Fund Manager Diaries: Brazil update

Brazil suffered a severe recession in 2016, experienced anaemic growth in 2017 and will likely continue this trend through 2018. Therefore the fledgling recovery is yet to visibly reduce unemployment and kick-start cyclical growth. Indeed, the market is pricing in a continuation, and even deterioration, of this difficult environment.

We are, however, constructive on the country, currently 58% of our Latin America portfolio, as we find it extremely attractive from a technical, business cycle and valuation perspective.

 

Concluding thoughts

The market is deeply sceptical and has heavily discounted asset prices on the basis of dysfunctional politics. We believe this view ignores the realities; the political class are under no illusions that fiscal reform is required, despite the roadblocks Brazil’s recovery has been delayed rather than reversed and valuations already discount a significant deterioration. In short, we see similarities to 2002, 2009 and 2016, years in which a massive change in Brazilian politics coincided with a violent drop in risk premia and sharp equity market rallies. Our positioning reflects our optimism and is biased towards out of favour, high quality companies that in some cases offer over 100% potential returns.


Investment notes from Greater China

Mike Sell, Alquity’s Head of Asian Investments spent ten days in Greater China visiting 22 companies in Hong Kong and four in Taiwan. He was joined by Dan Billis, a new addition to the Asia Investment team. Despite being caught in Typhoon Mangkhut, Mike and Dan visited both existing and new potential holdings. Our regular on-the-ground meetings in September provided a good opportunity to discuss the relentless negative news relating to the global trade war with the companies we met; whether and to what extent the imposition of tariffs impacts the Chinese domestic economy.

 

Concluding thoughts

The view from all our company meetings regardless of sector was undoubtedly positive. Overall, we returned with our conviction on the macro outlook reaffirmed. As a result, we sustain our long-standing view that the Chinese domestic economy is in a solid and much better shape than most people believe, which also strongly implies that trade woes and the imposition of tariffs are very unlikely to derail the underlying economic momentum in China. Once the majority of market players realise that the domestic economy is well-insulated from external shocks, the high quality stocks of domestically-focused companies (of which we have successfully identified a number) will continue to deliver, despite recent sentiment-driven poor share price performance. We have been increasing the weighting of China across our portfolios and will continue to do so.


South Africa: The long road to recovery

The vast potential of South Africa with its diversified economy, strong institutions and a young population, was restrained over the last decade by a combination of gross mismanagement, policy uncertainty and festering structural challenges, largely due to the administration of Jacob Zuma. Over this 10-year cycle, there was a notable decline in living standards and business confidence, and the South Africa equity market underperformed global emerging markets.

Concluding thoughts:

The conclusions drawn from our on-theground research reinforces our positive view on South Africa, as the foundations for the recovery we predicted are being laid. However, we are under no illusion about the process. The reality is that after 10 years of decline, the revival is likely to be lengthy with several bumps along the way. At the first juncture, we expect political
considerations to make the cyclical uptick develop slowly. The President will balance disparate and competing interests with a view to winning the electoral mandate necessary for the bold reforms which will open the economy and kickstart a job-led economic recovery.

Notably, gross fixed capital formation (a proxy for business confidence and investment) declined to a 10-year low as percentage of GDP in 2017, matching the extent of the fall observed after the global financial crisis of 2007-08. This suggests that the country is near the bottom of its economic cycle. Taking the plans of the companies we met into consideration, gross fixed capital formation will stay depressed over the next 12 months, but we are confident of its recovery over the medium-to long-term.


Trip Report: Mexico

In the last few weeks, we toured 3 major Mexican cities: Mexico City, Monterrey and Guadalajara, to meet with 17 companies and measure the pulse of the economy before this weekend’s presidential election. This trip was taken with an open mind; aiming to stress test our investment thesis for the country, which has been among the lowest allocation in our portfolios since Q4 2016.

 

Concluding thoughts:

The outlook for Mexico is less bright compared to the past 8 years and material risks are not totally discounted by the FX and equity markets, in our opinion. Earnings growth for most Mexican companies remain uncertain and valuations do not price in the risks we identified.

Having said that, I met with some exceptionally well-run companies, mostly in the consumer and infrastructure sectors, that benefit from structural growth trends, have built sustainable competitive advantages and are executing a well-thought strategy. Thus, would certain equities experience price corrections that more than discount the risks, we are ready to be contrarian and buy high quality companies trading at a discount to their intrinsic value.


Trip Report: Mumbai

Senior Investment Analyst Aaron Armstrong has just returned from a three day conference in Mumbai.

Having met with representatives from 23 companies, as well as a host of other market participants, he shares his latest thoughts on the investment case for India below.

 

Concluding thoughts:

Placed in the context of the last four years, since the Alquity India Fund was first launched, this is among the most positive set of insights we have ever come away with from an investment trip. With harmonised positive outlooks for economic growth, corporate earnings and political developments, we maintain conviction that India offers one of the most exciting investment opportunities anywhere in emerging markets at present.

 


Brazil Update

The purpose of my trip to Brazil was to evaluate the potential momentum of its economic recovery, the risk of an adverse outcome to the upcoming presidential elections, and companies’ outlooks and investment plans.

 

Concluding thoughts:

Lula will not be able to run as the appeals process for his criminal conviction will get stalled in the courts beyond the elections. His party, the PT, has until mid-April to submit a candidate and most other candidates are compromised in one way or another. Regardless, this party is rudderless and has no natural alternative leader to capitalise on Lula’s popularity. The risk of Bolsonaro, the extreme right candidate, is also remote given his lack of a national political machine and his low allocated TV advertisement. It is also likely that he
is his own worst enemy; he is known to make vulgar and demeaning comments.

The candidates from the centrist parties have the best chance of winning, and I would currently estimate this to be an 80% probability. Companies unanimously agreed that Brazil is changing, applaud the reforms and are investing for the future. Interest rates are significantly lower, inflation is under control and they believe the reform agenda will move forwards after elections. The equity and currency market recovered from their crisis lows, but in our opinion, the medium-term earnings potential for Brazilian companies continues to be underestimated.

 


Egypt and South Africa Update

Through 2017, we posited that the macroeconomic constraints that held back potential in South Africa and Egypt would ease and create a platform for recovery and growth.

Temi Iyiola (Analyst) takes a deeper look at how both economies are progressing andthe outlook for investors.

 

Concluding thoughts:

We see positioning in Egypt and South Africa as similar to that of Brazil 2 years ago, which we were able to effectively monetise in our Latin America fund, having protected much of the downside. Our Alquity Africa fund, with 70% of AUM in Egypt and South Africa, is positioned for cyclical recovery driven by political stability and economic fundamentals, as opposed to the alternatives in other African markets where the growth drivers are more volatile and linked to a less predictable commodity cycle.

At a stock level, the Alquity Africa fund is weighted to companies with sustainable competitive advantage, who provide exposure to domestic sectors in Egypt and South Africa that will benefit from growth over a 3 to 5 year time horizon. We own companies like Bidvest and KAP, industrials who have reinforced their competitive advantages while their competition were constrained, and companies like Edita, Oriental Weavers and MR
Price; well managed consumer names who are positioned to grow with consumption.

 


Fund Manager Diaries: Our Outlook for Vietnam

Delivering a return of 41%*, Vietnam has been the strongest performing Asian market during 2017. Representing over 13% of the Alquity Asia fund and 8% of the Alquity Future World fund, the country is a key differentiator versus our peers. 

Mike Sell, Alquity’s Head of Asian Investments, has just returned from a trip to the country to assess the prospects for continued growth in 2018.

During his trip Mike visited existing and prospective fund holdings to gain insight into Vietnam’s market, the macro economic outlook, the implication of long-term themes and the companies best placed to benefit from them.

* Data in USD, correct as of 15 December 2017

 

Concluding thoughts:

Overall, I returned from Vietnam with our conviction in the macro outlook and core positions reaffirmed. Although we will remain alert for risks of overheating and stress in the fiscal or external accounts, these certainly do not appear to be on the horizon at the moment. While the market has risen over 40% this year, I believe valuations are proportionate given the growth outlook and the risk-reward trade-off remains favourable.

The major challenge lies in discovering attractive new ideas, in companies where the values of management align with values of minority shareholders. Over the course of my trip, I have identified some candidates with this potential, either now or in the medium term, and fully expect upcoming listings to create additional opportunities.

 


The South Africa Diaries: Risks Skewed to the Upside

The ANC Elective Conference Election is expected to
take place from 16-20th December. Seizing the moment,
we embarked on an investor trip to South Africa to test
our investment thesis by gaining local insight into the
economic impact of the potential outcomes of the ANC
election and the macroeconomic challenges the country
faces.

Key takeaways:

1. The outcome ofthe ANC election has a key bearing on whether the country will address its economic challenges.

2. A positive outcome should see the close of the Zuma chapter and boost
sentiment

3. Strong institutions and resilient, highly adaptable companies are used to challenging conditions

4. There is strong potential for an election outcome that could kickstart recovery


Fund Manager Diaries – Mumbai, the modern and confident India

Mike Sell, Alquity Head of Asia Investments enjoyed an Indian Summer visiting 26 companies to assess how the economic reforms implemented by Prime Minister Modi were impacting our holdings and seeking out new opportunities for the Indian Subcontinent Fund. This trip report, split into three parts, provides a detailed assessment of this multi-year growth opportunity.

 

MODERN, CONFIDENT INDIA: THE FINANCIAL HUB OF MUMBAI

The city may only be an hour away from Ahmedabad by plane, but as India’s financial capital, the atmosphere is a world away. For example, the airport has a dedicated pick up area for Uber and Ola and as you drive along the expressway there are numerous advertising billboards for the latest stock market IPOs.

My meeting with Oberoi Realty gave me the opportunity to assess the impact of the Real Estate Regulatory Act on them and their peers. Stricter rules regarding payment collections from customers will result in fewer speculative projects, and thus lower overall supply. Consumer confidence has returned to the Mumbai property market, following the disruption from demonetisation, and I remain very comfortable with our investment.

Voltas, the air conditioning company, was additionally reassuring as management shared their view of the increasingly competitive environment and their strategy to counter it. The experienced management team has delivered to date; building a franchise that dominates with a 21% market share. We believe that air conditioning, like the automobile sector will see an acceleration in competition in the main cities. However, Indian companies will thrive due to their strong brand recognition, dealer networks and following Modi’s drive for rural electrification, increasing penetration into smaller cities and rural areas. Maruti, with whom we met in Delhi, still has a market share of almost 50% despite the entry of Hyundai, Toyota and Honda. I frequently spotted their dealerships on the road trip to Aligarh. As Voltas stated, there is wealth outside the major cities, and this is proven by car sales in these areas, which account for approximately 35% of Maruti’s total sales. This confirms that air conditioning is an affordable modern convenience and once reliable power is available, it becomes an accessible necessity.

Additionally, I scouted for new ideas in the construction sector as, anecdotally, Mumbai is currently building out the largest amount of infrastructure since India’s independence.

I had an informative introductory meeting with J Kumar Infrastructure, a major beneficiary of India’s focus on building metro systems in cities with a population over 5 million.

I also met with Sun Pharmaceutical, perceived as the market leader, to determine whether the intensified pressure on US generic drug pricing is adequately reflected in share prices and as a comparison to our position in Glenmark Pharmaceutical. The meeting reaffirmed our belief that whilst headwinds for the sector will persist for an extended period, Glenmark’s differentiated product offering and significant focus on environmental standards will result in continued profitable growth.

Similarly, I met with HDFC bank and LIC Housing Finance to ensure I understood the competitive environment in their respective segments. HDFC Bank is one of the best-run companies in India, and one I first met in the mid 1990s. As they reminded me, at that point the public sector banks’ market share was 90%, with international banks on 8% and private sector banks on 2%. 20 years later, the split is 68%, 5% and 27% respectively. In addition to the impressive growth this represents (including taking market share from international banks) there remains significant future potential for the private sector banks from not just India’s growing population and economy, but direct market share gains from the inefficient state owned banks.

Our long-term themes of urbanisation and demographics naturally lead us (but not exclusively so) to consumer related companies, and I met with four new potential ideas in Mumbai. Unfortunately, a number of these suffer from a lack of sustainable competitive advantage and so we will not undertake further analysis, but there is one potentially interesting addition to the portfolio in this sector.

 

CONCLUDING THOUGHTS

In total, I met with 26 companies during the trip and my clear conclusion is that the investment case for India remains on track with expectations, if not actually ahead due to the impact of GST. None of our existing holdings disappointed, and thus none will be exited from the portfolio. We also have some potentially great new ideas to consider adding to the portfolio over the coming months.