Asia Frontier Capital (AFC) - July 2015 Newsletter
"Water will eventually find its path"
In July 2015, the AFC Asia Frontier Fund gained +1.1%, underperforming the MSCI Frontier Asia Index (+4.3%) and the MSCI World Index (+1.7%) and outperforming the MSCI Frontier Index (-3.1%). The year to date performance of the AFC Asia Frontier Fund A-shares stands now at +2.1% versus the MSCI Frontier Asia Index which is up +0.8% during the same period.
The AFC Iraq Fund has officially begun investment activities, and as of 31 July 2015 the fund has returned –7.9% in the first month, outperforming the Rabee Securities RSISX which dropped –12.7%. Though the fund NAV was in negative territory this month, the outperformance of +4.8% in a single month is quite remarkable. The fund was not fully invested at the end of July and still holds cash which it can continue to deploy in the short run at cheaper prices to accumulate positions. This will lower the average price of the fund’s positions which should add to the upside of performance for the fund in the months and years to come.
The AFC Vietnam Fund returned +0.2% bringing the net returns since inception to +39.7%. The Hanoi (VH) index ended the month up +0.2% after wiping out almost the entire monthly gain from the first 2 weeks, whilst the Ho Chi Minh City (VN) index managed to keep a better part of its earlier gains and closed at +4.7%. Since inception, the AFC Vietnam Fund has outperformed the VN Index and VH Index by +21.1% and +18.6% respectively, in USD terms, over the same period.
The big news in frontier markets this month was the development in Iran with the striking of a deal on the country’s nuclear program. Six world powers, including the US, have agreed to an accord that is acceptable to all sides after more than a decade of dispute and ongoing negotiations. The core elements of the deal are that the international sanctions, currently crippling Iran’s economy, will be lifted progressively in exchange for a marked decrease in Iran’s nuclear capability and an ongoing monitoring of the nuclear development program. Iran has preliminarily agreed to enact restrictions to these activities such that they will not develop enough material to produce a nuclear weapon for at least 10 years. Whilst some UN arms embargos will remain in place, the gradual reduction of economic sanctions will almost certainly provide a boost to the local economy. Iran is generally known to be a frontier market but it may come as a surprise to find out that it is one of the 30 largest economies in the world by GDP in 2015 according to the IMF. Iran also invests more in scientific education than any other country in the Middle East and its elite technical universities have ranked amongst the top in the world. The agreement still has to pass through various political hoops in the US and other countries for final approval but the execution of this deal offers many Iranian businesses a golden opportunity to expand internationally, which could potentially pave the way for foreign investors to assist local companies’ needs for capital.
You can read more about Iran’s economy and factors impacting the local market later in this month’s Country Report and Travel Report. There is also information on how the Iran deal impacts Iraq in the AFC Iraq Fund Manager Comment.
Elsewhere in emerging Asia, China’s equity markets have continued their rocky ride with July seeing the biggest drop in Shanghai’s stock exchange in nearly 6 years. The Shanghai benchmark index dropped -29% since its mid-June peak and in a single day the market dropped a staggering -8.5%, making it the largest single day loss in 8 years. China’s government and market regulators have been frantically enacting emergency policies to stem the tide pulling markets down. With many listed companies suspending trading, and restrictions on short selling as well as the selling of shares for some market players, the bourse did bounce back during some stages in July. The rising and falling confidence that investors have in the ability of the government to overpower the market freefall has led to dramatic intraday swings. The situation has been further exacerbated by news that the US Federal Reserve will likely raise interest rates by the end of the year which has seen capital outflows from emerging markets including China. It should be noted however that the index is still up +21.4% YTD and +76.6% over the past 12 months (when the Chinese stocks were cheap and shunned by local and foreign investors). Many of the Asian frontier markets in which we invest are similarly considered cheap but also have the added benefit of having an extremely low correlation to US, global and emerging markets.
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AFC Asia Frontier Fund (AAFF) USD A-shares gained +1.1% in July 2015, underperforming the MSCI Frontier Asia Index (+4.3%) and the MSCI World Index (+1.7%) and outperforming the MSCI Frontier Index (-3.1%). The year to date performance of the AFC Asia Frontier Fund A-shares stands now at +2.1% versus the MSCI Frontier Asia Index which is up +0.8% during the same period.
The fund’s positive performance was due to stable returns from the top 4 markets but it lost out from resource exposure in Mongolia and a correction in Iraq after a run up in May and June. Since Mongolia and Iraq are not part of the MSCI Frontier Asia Index, the underperformance from these markets affected overall performance relative to the index. The month also saw a rally from higher index weighted stocks in Vietnam, such as banks and insurance companies, which the fund does not currently hold.
However, July saw stable performance from our top holdings and from our key markets. The results being announced from some of the companies show good year-over-year growth both in top line and bottom line. The benefit of lower costs in the form of lower commodity prices is now showing through on the bottom line and revenue growth is being aided by higher consumer disposable income given the lower energy prices. This was evident in some of the Bangladeshi and Sri Lankan consumer companies which have declared their quarterly results. Also non-consumer companies in Vietnam, which have declared results, are showing expansion in margins due to lower commodity prices. In Vietnam, the non-consumer companies in the construction and infrastructure industries are showing healthy topline growth as volumes pick up on the back of strong GDP growth. Volume growth from cement, steel, and pipe companies has been double digit for the quarter. The fund has exposure to the cement and pipe industry but no steel stocks yet. Cyclical companies in Vietnam can continue to show good numbers in the upcoming quarters and the fund has taken more exposure to such companies over the past month.
Economic activity in Pakistan is also picking up with auto sales (motorcycle, passenger cars, and trucks) showing double digit growth rates over the past few months. Cement dispatches have also grown so far this year on the back of an increase in construction activity. So far, only one of the larger Pakistani banks has declared numbers and the outlook provided by management is quite positive given that low interest rates could see credit growth pick up later this year. The China Pakistan Economic Corridor should also provide another kick to overall growth at some point next year.
Sri Lanka goes to the polls for their elections later this month and it will be interesting to watch the results given that Mahinda Rajapaksa (the former President) will be contesting. Despite initial halts, the government appears to be executing on infrastructure projects again. There was news that the government is looking to re-award the Northern Expressway project to local contractors as this contract had been cancelled once the new government came to power. Also last month, work on the Southern Expressway extension was approved. These positive developments led to the appreciation of an infrastructure company in our portfolio. This stock had taken a beating following the elections in January 2015 but now is seeing some positive developments.
The outlook for AFC’s key markets is stable to positive given the benefit that companies and also the overall economies will have from low commodity prices and higher disposable income levels.
The best performing indices within the AAFF universe in July were Vietnam (4.7%), followed by Bangladesh (+4.6%) and Sri Lanka with +4.4%. The poorest performing markets were Iraq (Rabee Index) with (-13.3%) and Mongolia (-8.1%). The top-performing portfolio stocks were a Bangladeshi pharmaceutical company (+24.5%), followed by a Vietnamese plastic pipe producer (+19.9%), a Sri Lankan consumer goods company (+15.8%), and a Bangladeshi consumer products company (+15.6%).
In July we were quite active in switching some of our holdings. We added to existing positions in Mongolia, Sri Lanka, and Vietnam and added two new holdings in Vietnam (an auto battery maker and a truck manufacturer) and an investment company in Myanmar. We completely exited two companies in Vietnam and reduced the fund’s holdings in two companies in Vietnam and one in Cambodia. The fund has also amended its approach to investing in Iraq stocks and has allocated capital to the new AFC Iraq Fund. This change will not result in any additional fees charged to the clients of the AFC Asia Frontier Fund.
As of 31st July 2015, the portfolio was invested in 116 shares, 1 fund and held 5.7% in cash. The two biggest stock positions are a pharmaceutical company in Bangladesh (4.5%) and a Pakistani pharmaceutical company (4.2%). The countries with the largest asset allocation include Vietnam (26.4%), Pakistan (20.0%) and Bangladesh (13.5%). The sectors with the largest allocation of assets are consumer goods (40.9 %) and materials (14.3%). The estimated weighted average trailing portfolio P/E ratio (only companies with profit) was 14.82x, the estimated weighted average P/B ratio was 1.63x and the estimated portfolio dividend yield was 3.64%.
AFC Iraq Fund Class D shares returned -7.9% in July 2015, outperforming the Rabee USD Index (RSISUSD) which returned –12.7% in USD terms. The fund outperformed the RSISUSD by +4.8% in July due to a combination of stock picking and selective trading. With the drop in markets during the first month the fund has also retained some cash to take advantage of lower market prices.
In the first month of trading for the AFC Iraq Fund we were quite active throughout the month with investment activities. The fund built positions in several Iraq listed financial institutions, insurance companies, and banks as well as other sectors including pharmaceuticals, telecommunications, and agriculture. It also added to foreign listed holdings, which derive the majority of their business from Iraq, in the energy and oil sectors. The fund has only undertaken buying activities and as yet has not made any full or partial exits.
With the RSISUSD index down -12.7% in July almost no stock on the ISX escaped being dragged with it, however notable out-performers were Gulf Insurance (+5.1%), Iraqi Date Processing & Marketing (+1.9%) and Al Mansour Pharmaceuticals (+1.1%). The recent decline came on the back of two very strong months for the index with May (+16.1%) and June (+16.3%) both seeing good returns. YTD the index is down (-9.2%) but since the recent bottom in March 2015 it is up +35.8%. The explanation for the downturn last month is related to the decline in liquidity from both local and international players as well as the impact of Ramadan.
Net foreign inflows to Iraq were roughly flat for the month after a strong uptick in June. This most likely reflects the lower risk appetite with significant outflows seen in other emerging markets. Although the dynamics for Iraq are vastly different from those of other frontier and emerging markets, herd mentality can overpower these differences in extreme periods.
RSISX Index vs Net Proxy Portfolio flows
Local liquidity was also drained by a combination of Ramadan, the summer holidays, and the exceptional heat. Ramadan normally marks a meaningful slowdown in commercial activities in almost all Muslim countries and it shifts by 11 days every year due to the movements of the lunar calendar. This slowdown is exaggerated when it takes place in the summer holidays and in 2015 Ramadan went from mid-June until mid-July which, in Iraq, compounded the effect as the hottest months of the year are July and August. In July this year it was so hot that the government declared mandatory holidays twice with the mercury rising to over +46 degrees Celsius (+115 degrees Fahrenheit). While some of our readers in the tropics may have experienced similar temperatures before, it must also be mentioned that the ‘Heat Index’, known more commonly as the ‘feels like’ temperature, was significantly higher. In the last week of July, Baghdad was declared the hottest place on earth with a ‘feels like’ temperature of a staggering 70 degrees Celsius (159 Fahrenheit) which, for the budding chefs out there, is the exact temperature to perfectly slow cook an egg over a period of 23 minutes (http://www.chefsteps.com/activities/the-egg-calculator)! Iraqis jokingly say that they cannot go to hell because they already live in one, which was almost true as the vast majority had to deal with this heat without air-conditioning or even electric fans due to severe electricity shortages. Unreliable electricity access is one of the sources of unrest in Iraq and there were demonstrations in a number of cities in relation to the government’s lacklustre provision of basic services. Further to this, though it may seem like an unusual link, the recent news of Iran’s nuclear deal may put Iraq a step closer to solving this as well as other domestic problems.
With the opening of Iran’s economy it is hopeful that there will be a period of increased political stability in the Middle East as well as fewer regional proxy wars which will help Iraq to rebuild its economy and put it solidly on the path to a post conflict recovery. Infrastructure will be at the forefront of this process with the severe shortages of electricity being one of the main obstacles to Iraq’s economic and social development. At present Iraq has a daily capacity of about 8,500 megawatts, having lost about 4,000 megawatts due to the ISIS military conflict. It is estimated that the current demand is at 18,000 megawatts and this is projected to grow to 42,000 megawatts by 2030. Presently, Iran exports 1,300 megawatts of electricity daily to Iraq, which is valued at USD 1 billion annually. Following the recent nuclear accord, Iran announced that it will start a USD 2.5 billion project to build a natural gas combined cycle power plant in Iraq - which was agreed over 18 months ago. This will add an additional 3,000 megawatts to the available supply of electricity. Iran and Iraq signed an agreement in 2013 for Iran’s gas exports to supply power plants in Iraq but implementation has been delayed due to instability.
At the moment Iran exports about USD 12 billion a year in goods and services to Iraq, which account for 17% of Iran’s total exports which makes Iran the second largest import market for Iraq after Turkey. Iran also invests around USD 10 billion per year into Iraq. Iran is one of the world’s largest cement exporters with Iraq being their primary export market. The collapse of construction in Iraq, after the ISIS crisis, has slowed down infrastructure development and has resulted in an excess cement supply of 30% in Iran. Infrastructure, as well as other sectors, is heavily dependent on financial services and it is very likely that Iraq’s banking system will be a significant beneficiary of eased sanctions in Iran as it enables the smoother functioning of capital flows to finance investments, a process which has been severely handicapped by banking restrictions. The ability to finance business operations and international trade will also be greatly enhanced with the relaxation of banking restrictions and the positive effects will be compounded by an increase in economic stability.
Other parts of the economy, such as tourism, also have a lot to look forward to as Iraq is home to some of Shia Muslims’ holiest sites. In particular Najaf, Karbala, Kadhimiya, and Samara look to benefit as they see a great deal of religious tourism. As is quite common in frontier markets, it is difficult to get exact data on the economic impact of tourism but estimates are that Karbala, Najaf, and Kadhimiya each receive millions of tourists annually. Whilst the final dollar figure is up for debate, what is apparent is that a boost to the local Iraqi economy and increased spending power will allow a greater number of Iranian Shia Muslims to make religious pilgrimages to sites in Iraq.
Looking at the portfolio, as of 31st July 2015, the AFC Iraq Fund was invested in 14 shares and held 5.9% 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 (88.3%), Norway (5.87%), and the UK (5.85%). The sectors with the largest allocation of assets were financials (49.2%) and consumer staples (21.4%). The estimated weighted average trailing portfolio P/E ratio (only companies with profit) was 13.73x, the estimated weighted average P/B ratio was 1.15x, and the estimated portfolio dividend yield was 3.12%.
Hot off the Press: Protest and Demonstration Lead to Political Reform
The significance of the implications can be appreciated by considering some of the history of Iraqi politics that lead to this point. Following the invasion of ISIS in mid-2014, calls intensified for the removal of the then present government, whose disastrous policies since 2006 created an environment similar to that of a failed state. This also lead to the alienations of a significant portion of the discontented population that the leaders of the, now called, Islamic State (ISIS/ISIL) were able to exploit.
The creation of a new inclusive government under new leadership of Haider al-Abadi was made possible by the actions of Grand Ayatollah Sistani, Iraq’s top Shia cleric, who lead the call for an inclusive Iraq. The cleric’s opposition to the prior leadership led Iran to drop its support to the prior leadership and, seemingly, join the West in their view of the necessity of a new inclusive leadership. Grand Ayatollah Sistani is extremely influential in both Iraq and Iran. Most recently he was visited by Iran’s foreign minister, Mohammad Javad Zarif, as part of his tour of the region in late July, to be updated on the nuclear accord developments. His support will override local objections and carry Iran’s agreement.
The inclusive government under the new Prime Minister started the repair process with a conciliatory approach to the alienated Kurds and Sunnis which later led to the Kurdistan Regional Government (KRG) oil agreement and gradual reclaiming of territory from ISIS. The new Prime Minister’s tenure has not been all smooth sailing, however, as proposed measures have been continuously sabotaged by the actions of the prior leadership and its sectarian political quota system. In blocking attempts for the inclusion of the alienated Sunni tribes in occupied areas it compromised the fight against ISIS. Additionally, entrenched interests derailed the government’s economic reform policies which were greatly exacerbated by the cost of the ongoing war & lower oil prices.
After the recent moves by Prime Minister Abadi he has received the full support of the religious leadership, as well as the masses, to implement a substantial reform package. This represents a tremendous opportunity for real change as it is has a realistic chance of changes being implemented given the exceptional level of public support. The political situation is in flux on a daily basis which will impact the likelihood of a change to the status quo as well as the chances of reform being executed effectively.
Whilst only time will tell to what extent these actions and reforms have a real impact, from the current state of affairs it look to be of great benefit from the AFC Iraq Fund’s perspective. The investment environment will benefit from a stable, strong government that has popular support as they can then effectively marshal resources in the fight against ISIS and the rebuilding of impacted areas after the end of the conflict. A further rapprochement with the Kurdish Regional Government to fully implement the already agreed oil deal will help to end the liquidity squeeze facing Kurdistan which will be of benefit to Iraq.
The effective implementation of the government’s economic policies, that will accelerate the development of the private sector, should be the engine of employment and growth. In the short term three of the key measures that were part of the package should have a positive impact. Firstly, the implement the tariff system to support key industries that has been delayed all year. Secondly, the activation of the USD 4.5 billion loans for specialist state banks to lend to key semi-state enterprises in industry as well as agriculture. These companies are typically 51% owned by the state in key traditional areas of strength in Iraq. Thirdly, the acceleration of government payments to private sector contractors whose businesses have been held up and negatively affected by previous delays which in turn negatively affected the commercial banking sector. Overall, the recent developments in Iraq look to be very positive for the future of the country and will likely contribute to the positive returns of the AFC Iraq Fund in the future.
In July 2015, the AFC Vietnam Fund returned +0.2% bringing the net return since inception to +39.7%. In the last few weeks old highs for the market indices could not be overcome or sustained which could be expected after the recent strong rebound. The Hanoi index ended the month up +0.2% after wiping out almost the entire monthly gain from the first 2 weeks, whilst the Ho Chi Minh City index managed to keep a better part of its earlier gains and closed at +4.7%. Given the portfolio makeup of the AFC Vietnam Fund it was less of a rollercoaster ride and the fund held its ground to end the month up.
At first glance it may appear that there were no significant changes in the stock market’s behaviour in July 2015 as blue chips in Ho Chi Minh City and several large caps in Hanoi built on last month’s upward trend and again performed quite strongly. Across the board, however, most shares in Vietnam lost ground this month. The indices prices have been dominated by moves in banks and insurance stocks and shares with a full foreign ownership limit as well as potential winners of the various free trade agreements have also been advancing nicely. At the same time we observed, in the last couple of weeks of trading, that the underperformance of small caps has ended. This is the first time that this has been seen in months, though an outperformance by this segment of the market hasn’t materialised as yet. The first few announcements of quarterly earnings, amongst other factors, have been a catalyst for this trend change, though most companies haven’t reported yet.
Advance/Decline Ratio (Market Breadth)
All of us are, of course, waiting for a new, sustainable upward trend to establish itself. It must not be forgotten that the indices are currently trading at about the same level as in August 2014 in spite of an improving economy and favourable valuations. In recent weeks there have been several noteworthy developments, including the imminent abolition and relaxation of most foreign ownership limits, an official increase in the economic growth target from 6.3% to 6.5%, an expected inflation target of below 4% for 2015, and meaningful progress in free trade agreements. Even with other economic indicators such as retail sales, credit growth or PMI (Product Manufacturing Index) one recognizes clearly the improved medium-term trend.
A recent comparison of regional stock markets shows that Vietnam would have to rise by about 50% to catch up with the "competition". When this is combined with the excellent growth prospects for the coming years this makes the market even more attractive.
One factor to which too little attention is paid is the market behaviour and the psychology of market participants, which ultimately decide whether a stock is bought or sold. Every year there are many volumes of undeniably valuable academic studies on Vietnamese and world politics, economics, business and global stock markets produced which are read and discussed. Whatever the ultimate buy or sell decision of private and institutional investors is based on, it is best simplified to the underlying hope for profits or the fear of losses. In my experience it usually does not matter to the majority of market participants whether a listed company is being valued at a price/earnings ratio of 5x or 50x as long as one expects further gains.
As we can observe from the example of the rapid and seemingly chaotic development of the Chinese stock market over the past 12 months, retail investors can create a stock market rally and eventually let this bubble burst as well. In Vietnam it is these small investors which are currently missing from the market. Also, despite the fact that domestic investors in Vietnam are already responsible for 80% - 90% of trading activities, it is important to mention as well that there has been an absence of new investors coming online. Currently, active local investors are mainly following shares attracting foreign buyers so they have primarily only showed interest in a handful of index names. It is a pity that Vietnam doesn’t produce statistics about new brokerage accounts as this can be a good market indicator. In China at the height of the recent bull market 1.6 million new accounts were opened in just one week! The infamous stereotype that taxi drivers and housewives drive the last phase of a stock market rally has been confirmed once again by looking at China’s recent experience.
It might be the source of some curiosity why we have discussed this topic in such a detailed manner, as the development and uncorrelated nature of the Vietnamese stock markets should be regarded as a positive. The current press coverage of China's stock markets in the Vietnamese as well as global media is certainly not helping to attract new investors. As we have seen again and again in history, the distance between fear and greed, or vice versa, is often shorter than one might expect.
What is important to draw from this is that the economic policies, focus on education, investment mentality and the economic development path of Vietnam can best be compared with that of the Chinese approach - even though some Vietnamese people may not agree with this. It should also be mentioned that there are clear parallels in the development of these equity markets. In the 25 years since the stock market debut in China, there were four market bubbles with excessive valuations and an increase of the index between 150% and >1000% in a relatively short time period. In the 15 year old history of the Vietnamese market, we have had only two comparable bubbles with a 400% gain and similar valuations (2001/2007). These stock market bubbles and bursts are not an exclusive phenomenon of China and Vietnam as we have seen this occur in recent decades among others in Asia such as Japan, Taiwan, and Thailand. Even the supposedly savvy investors in Europe and the US were able to accomplish similar trends as they irrationally pushed up prices driven by the bullish force of greed. You can see some semblance of this recurring even today with many market participants willing to pay 50-100 times earnings for social media/tech companies though many of them are not even profitable. By contrast our portfolio of Vietnam holdings is valued with a mere average 7.2 times expected earnings for 2015, leaving significant room for upside whilst maintaining protection on the downside.
In July the fund’s largest positions were: Sam Cuong Material Electrical and Telecom Corp (3.4%) - a manufacturer of electrical and telecom equipment, Nui Nho Stone JSC (2.0%) – a construction materials company, Bao Viet Securities JSC (2.0%) – a brokerage company, Binh Duong Minerals and Construction (2.0%) – a construction materials company, and VNDirect Securities Corporation (1.7%) – a brokerage company.
As of 31st July 2015, the portfolio was invested in 83 shares and held 8.1% in cash after inflow of new capital this month. The sectors with the largest allocation of assets were consumer goods (34.4%) and industrials (21.8%). The fund’s weighted average trailing P/E ratio was 7.17x, the weighted average P/B ratio was 1.14x and the average dividend yield was 5.96%.
Although Iran is not currently included in Asia Frontier Capital’s investable country universe, it is a market that has potential to be part of our portfolio in the future once international sanctions and restrictions are lifted. As such, we have been closely tracking the developments of the recent Iranian nuclear deal and are excited about the future potential for investors as Iran gradually comes in from the fray.
On 14 July 2015, Iran and the EU3+3 (UK, France, Germany, US, China, and Russia) reached an agreement on the Iranian nuclear program – the Joint Comprehensive Plan of Action (JCPOA) - after tense negotiations and years of failing to reach an agreement deemed suitable by both sides. The JCPOA lays out the path to the termination of sanctions against Iran levied by the UN Security Council, the EU, and the US, in exchange for limitations on Iran’s nuclear program, reducing the country’s uranium stockpiles, and ongoing verification of Iranian compliance with the deal.
The immediate reaction on the ground in Tehran was largely one of celebration – Iranians have long suffered under the weight of years of crippling sanctions and a floundering economy. Domestic Iranian companies, particularly manufacturers, have seen their exports dwindle as trading partners cut off ties to comply with Western sanctions. Soaring inflation and unemployment have increased in recent years, and the weakening Iranian rial (which lost half of its value against the US dollar between 2011 and 2013) has rendered foreign goods all but unattainable to everyday Iranians. Well educated and cosmopolitan, Iranians of all types see improved prospects for their country with the ending of sanctions. Consumers will have increased access to high-quality (and affordable) imported goods, businessmen and companies will find financing and trading easier, and stockbrokers should see international investor participation pick up as foreign capital flows in to the Iranian market.
Iranian Capital - Tehran and Alborz Mountains
From an economic standpoint, there is certainly much to look forward to. An estimated USD 120 billion in oil revenues will be unfrozen, boosting government and consumer spending. The country’s GDP by purchasing power parity (PPP) of USD 1 trillion makes it the 2nd largest economy in MENA after Saudi Arabia, although unlike Saudi, where oil and oil-related sectors comprise over half of GDP, in Iran oil only accounts for roughly 15% of GDP. The potential upside is huge, as Iran’s combined proven oil and natural gas reserves are the largest in the world. Iran has the world’s 4th largest proven petroleum reserves and the largest natural gas reserves in the world, as well as numerous metal and mineral deposits. There is substantial room for improvement, however – much of the equipment used in Iran’s resource sectors is outdated and there is a huge need for investment in the sector. The Deputy Oil Minister for commerce and international affairs recently announced that Iran has identified 50 oil and gas projects it will offer for foreign bidders, valued at USD 185 billion. One breakthrough is the revised petroleum contract structure for foreign oil companies, called the Integrated Petroleum Contract (IPC), which mandates longer term contracts of 20-25 years, a substantial improvement for global oil companies over the previous short-term contracts that were in use. In anticipation of July’s deal, several global oil companies, notably Royal Dutch Shell, Total, and ENI, held talks with Iran’s oil minister in the months prior to the nuclear deal to begin discussing possible areas of cooperation in the country’s oil and gas sector.
For investors, two exchanges comprise Iran’s securities market; the Tehran Stock Exchange (TSE) and the Iran Fara Bourse (IFB). The TSE is Iran’s largest stock exchange, with a market capitalization of roughly USD 100 billion, attractive valuations well below global peers in emerging / frontier markets (weighted average P/E ratio of 5.3x), and 316 listed companies spanning the chemicals, oil & gas, telecoms, banks and financial services, industrial conglomerates, cement, metals, pharmaceuticals, consumer, fertilizer, steel, and automotive sectors.
Tehran Stock Exchange (TSE)
Opportunities certainly abound, as domestic companies make up some of the region’s leading manufacturers and have managed to maintain operations against challenging odds. Iranian industrial production stands to gain dramatically from sanctions relief – current production capacity is estimated to be at 60-70% of possible output. Iranian companies may face increased competition, however, as Western corporates are beginning to re-examine their strategies for Iran as the nuclear deal and path towards sanctions repeal unfolds. Prior to the enforcement of sanctions, Iran’s largest trading partners were primarily European (Germany, France, Italy), but with Western markets largely closed off, Iran’s biggest trading partners have shifted to China, UAE, South Korea, India, and Turkey.
The Iranian automotive market is one of the largest in the Middle East, and the country’s auto production surpassed 1.5 million cars in 2011 before sanctions crippled the industry and led several foreign firms to exit the market. Now, foreign car companies are jockeying for position to establish market share, with European and Korean companies leading the pack, as many American automakers are still barred from doing business in Iran. For French carmaker Peugeot, Iran was the company’s second largest market after France until it withdrew from the country in 2012, but it will face stiff competition from Renault, Volkswagen, and competing Asian carmakers. In the aftermath of the nuclear accord and the potential repeal of sanctions, experts estimate that, within five years, Iranian auto production could skyrocket to 4 million cars per year from the current level of 1.4 million cars per year.
The country’s demographics are promising, making the consumer sector another area with massive growth potential. Iran has a population of 78 million, roughly 70% of whom are under 40 years old, with high literacy rates (99% among young people) and strong traditions of scientific and technical education as well as expertise. Western goods are expensive and relatively difficult for ordinary Iranians to get, although they are popular and in high demand. From iPhones to Nike running shoes to McDonalds, many Iranians are eager to reconnect with the world and gain access to many of the products commonly found around the globe that have historically been hard to come by in Iran. The young, chic population offers enormous potential for global brands as they can tap into a new market and engage with customers who long looked forward to the day when international products would become readily available. Even during the sanctions era, Iran was the 7th largest cosmetics market in the world, and Western brands – particularly American brands – still have strong brand name recognition in Iran. The Wall Street Journal recently pointed out that tissues are still called Kleenex in Iran after 37 years, highlighting the power of first mover advantage and the importance of capturing market share early on. Many major multinational companies are planning joint ventures or new market entry strategies as the country opens up, with particular sectors of focus including fast-moving consumer goods, consumer electronics, luxury retail, and hospitality / leisure. Many of the corporations that stand to benefit the most are those that already have a presence in the country but have been hurt by sanctions, including Danone, Nestle, Peugeot, Airbus Group, LVMH Moet Hennessy Louis Vuitton, and British American Tobacco. Western restaurant franchises don’t currently operate in Iran, but copycat Iranian versions can be found in Tehran, from “Mash Donald’s” (McDonalds) to “Pizza Hat” (Pizza Hut) to “Kabooki Fried Chicken” (Kentucky Fried Chicken).
Many risks remain, however, for Iran’s road to economic recovery. The public sector is bloated, corruption and red tape remains, regional conflicts and power struggles are many, and the path forward for Iranians, international businesses, and foreign investors is uncertain. But despite the challenges and hurdles to overcome, we remain bullish on the longer term outlook for Iran and look forward to the country’s “catch-up” as ordinary Iranians reconnect with the rest of the world.
A short history of US & Iran relationships
Within this context, the US and Iranian hostilities can be largely understood. From Iran’s perspective, its activities supporting foes of the US, and their allies, are part of its self-defence as it is destabilizing its enemies. From the US, and its allies, perspectives these are the actions of an expansionary revolutionary regime seeking regional control through destabilization.
Sunni-Shia divide in context
The current form of supposed Shia-Sunni rivalry is a construct to justify political differences similarly to the historic divide between the Ottoman and Persian Empires of the last few centuries. It is certainly is a crucial factor in relationships but it is pushed/pulled as a lever in geopolitical manoeuvring.
The alliances and rivalries in the region in the 60’s and 70’s were shaped by relationships with the US and the former USSR, irrespective of Sunni or Shia affiliations. Thus Iran and the Gulf states were pro US, while the revolutionary republics of Egypt, Syria, Iraq, and Yemen were pro USSR.
In particular, the change of alliance for Iran pre-1979 from pro-Israel/anti-Syria to pro-Syria/anti-Israel after 1979 is a clear case of geopolitical shifts and not as a pan-Shia alliance as is often described in the media.
As a consequence, the Iranian nuclear accord is a significant new chapter in regional Iranian-US relations and as such is a major milestone for the Middle East. Ultimately it could herald a new era for the region which will most likely take the form of major investment and infrastructure capital spending, which the region needs badly. This will be a positive for most parties as prosperity will reverse the rise of extremism.
Events of 2014 accelerated the negotiations
The nuclear accord solidifies the realignment of interests of international and regional players that took shape in the face of the common threat of ISIS following the fall of Mosul and which further developed during the military campaign in the following months.
The realignment is coupled with the bigger geopolitical picture and the need for a re-examination of the proxy wars that compounded the regional issues and accelerated the rise of extremism. At the heart of these issues are the socioeconomic inequalities and the demographic pressures that gave rise to the Arab spring of 2011.
Mutual dependencies will hopefully ensure the success of this accord. Iran has a need to revive and reconnect to the world economy and to provide opportunities for its restive young population which is facing an estimated 25% unemployment rate. Europe’s need to lessen its dependence on Russian gas will also support the sourcing of Iranian gas via a pipeline through Turkey. Similarly this is the case for China, which is looking to access Iran’s gas via a pipeline through Pakistan.
This will all lead to massive infrastructure investments that will boost a regional economic revival. The first steps have already started, with China funding the Pakistan side of the Iran gas pipeline as part of its significant investments in Gwadar. Billions of dollars in investment have been committed to Egypt for giant construction projects. The World Bank and the IFC have accelerated investments in Iraq to help rebuild liberated areas. Finally, the recent active military engagement by Turkey in Iraq will help to complete this realignment and will likely hasten the ISIS containment process significantly.
In line with our process of covering frontier countries from the ground, this month we will focus our travel report on Iran. As someone from our team is usually in one far flung destination or another each month, our travel reports are normally a first-hand account. For Iran, however, this proved to be difficult, as no one from AFC’s investment team has been there in decades. As such, we have a guest contributor this month in the form of one of AFC’s adventurous investors, Espen Baardsen, who recounts his two week experience driving around the heartland of the former Persian empire at the end of 2014.
There was a vague sense of trepidation as our plane headed towards Tehran. Two weeks of exploring Iran seemed like a fun adventure a few months ago while sitting at home in London. Now, with darkness descending, scenes from the film ‘Argo’ flashing through my mind, and thoughts turning to the war in next door Iraq, I was less sure. That the crowded Turkish Airlines plane was one of the oldest I’ve been on didn’t help. But then the woman sitting next to my wife started chatting to us, and before long gave us her phone number in case we had any problems in Iran or if we just wanted her to show us around her home town of Yazd. It felt like a good omen for the trip. As the plane descended towards Tehran, my wife and all the women who weren’t already wearing the hijab, or headscarf, put theirs on. No turning back now.
Unfortunately a plane full of oil workers from Azerbaijan had landed at the same time as us and most of them decided to jump the long immigration queue. A fight was narrowly avoided at one point. When we got to the front an hour and a half later, the officer looked at our visas for a minute, stamped the passports and we were in. It was a relief considering the convoluted procedure to obtain the visas at the Iranian embassy in Dublin - there is no embassy in London - which amongst other things required us to visit the local police station and be fingerprinted in a holding cell. I suspect it was something to do with me being born in America, and having a passport full of stamps from some of the world’s more ‘colourful’ destinations.
We found Tehran airport to be generally disorganised and badly maintained but I’ve seen worse. It took another hour to find our luggage, go through customs, find our guide and get into a car. Given that it was 4am by now, the drive into the city was only less than an hour. During the day it would be a couple of hours at least.
Our hotel in Tehran was a 1980s throwback with pink carpets and highly varnished black wooden furniture, topped off with a rock hard mattress. The pink theme extended to the bathroom unfortunately. This would be a recurring thing in Iran - hotels that feel like you’re in a time warp, in desperate need of refurbishment (although all had some form of wifi). It’s not surprising given that the bulk of their customers are price-sensitive domestic tourists. Foreign tourists were few and far between wherever we went, except for Isfahan. Mostly it was large groups of pensioners from Nordic and Mediterranean countries on package tours, and a few younger couples. We saw just one British couple and no Americans during the trip. The scope for growth in the foreign tourism sector is vast, especially at the higher end.
The next morning, Mohammed, our guide/driver, who was a prisoner of war for eight years in the Iraq/Iran war, took us around Tehran. First impressions were of organised chaos. Most road junctions don’t have working traffic lights so it becomes a game of ‘chicken’ between cars and also pedestrians. You run to cross the road as there are no pedestrian crossings. If you miss your turn-off in a roundabout, just slam the brakes and reverse. No one wears seat belts. That said, we only saw one accident during the three week trip and that was in the desert in the south where drivers tend to drive too long distances and get tired.
With a completely inadequate public transport system, everyone has to drive everywhere. In a badly-planned city of over 8 million, the city is in gridlock for large parts of the day. Our first stop was the former US embassy, now officially renamed The Den of Espionage and used by a militia dedicated to defending the 1979 revolution. Our guide didn’t want us spending more than a few minutes there, and advised against my wife even getting out of the car so there was only time for a quick photo.
We moved on to the main bazaar in Tehran - a bustling, semi-underground warren of cave-like shops selling everything from carpets to women’s underwear to all manner of old and new electronics. I liked the row of shops selling designer labels. No clothes, just clearly counterfeit labels of brands such as Gucci, Armani and Burberry to be sewn into whatever.
Outside stood a group of a few dozen men, loudly debating something, while waving wads of cash around. This was the local currency exchange, where we swapped a few Benjamin Franklins, for a stack of rial and tomans so big that it wouldn’t fit into two wallets.
The next day we left for Kashan, a desert oasis town a couple of hours south, famous for its fields of roses. The traditional local houses and mosques are made of a mix of mud and wood, but intricately tiled and decorated inside. Parts of the town look like Luke Skywalker’s desert village in the original Star Wars films. En route to buy some of this famed rose oil, we got side-tracked in the bazaar by a shop selling gold coins with Ayatollah Khomeini’s profile. I had to get one, especially as the price was in line with the current open market gold price. I can add Iranian gold ‘Khomeinis’ next to my collection of American Eagles, Canadian Maples and S.A. Krugerands.
Our trip then took us to Yazd, one of the oldest cities in the world, and a key historic hub on the road from Isfahan to Kerman, on the main trading route to Central Asia. The locals were pioneers in air conditioning, using wind towers and piped water to cool their homes, so it has some unique architecture. Today, the city is known for its textiles and confectionery industries.
After a couple of nights in a remote village, visiting nomads and hiking, we were back in civilisation - albeit a very ancient one. A visit to Persepolis is a highlight of any trip to Iran, yet we were pleasantly surprised to find it almost empty. The site is genuinely awe-inspiring, especially considering it was built between ca. 550 and 330 BCE. You can still see the signs of the fire lit by Alexander the Great’s army that destroyed the city.
Next up was Shiraz. That might make you think of wine, but of course, Shiraz is a shiraz-free zone as is the rest of Iran. The old vines were all ripped up after the revolution - a tragedy in my opinion. The city looked like a much more pleasant place to live than Tehran. The hotels are much closer to international standards than anywhere else in Iran barring Tehran. Some of the restaurants would not have seemed out of place in central London - with prices to match. Inside there were plenty of young couples, clearly on dates.
In Shiraz we visited Shah Cheragh, containing the tomb of two holy martyrs. A bomb exploded here in the 1980s, killing a mullah, so bags and cameras are banned and foreigners have only been allowed to visit since last year. As it’s so holy, women have to wear a ‘chador’ (meaning ‘tent’ in Farsi). It’s a large piece of usually black fabric that women wrap themselves in, from head to ankles, so that no part of their bodies, or even the vague shape of their bodies can be made out, except the face. Unaccustomed to wearing one, my wife spent the entire time trying and failing to keep her chador together. As not many foreigners make it in here, we had some glances but an English-speaking female guide came to walk my wife through the women-only areas and it all felt very welcoming. The shrine itself was beautiful, with walls entirely covered with tiny mirrors in extraordinary patterns.
The final major stop was Isfahan, hands down Iran’s most beautiful city and the biggest draw for tourists. Its mosques, squares, and palaces are some of the finest examples of Islamic and Iranian architecture and it’s impossible not to be awed by the artistry involved. We also visited its thriving Armenian quarter and the Orthodox Christian cathedral. The city is full of tourists, with demand for decent hotel rooms far outstripping supply. Our hotel there was both the most expensive and the worst we had in Iran. The good restaurants are packed full. On the plus side, we did have the best coffee of the trip in a coffee shop proudly serving Illy coffee next to the Naghsh-e Jahan square. Unsurprisingly, it was full of Italians.
Iran gets a certain reputation, obviously, but it’s nothing like the image many have of it. We didn’t feel unwelcome for one moment. Most people just ignored us and the ones who didn’t usually came up and in a curious, friendly way wanted to know where we were from and what we thought of Iran. At a petrol station in the middle of nowhere a big, tough-looking guy came up to me, stuck his hand out to shake, looked me in the eye, and said “CHELSEA!”, to which I replied, “TOTTENHAM!”, and the guy said, “Yes, Tottenham!”, smiled and as that was the extent of his English, walked off.
What’s noticeable after a while is the lack of ‘Western’ influence. There are no foreign films, magazines and very little foreign music even. The only Western book we saw on sale was Alex Ferguson’s biography. Nevertheless, most people have at least a bit of English. There’s some Turkish television, which they get via satellites that are technically illegal. The local television is very state controlled, although newspapers seem to be slightly freer in what they can write. Unsurprisingly a huge number of websites are blocked, but VPN is widely used to get around this.
Yet the overriding impression I got is that Iran doesn’t seem to look to its east or its west. It’s a country that mainly looks in on itself and back to a glorious past of Cyrus the Great, Persepolis, the Sahavids and so on. They see themselves as very distinct to the Arabs in the surrounding countries. They are Shia, in a vast area dominated by Sunnis. They are also very proud of their pre-Islamic and Zoroastrian heritage. The country’s biggest holiday is Nowruz - Iranian new year - which originated in the Achaemenid Empire. Their patriotism and love of flag is matched only by Americans. Flags are everywhere you go. Hundreds line the motorway as you enter Tehran - an impressive sight. It is as ubiquitous as pictures of Khomeini.
It’s a paradoxical place. Their suspicion of the West makes drinking a Coca Cola a potentially disloyal act. They worry that Pepsi might have ‘Israeli connections’. Neckties are ‘Western’ and not worn. Yet at the same time they admire much about Europe and America and seem almost hurt that the West refuses to treat them more like equals when it comes to culture, science, and arts. And it makes sense if seen in historical terms; this part of the world was far in advance of Western Europe - not to mention North America - in terms of civilization and culture for all but the past five centuries or so out of the past five thousand years over which human history can be traced back.
From a foreign investor’s perspective I think it is important to remember that biggest beneficiaries of the loosening of sanctions in Iran will be the Iranian consumer and some foreign businesses. Perhaps this is part of the reason that it has taken so long for an agreement on Iran’s nuclear program. From a business perspective there will be many losers and surely some of them will be owned or linked to the military which have substantial investments in the economy.
It becomes obvious upon being there that there are many businesses with poor quality products that will struggle against foreign competition. In addition, USD 50 oil and a huge increase in supply coming from neighbouring Iraq will cause the government to tighten the purse strings. Much of the equity market capitalisation is made up of resource or resource-related businesses which I would personally prefer to avoid.
That said, there will surely be some excellent buying opportunities. I would focus on the domestic consumer and also on the tourism sector. Both will get a big boost from the easing of sanctions and a change in perceptions of the country. There are businesses that have spent the previous few decades building brand loyalty with the consumer making them more insulated from foreign competition. Perhaps they also have an advantage by being perceived as ‘Iranian’. I would expect those brands to prosper and present good buying opportunities on the stock market. In addition, the hotel and tourism sector has huge potential to grow from a relatively low base.
Lastly, there are many tech and internet businesses that have prospered despite sanctions and finding the ‘winners’ could be very profitable for those that are willing to spend the time to find them.
I hope you enjoyed reading our monthly newsletter and I would like to extend my gratitude to our guest writer for contributing the Iran travel report. If you would like any information about our funds or markets please let me know.
With kind regards,
Asia Frontier Capital Limited
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