Asia Frontier Capital (AFC) - May 2017 Newsletter
May 2017 was characterized by a strong performance for emerging markets and for a number of frontier markets in our universe as well. Developed markets were also mainly positive with the S&P 500 Index up +1.2%, though the Nikkei 225 Index was down −0.4%. The MSCI Emerging Markets Index rallied +2.8% while the MSCI Frontier Markets Net Total Return USD Index soared +4.3%. However, the highlight of last month was the upgrade of Pakistan from the MSCI Frontier Markets Index to the MSCI Emerging Markets Index. This resulted in quite a large money and allocation shift within our investment universe. There’s more about this in the AFC Asia Frontier Fund manager comment below.
The AFC Asia Frontier Fund gained +0.9% in May, in line with the MSCI Frontier Markets Asia Net Total Return USD Index which increased by +1.1%. The fund is now up +79.9% since inception, which corresponds to an annualized return of +12.0% p.a.
The AFC Iraq Fund returned −3.1% in May and its performance year-to-date is −6.7 %.
The AFC Vietnam Fund rose +3.0% in May, in line with the VN-Index in USD terms which rose +2.8%. The fund is now up +78.7% since inception, which corresponds to an annualized return of +18.4% p.a.
Thomas Hugger took the top spot in Citywire’s line-up of best performing frontier markets managers
CEO of Asia Frontier Capital and Fund Manager of the AFC Asia Frontier Fund, Thomas Hugger, outperformed all other frontier fund managers in Citywire’s database over a 3-year period up to 30th April 2017. The fund performed +36.52% over this time period, while the MSCI Frontier Markets Total Return USD Index lost −7.76%. The average return of peer fund managers in the frontier markets category fared slightly better at −4.93%. Additionally, the fund outperformed other funds by a huge margin in terms of the risk measure “maximum drawdown”. The fund has had a maximum drawdown of just −5.7% over this 3-year period, while investors in the next best fund, in terms of risk, may have faced a drawdown of −14.2%. Also, in terms of standard deviation, another risk parameter, which is 7.3%, the fund ranks #1 again over the 3-year period.
Full article on Citywire.com (a login/free registration may be needed)
Launch of an AFC Asia Frontier “Parallel Fund” in Luxembourg
In order to provide better and easier access for our European investors, Asia Frontier Capital has decided to launch a “Parallel Fund” of the AFC Asia Frontier Fund in Luxembourg. The launch of AFC Asia Frontier Fund (Lux) is slated for the beginning of the 3rd quarter of 2017.
The Luxembourg-based fund will invest up to 84% in the existing Cayman Islands based AFC Asia Frontier Fund and the balance will be invested directly in stocks that the Cayman Islands fund is also holding. We expect that the performance of the Luxembourg based fund will be very similar to the existing Cayman Islands-based fund.
Ahmed Tabaqchali presents at the Iraq Petroleum Conference
Ahmed Tabaqchali, the CIO of the AFC Iraq Fund, presented at the Iraq Petroleum Conference which was held in London on 22nd and 23rd May 2017. The event gathered over 200 senior industry professionals and government representatives for insightful debates on the new strategies for Iraq’s energy sector.
Ahmed Tabaqchali makes a point at the Iraq Petroleum Conference
Summing up the general takeaway from the conference Ahmed said: “Senior industry professionals and government representatives at the “Iraq Petroleum Conference” appraised the significant progress of Iraq’s energy industry in the face of substantial challenges over the last two years. The industry emerged stronger through focusing on core strengths and starting partnerships with international companies and local enterprises. AFC contributed to discussions on the role that private capital can play in providing equity capital to Iraq’s start-ups and private companies as they gear up to participate in joint ventures with the State and international players in the next phase of growth in Iraq’s energy industry.”
AFC Asia Frontier Fund (AAFF) USD A-shares gained +0.9% in May 2017. The fund underperformed the MSCI Frontier Markets Asia Net Total Return USD Index (+1.1%), the MSCI Frontier Markets Net Total Return USD Index (+4.3%), and the MSCI World Net Total Return USD Index, which was up +2.1%. The USD A shares achieved a NAV of USD 1,796.96 which is a new all-time high (the previous high was in April 2017 at USD 1,780.72). The performance of the AFC Asia Frontier Fund A-shares since inception on 31st March 2012 now stands at +79.7% versus the MSCI Frontier Markets Asia Net Total Return USD Index, which is up +43.6%, and the MSCI Frontier Markets Net Total Return USD Index (+40.0%) during the same time period. The fund’s annualized performance since inception is +12.0% p.a., while its YTD performance stands at +5.4%. The broad diversification of the fund’s portfolio has resulted in lower risk with an annualised volatility of 8.93%, a Sharpe ratio of 1.33 and a correlation of the fund versus the MSCI World Net Total Return USD Index of 0.33, all based on monthly observations since inception.
It was another month of positive performance for the fund led by the fund’s holdings in Vietnam, Pakistan and Sri Lanka. The big event of the month was Pakistan having its last trading day as a frontier market on 31st May 2017 as it moved into the MSCI Emerging Market Index on 1st June 2017. Though Pakistan has regained its status as an emerging market, the fund will still remain invested in the country and Pakistan will continue to remain in our fund universe as it continues to have all the qualities we look for in a frontier market, i.e. under-researched, politics, macro and economic development. From our on-the-ground experience we clearly see that the Pakistani economy is still far behind other Asian frontier economies, especially countries such as Sri Lanka and Vietnam. However, the index provider, MSCI gives more weight to market related factors, such as free float, liquidity and most importantly access for foreign investors and therefore does not necessarily look at other factors which Asia Frontier Capital does.
Though performance was positive this month, the fund underperformed the MSCI Frontier Market Index as the upgrade of Pakistan to the MSCI Emerging Market Index led some frontier-focused equity funds to sell their entire Pakistan allocation and replace it with other frontier markets, such as Argentina, Nigeria and Romania which have led to a rally in the MSCI Frontier Markets Index with the aforementioned markets surging by +6.3%, +14.5% and +6.6% respectively last month. Since we do not invest in non-Asian frontier markets such adjustments/re-allocations would impact our relative performance in a disruptive fashion and we expect some more adjustments to happen in Pakistan in the next few weeks, similar to the experience of Qatar and UAE in the months following their upgrades to emerging market status back in 2014.
Pakistan will have a weighting of 0.1% in the MSCI Emerging Market Index via six stocks. Three banks, one oil & gas company, one cement conglomerate and one holding company. Of these six names, the fund has exposure to only one—the cement company. We prefer to follow a value approach and didn’t play the emerging market upgrade strategy as we are generally positive on Pakistan in the long term due to improving GDP growth rates, a better security environment and the infrastructure related investments linked to the China Pakistan Economic Corridor (CPEC). As a result, Pakistan has been the top performing market for the fund since inception.
Within Pakistan, performance was led by an oil & gas company, a bank, and a motorcycle manufacturer, while Vietnam had a good overall performance for the fund as strong manufacturing growth continues this year on the back of foreign direct investment “FDI” flows. Sri Lanka continued to do well and we added to our existing exposure based on both attractive valuations as well as incremental positives in the country.
On 25th May 2017 the IMF signed off on a three-year, USD 434 million loan for Mongolia which is part of a larger USD 5.5 billion financing package comprised of Japanese, Chinese, Korean, Asian Development Bank and World Bank funds. Approval of the bailout package should see a stabilization in Mongolia's fiscal situation as the Mongolian government's Economic Recovery Plan focuses on building foreign exchange reserves and strengthening the banking sector, while emphasizing debt minimization and growth. News of the bailout being finalized has seen Mongolia's currency, the Tugrik, stabilize and appreciate over the past month. The next milestone we are awaiting is the Presidential election on 26th June 2017.
The best performing indexes in the AAFF universe in May were Vietnam (+2.8%), Pakistan (+2.6%), and Sri Lanka (+1.0%). The poorest performing markets were Iraq (-7.4%) and Cambodia (-2.6%). The top-performing portfolio stocks this month were a Iraqi junior oil exploration company which we sold with a gain of 58.8% this month, a Vietnamese telephone equipment company (+28.6%), a Mongolian iron ore mining company (+27.1%), and a Mongolian copper and gold mining company, which was up +23.8%.
In May, we added to existing positions in Cambodia, Laos, Mongolia, Pakistan, Sri Lanka, and Vietnam and reduced our exposure in Bangladeshi, Mongolian and Pakistani holdings and completely exited one Mongolian coal company and an Iraqi junior oil exploration company. We newly added a Mongolian junior copper and gold exploring company, a Sri Lankan construction company, a Sri Lankan consumer goods focused holding company and a Vietnamese infrastructure company.
As of 31st May 2017, the portfolio was invested in 119 companies, 1 fund and held 7.4% in cash. The two biggest stock positions were a pharmaceutical company in Bangladesh (8.2%) and a Pakistani cement company (2.5%). The countries with the largest asset allocation include Vietnam (24.9%), Pakistan (24.7%), and Bangladesh (16.2%). The sectors with the largest allocations of assets are consumer goods (30.5%) and healthcare (15.4%). The estimated weighted average trailing portfolio P/E ratio (only companies with profit) was 16.75x, the estimated weighted average P/B ratio was 3.10x, and the estimated portfolio dividend yield was 3.68%.
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AFC Iraq Fund Class D shares returned −3.1% in May as the market continued the process of correction and profit-taking after the strong upside momentum that began in late summer of last year into February.
Avg. daily turnover / Iraq Stock Exchange (ISX) (green) vs
Net foreign turnover which was negative in April has become somewhat less negative as the chart below shows.
Foreign Turnover index on the ISX (green) vs 10-day average (red)
As a result, the market’s historic correlation with Brent prices and Iraq’s Euro Dollar Bond (USD 2.7 billion, issued 2006, due 2028 with a 5.8% coupon), has diverged like much of last year. The bond continues to trade higher as Iraq’s rehabilitation in the eyes of foreign institutional investors continues along the lines discussed here over the last few months, and is up about +2.9% for the month almost regaining the highs last seen in 2014.
Rabee Securities’ RSISUSD Index (green), Iraq’s USD 2.7 bn Bond (gold)
The divergence since March, for the most part, could be explained by the fragility of the early stages of a local liquidity revival in the economy. The liquidity crunch, since mid-2014, driven by the combination of low oil prices and increased military spending had a huge negative effect on economic activity and ultimately on the equity market. The government’s response by underspending on wages, pensions, goods, services, and investments was devastating for the economy as it is the largest employer in the country and the largest player in the non-oil economy with its orders/contracts driving multiple industries. This dynamic is best illustrated below with the correlation between oil revenues and M2 or liquidity, which became extremely strong from mid 2014 to the present as FDI’s, capital investments, and investment inflows were negative during this period.
The effects of the liquidity crunch were transmitted to the stock market through lower prices from mid-2014 until mid-2016, and the reverse for its recovery afterword’s as seen below.
Unlike the negative consequences of the liquidity crunch which were felt in relatively short order, the positives of the revival in liquidity will take much longer to filter through to the economy. This is because the government is continuing to pursue a restrictive fiscal policy, and thus the upturn will be driven solely by a recovery in non-oil capital investment spending. Non-oil capital investment spending is estimated to be up +192% yoy in 2017 after contractions of -68% in 2016 and -50% in 2015, which in turn will drive growth of non-oil GDP of +3% in 2017 vs. contractions of -5% & -14% in 2016 & 2015 respectively (IMF, December 2016). Such capital spending will take time to move from the planning stage to the implementation stage given the chronic structural and institutional challenges that Iraq suffers from while at the same time all resources are focused on the battle to liberate Mosul and Western Anbar, while maintaining basic services in the country at large.
The often-cited statement here that “a change of direction is at hand with the opportunity to acquire attractive assets that have yet to discount a sustainable economic recovery” is still very much in play as Iraq is no longer at the mercy of neither low oil prices nor escalating cost of war as it was for much of the last 2.5 years. With the change of direction driven by the reversal of these circumstances, i.e. deescalating & eventually declining costs of war, Brent crude averaging above USD 50 a barrel so far 2017, foreign aid, and loans. This line of reasoning is supported by the observations made earlier about the price action of Iraq’s Eurobond, as it implies increasing interest in Iraq, which should lead to FDI’s which in turn will provide a new source of liquidity in the economy, provide a further boost to M2 growth and ultimately further liquefy the equity market.
For the medium term, the IMF estimates that government expenses will exceed revenues until 2021 with the gap bridged by a combination of external (60% in 2017) and Internal financing (40% in 2017) until the economy can sustain itself. The effect on economic activity is felt through the steady M2 growth and following acceleration as the chart below shows.
These estimates have room for expansion as they are based on estimates of flat oil production/exports from 2016 onwards and Iraqi Oil prices of USD 42 in 2017 increasing by an average of USD 2 a year (Iraqi oil sells at about USD 5 discount to Brent). While Iraq has joined OPEC’s production cuts of 10% for 2017 until at least Q1/2018, this cut is from a higher baseline than that was assumed by the IMF. Also, YTD average realized prices have been higher than projected with the net effect estimated, by AFC, +8.8% higher oil revenues than projected YTD. With the budget extremely sensitive to oil exports & prices, the higher than realized oil prices, should they be sustained by year end & beyond, could have a meaningful positive effective on the economy as they will either increase non-oil investment spending, lead to decreased demand for local financing or a combination of the two. On the other hand, the higher than projected oil revenues YTD should provide a cushion for revenues to meet initial projections for the year should oil prices decline from current levels.
In laying out the outlook for 2017 in our December’s newsletter that “the catalyst for a new bull market in the Iraqi equity market was set by the battle to liberate Mosul in October” came with the observation that “ … bull markets climb a wall of worry” applies to Iraq, but with many such walls to climb to name a few: delayed execution of investment spending, continued political squabbling and instability, weakening oil prices, and potential new regional conflicts. Hence, the recovery will likely be in fits and starts with plenty of zig-zags along the way as liquidity is still scarce with a time lag before it can filter down into the economy.” The market weakness of the last few weeks is one such wall to climb and likely with a few more walls to climb down the road.
As of 31st May 2017, the AFC Iraq Fund was invested in 14 names and held 5.5% in cash. 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 (97.7%), Norway (1.9%), and the UK (0.4%). The sectors with the largest allocation of assets were financials (50.7%) and consumer staples (25.0%). The estimated trailing median portfolio P/E ratio was 11.20x, the estimated trailing weighted average P/B ratio was 0.90x, and the estimated portfolio dividend yield was 3.02%.
The AFC Vietnam Fund returned +3.0% in May with an NAV of USD 1,787.13, a new all-time high, bringing the net return since inception to +78.7%. This represents an annualised return of +18.4% p.a. The May performance of the Ho Chi Minh City VN Index in USD was +2.8% while the Hanoi VH Index gained +4.9% (in USD terms). Since inception, the AFC Vietnam Fund has outperformed the VN and VH Indices by +43.9% and +50.9% respectively (in USD terms). The broad diversification of the fund’s portfolio resulted in a low annualized volatility of 8.83%, a high Sharpe ratio of 2.06, and a low correlation of the fund versus the MSCI World Index USD of 0.30, all based on monthly observations since inception.
News about a higher Vietnam weighting in the MSCI frontier market index and rumors that Vietnam will be added to the MSCI watch list for a potential upgrade to emerging market led to strong buying interest in blue chip stocks on both exchanges. Some banks, with a fully used foreign ownership quota, advanced by 10-20% over the past month, but also brokers, some of which we own, had a similar run and pushed up the indices, in particular, the Hanoi-index.
We decided to sell two more of our oldest investments at very attractive prices due to an increased appetite in the small and midcap segment. We believe that these two companies are no longer as inexpensive as the rest of our portfolio and we have therefore increased our position size in some of our existing stocks according to our investment model. Additionally, we found some new and attractively valued midcap stocks which we have added to the portfolio.
Vietnam – the most compelling investment case since China’s stock market evolution twenty years ago
At any given time, there are numerous investment opportunities across the globe. For example, US stocks could see further expansion in valuation given their leading position in innovation, Europe could come out of the doldrums they have been stuck in for the past 10 years and finally see some economic growth again, but Emerging Markets in particular are looking better than they have over the past six years. Vietnam specifically is still one of the very few places in the world where all prerequisites are given for continuous growth and financial gains over the long term and we expect them to follow and participate in the 20-year long China success story.
Vietnam is still in the very early stage of a long-term upward trend, both in terms of economic growth and evolution of financial markets. The comparison with China is sometimes seen as overdone by many people, but in our view, it is most appropriate and we would even make the argument that Vietnam is in many respects in a more advantageous situation than China was 20 years ago.
Within ASEAN, Vietnam has a long way to go to catch up with Thailand, for example, with which it has a growth advantage of around 3-4%. We estimate it will take around 25 years, or a full generation, for Vietnam just to catch up with the level of Thailand.
When travelling across Vietnam one can observe a very young, motivated and well-educated population, which certainly underpins the country’s high growth prospects. Public spending on education is about 6.3% of GDP, two percentage points more than the average for low and middle-income countries. Although some governments spend even more, Vietnam’s expenditures have been well focused, aiming to boost enrolment levels and ensure minimum standards. In global rankings, 15-year-olds in Vietnam beat those in the US and Britain in math and science. Another good sign of the development of a country is the rate of urbanization; Vietnam still has one of the lowest urbanization rates in South East Asia.
Early investors in the AFC Vietnam fund have seen gains of 78.7% since inception 3 ½ years ago, yielding over 18% per year. The intention of taking profits is a common human behavior, but the only investment decision for buying or selling an investment, regardless if profitable or at a loss, should be simply the question, if this investment at the current price level is still worth buying or not. In the investment case for Vietnam we are certainly answering this question with a clear “Yes”.
Vietnam could easily be an investment handed over to the next generation as we see high growth rates for at least the next 20 years. Over the medium term we do not even see signs of either overheating or over-speculation and hence the start of the next structural bear market could still be many years away. Vietnam has a relatively well-developed stock market with more than 1,200 listed companies and will be soon introducing a derivative market. The population is very optimistic about its future economic outlook and according to Nielsen’s Global consumer confidence report it ranks number five in the world. Further, GDP per capita is increasing rapidly and hence it has one of the fastest growing middle class in the region. Nevertheless, Vietnam’s investor base is growing at a healthy and stable rate, given that their still low-income level, and does not show any signs of strong increases like we saw in the highly speculative phase of China, where 100,000 of new trading accounts were opened in a single week!
What really excites us is that we finally observed a confirmation of a breakout on the upside of the market, as described over the past few months.
We are neither able to predict the absolute nor relative performance of Vietnam compared to other markets, nor can we predict the future performance of our fund, but given all the information we have, our optimism for a continuation of the very steady fund performance compared to other investment alternatives has not changed.
A significant development moving Vietnam in the right direction is the country’s credit rating outlook which having been changed from “Stable” to “Positive” by the two credit agencies, Moody’s and Fitch. Vietnam’s rating change reflects its strong economic growth, manageable debt levels and continuous strong foreign direct investment inflows.
As of 31st May 2017, the AFC Vietnam Fund was invested in 77 names and held 5.2% in cash. The sectors with the largest allocation of assets were consumer goods (32.2%) and industrials (24.6%). The fund’s estimated weighted average trailing P/E ratio was 9.75x, the estimated weighted average P/B ratio was 1.68x and the estimated portfolio dividend yield was 6.81%.
In line with our process of being on the ground in the countries we invest in, Ruchir Desai, Senior Investment Analyst at Asia Frontier Capital, travelled to Sri Lanka to attend an investor conference. The photos in this article are all by AFC.
I was back in Colombo after a year to attend an annual Sri Lanka conference that I have attended previously, but this year the conference was expanded to an Asian frontier markets conference and included participation from Bangladeshi, Pakistani and Vietnamese companies. This is good for us since I was able to meet with companies that the AFC Asia Frontier Fund has invested into, as well as meet with companies we have on our shortlist.
I arrived in Colombo a few days prior to the conference so that I could meet with local companies on our shortlist which wouldn’t be attending the conference. I usually prefer to get out of the hotel and meeting rooms and onto the ground to gain a more local perspective. Last year the macro situation in Sri Lanka was not necessarily positive, but things appear to be changing for the better. The coalition led government got off to a slow start after coming to power in 2015, but this is the reality of coalition governments in the region.
The past few quarters have seen some positive changes. Major infrastructure projects, such as the Colombo Port City (renamed to Colombo International Financial City) and the Central Expressway have re-started and the city appears to have more construction projects underway. It is not difficult to miss the reclamation work in progress for the financial city if you walk down the Galle Face Road which also has the Shangri-La and ITC hotels under construction. The Central Expressway will link Colombo to Kandy in the centre of Sri Lanka (~120 km from Colombo) with the first phase of construction having started earlier this year. The government is making moves to increase tax collection (the VAT rate was increased from 11% to 15% last year), while it is also looking to further integrate the country with other Asian economies, such as India, China and Singapore, via free trade agreements which will be beneficial in the long run. Sri Lanka has also regained the GSP+ status from the European Union which should help improve export growth over the next few years, especially in textile related exports to Europe.
Colombo International Finance City reclamation work in progress
In the near term though, inflation and the current account deficit will probably be higher than expected due to the drought which impacted the country earlier this year, leading to higher imports of rice and coal (hydropower plants could not operate due to the drought), but higher oil and coal prices and the Rupee depreciation have not helped either. Further, with the VAT led price increases and drought having an impact on consumer purchasing power, consumer spending could also see a near term impact.
However, the negative sentiment over the last year has led to historically low valuations and one can argue that these negatives (inflation, higher interest rates, deficits, coalition government) are now priced in. On the back of a pick-up in construction activity most infrastructure related companies, i.e. cement, construction and wiring/cable companies, have been showing good revenue and profit growth over the past few quarters, whilst earnings of other sectors, like banking and consumer, have been stable. As we have written in manager comments in the past few months, there are bottom up stock selection opportunities in Sri Lanka and we have increased our weight to the country since March 2017.
Coming to the Sri Lankan companies I met, the infrastructure related companies sounded very positive on their outlook and this is backed by their recent quarterly results. Within the consumer related space, pharmaceutical distribution companies had a near term negative profitability impact due to price caps being imposed on essential drugs by the government. However, this was a one-time impact and drug distribution companies are still expecting double digit volume growth from these businesses. Consumer staple and consumer discretionary companies could face near term headwinds due to higher inflation, VAT led prices increases and rising interest rates.
Inside an outlet in one of Sri Lanka’s leading pharmacy chains
I also had chance to meet with Pakistani, Bangladeshi and Vietnamese companies at the conference, some of which the AFC Asia Frontier Fund is already holding in its portfolio. The Pakistani consumer discretionary and cement company that I met with both sounded very positive on their outlooks and this is not surprising. Consumer discretionary companies in Pakistan (auto, consumer appliances) have done very well over the past year on the back of low interest rates, a better security environment, an improving economy and an under-penetrated consumer market. Domestic cement sales have grown at double digits over the past year backed by rising housing construction and infrastructure related activities. Though there are worries over Pakistan’s current account deficit and foreign reserve position on the back of rising imports (mainly machinery imports which is a good sign), we continue to be positive on the longer-term prospects of the country due to the “China Pakistan Economic Corridor” (CPEC) related investments, an improving security environment and the possibility of Nawaz Sharif’s party, the PML (N), staying in power in next year’s elections.
The Bangladeshi telecom and consumer discretionary companies that I met with were both very positive on their outlooks. Smartphone penetration in Bangladesh is still only at 28% and data revenues for this telecom company grew by 68% in the first quarter of this year. With rising smartphone and internet penetration, data revenues can show double digit growth over the next few years while recent consolidation in the Bangladeshi telecom market has helped stabilise pricing for voice calls. The consumer sector in Bangladesh is one which we are positive on due to rising disposable incomes growing from a low base and the very under-penetrated consumer sector in Bangladesh. For example, air conditioner and refrigerator penetration rates in Bangladesh are only 3% and 20% respectively compared to global averages of 60% and 85% respectively. However, remittances from overseas workers play a big role in consumer spending and remittances have been weak so far this year as most of them stem from the Middle East where lower oil prices have subsequently led to lower demand for overseas workers.
One of the Vietnamese companies I met is a steel producer and is amongst the top two in this sector in Vietnam. Infrastructure related companies continue to do well in Vietnam due continued strength in the economy, backed by industrial production leading to greater demand for infrastructure investments. We have been positive on Vietnam over the past five years and remain positive on infrastructure, real estate and consumer discretionary companies.
This trip gave me the chance to meet with 25 companies. So far, this year as a team we have met with 80 companies, a process which we give importance to. I am off to Ho Chi Minh City in June to meet another set of companies and look forward to being back in Colombo next year.
I hope you have enjoyed reading this newsletter. If you would like any further information, please get in touch with me or my colleagues.
With kind regards,
Asia Frontier Capital Limited
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