or provincial agencies are saddled with piles of debt. However many financial analysts here in Hong Kong have warned about this misallocation of capital for years and finally this bubble is bursting. What is more important is that Chinese consumers will continue to buy more and more expensive consumer goods since they are able to spend more due to higher income levels. I believe that China is on the right long term track to change from an export and industrial driven economy to a consumer-led economy like Japan, Hong Kong, Taiwan, and South Korea did in the past – but this will not happen overnight. Resource extracting countries will be the short to mid-term losers and, on the contrary, countries depending on commodity imports will be the winners. This bodes well for Bangladesh, Pakistan, Sri Lanka, and Vietnam in our investment universe this year.
If you would like any further information, please get in touch with me.
With kind regards,
Asia Frontier Capital Limited
This document does not constitute an offer to sell, or a solicitation of an offer to invest in AFC Asia Frontier Fund, AFC Asia Frontier Fund (non-US), AFC Iraq Fund, AFC Iraq Fund (non-US), AFC Vietnam Fund or any other funds sponsored by Asia Frontier Capital Ltd. or its affiliates. We will not make such offer or solicitation prior to the delivery of a definitive offering memorandum and other materials relating to the matters herein. Before making an investment decision with respect to our Funds, we advise potential investors to read carefully the respective offering memorandum, the limited partnership agreement or operating agreement, and the related subscription documents, and to consult with their tax, legal, and financial advisors. We have compiled this information from sources we believe to be reliable, but we cannot guarantee its correctness. We present our opinions without warranty. Past performance is no guarantee of future results. © Asia Frontier Capital Ltd. All rights reserved.
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