south arica

Investment Process in Action: the South Africa Diaries

Recently our African investment team visited South Africa as part of their continuing management of existing investments and pursuit of new opportunities. The trip provides a clear snapshot of our investment process in action.

 

Our unconstrained universe

In January 2016 our fund exposure to stocks in South Africa was 33%, today it’s 60%. We had spotted a deeply undervalued currency and a country concerned about the unpredictable behaviour of President Zuma. Flash forward to today and we find its enduring institutional strength helped maintain its investment grade rating, the currency appreciated over 20% and the external positioning continues to improve with the recovery of commodity prices. Our non-benchmarked approach enabled us to build our position in companies with the potential to deliver great returns over the next 3-5 year cycle, not just from a short-term bounce in sentiment.

 

Prospects for improving country risk

We assess country risk in terms of economic health and institutional and government quality. It is clear that Zuma has been a disastrous leader for South Africa. However, 2017 holds the prospect of change as the ANC are electing a new chairman. So a real prospect of a positive leadership change, alongside a strong central bank could mark the beginning of a reform driven agenda, triggering a return to faster economic grow.

 

The “Tail”Winds of Change

As we anticipated, we are now witnessing the headwinds being replaced by cyclical tailwinds with inflation falling, exports rising, and business confidence improving.

At Alquity, we focus on the cycle of profitability with the primary aim to invest in companies towards or close to the bottom of their cycle and where our expectations are significantly greater than the market. One such company is KAP Industrial Holdings, a leading supply chain logistics and manufacturing business. As the South African economy faced headwinds the business maintained its profitability but the market punished its share price, implying a structural change in outlook. As the economy improves, KAP is therefore well positioned to capture growth and increase profitability ahead of market expectations.

 

Hidden Gems with sustainable competitive advantage

South Africa is a complicated place to do business, which makes it an unlikely destination for direct investments. This allows savvy domestic operators to build world class operations with sustainable competitive advantages. A good example is the clothing & food retail operator Woolworth, that developed its own supply chain and branded food company. Recently it removed all plastic microbeads from its private label beauty and personal care products, making it easier for consumers to avoid being part of an environmental problem that is causing worldwide concern. This reflects their strong supply chain management and responsiveness to consumer trends.

In summary, as a country with strong institutions, great companies and abundant resources it is not surprising that a recent Bloomberg article revealed that South African equities have delivered the highest average return in US Dollars, for any equity market, over the past 100 years.


Peru: Cementos Pacasmayo and Ferreycorp – two world-class teams

A two-week trip to Latin America, travelling through Argentina, Chile and Peru, gives our fund management team food for thought as change is underway in the region.

 

Piura is located about 400km north of Lima with a population of 500,000 people. We came to Piura to visit Cementos Pacasmayo’s brand-new cement plant and Ferreycorp’s workshop.

Our day began early, and we woke up at the crack of dawn to avoid the sweltering heat, with our journey taking us through the city’s main retail artery. It was mostly populated by local retail operations characterised as simple stores, though the regional behemoth and a holding in our fund Grupo Falabella, was well represented with Tottus, its supermarket operation, and Falabella, its department store.

Driving out of the city involved dodging the swarm of three-wheeler taxi cabs, which we learned was the most popular taxi type and an easy alternative for self-employment. Upon exiting the city we were surrounded by the desert environment of Piura, a perfect location for a cement plant due to the expansive and uninhabited location.

Retail sites in Piura
Retail sites in Piura

The plant took 3 years to build costing US$ 370million. Using the most advanced German technology the plant was built with the goal of limiting its environmental impact. It sources its raw material from a nearby quarry, avoiding having to import clincker (a critical binding agent for cement).

The 1 million square meter operation was truly impressive. Health and safety procedures were evident from the moment we entered the facility as each one of us had to pass a breathalyser test to ensure we would not put anyone at risk. Cementos Pacasmayo has been on our watchlist since the launch of the fund, as a high quality company benefiting from a local dominance and high barriers to entry.

By the time we ended our visit the temperature had risen to 30C, so a good time to make our way in an air-conditioned minivan to Ferreycorp’s regional offices. We were welcomed by the group treasurer, who travelled especially to Piura to host our visit, and the local sales and operations team.

The sales team presented the firm’s positioning in Piura, which is endowed with a high level of industrial diversity in the form of agricultural, mining, fishing and infrastructure activity. The past few years have been lean years for the sector, with many players exiting and/or lacking commitment to the local market. Ferreycorp’s long term commitment and strategy led to them increasing their regional market share to 70%. The presentation was followed by a visit to their parts supply room, not only was this a superbly organised meeting, it also showed their adherence to ‘just in time’ practices with carrying parts that they know will be in demand according to their programmed maintenance schedule of the regional fleet of machines. One of their key comparative advantages is having highly skilled personnel that undergo significant amount of training throughout their Ferreycorp careers. Being a 5-star rated Caterpillar dealer is one of the major reasons why companies select Ferreycorp and reinforces their market leading position. We currently have 2.9% of the fund in Ferreycorp and we estimate it is currently selling at a 35% discount to intrinsic value.

Meeting the Ferreycorp team
Meeting the Ferreycorp team

We left Piura with a better understanding of Pacasmayo’s long term vision and Ferreycorp’s regional opportunity. Continuation of the city’s development will come through the development of its natural resources, both in the soft commodity and bulk materials area. Its low cost profile and high productivity potential will continue to attract entrepreneurial investment, which we believe will lead to a strong and sustainable level of growth.


Chile: time for Bachelet to be substituted?

A two-week trip to Latin America, travelling through Argentina, Chile and Peru, gives our fund management team food for thought as change is underway in the region.

 

After 4 years of poor political management, corporate Chile is eagerly looking forward to a new political cycle. Based on our discussion with company managers, clients and bankers, the last local elections outcome and Bachelet’s approval rating of less than 15%, we can safely say that change is on the horizon. Their hope is that the elections this year will extend the structural political swing from populist left to a more pro-business right, following in the footsteps of Argentina, Peru and Brazil.

Over the last few years, the companies we’ve met have scaled down investment in Chile, using their highly cash-generative domestic base to re-invest in more investor-friendly and growing markets in the region: namely Peru, Colombia, Mexico. For example our holding Falabella has increased its share of business in Peru, Colombia, Argentina and Mexico combined, from 26% in 2009, to 45% in the latest 2015 results.

Chile is not a typical emerging market; it enjoys first-world type of infrastructure, has sophisticated consumers and world-class industry. Our tour of Las Condes, the Costanera Center and Valparaiso provided ample evidence if this was needed.

Our holdings in Chile are supported by very strong fundamentals and capable managers leading world-class operations as illustrated by our visit to the Embotelladora Andina plant a few miles away from Santiago (3rd largest bottler of Coca-Cola in Latin America, with concessions in Chile, Argentina, Paraguay and Brazil). With a strong track-record of capital allocation over several cycles, delivering good returns to shareholders like us. All this comes at an undemanding valuation as they suffer from the “Bachelet discount”, despite most of their growth coming from neighbouring countries.

Visiting the Andina Plant in Chile
Visiting the Embotelladora Andina Plant in Chile

The election later this year may well be a catalyst for a re-rating of Chilean Equities after 4 years in the doldrums (-9% as measured by the MSCI Chile over the last 4 years in USD). But this will just be the cherry on the cake as the fundamental earning power of the multi-latinas will keep delivering over the long term.


Argentina: Macri, the “Messi” of the Argentine economy?

A two-week trip to Latin America, travelling through Argentina, Chile and Peru, gives our fund management team food for thought as change is underway in the region.

 

Touring the Bohemian area of Palermo Soho in Buenos Aires, with its eclectic collection of trendy shops and restaurants, it doesn’t feel as though the country is in a recession. It’s been over one year since Mauricio Macri was elected president of Argentina and we came to meet with industrial and consumer companies to gauge the position of Argentina’s economic recovery.

buenos aires
The view over Buenos Aires

Since Macri took power he has reached an agreement with sovereign bond holdouts, removed capital controls and amended the regulated tariffs. This has allowed institutions to regain trust and begin to act responsibly, by being transparent about fiscal challenges and the real economy.

This move away from the farcical “Kirchner” economic model is increasing business confidence and  willingness to invest in growth. For example, the country’s largest mall operator is looking to finally receive municipal approval for a 10 million square meter residential project, for which they’ve been waiting more than 10 years.

The economic adjustment is well underway and was further confirmed by meeting with our holding Pampa Energia, whose electricity distributor Edenor, saw its electricity tariffs increase allowing them to capture a proper return on assets and invest to expand. The average household’s electricity bill in northern Buenos Aires rose from US$3/month to US$16/month, but is still among the lowest in Latin America. We hold 4.5% of the fund in Pampa Energia, and its value has climbed 350% since we initiated our investment.

The consumer sector in Argentina is not doing well, in large part due to the high level of unemployment (8.5%), and a still high, though declining, level of inflation.

Both these factors are symptoms of an economy going through its cyclical adjustment. The main factor to follow, which will over time improve both employment and consumption, is a resumption of infrastructure investment. This is crystal clear to Macri and will be the pathway to prosperity.

The economic adjustment is well underway and was further confirmed by meeting with our holding Pampa Energia, whose electricity distributor Edenor, saw its electricity tariffs increase allowing them to capture a proper return on assets and invest to expand. The average household’s electricity bill in northern Buenos Aires rose from US$3/month to US$16/month, but is still among the lowest in Latin America. We hold 4.5% of the fund in Pampa Energia, and its value has climbed 350% since we initiated our investment.

The consumer sector in Argentina is not doing well, in large part due to the high level of unemployment (8.5%), and a still high, though declining, level of inflation.

Both these factors are symptoms of an economy going through its cyclical adjustment. The main factor to follow, which will over time improve both employment and consumption, is a resumption of infrastructure investment. This is crystal clear to Macri and will be the pathway to prosperity.