Transcript Frontier markets are inefficient

Managing Frontier Market Portfolios
Nick Padgett, Managing Director, Frontaura Capital
CFA Institute
Investing in Africa Traveling Conference Series
February 2013
Frontaura Capital LLC
180 North Stetson Avenue, Suite 1935
Chicago, Illinois 60601 USA
Tel: +1 312 777 1500
Fax: +1 312 268 5004
[email protected]
www.frontauracapital.com
FRONTAURA CAPITAL LLC
FRONTAURA GLOBAL FRONTIER FUND LLC
FRONTAURA GLOBAL FRONTIER FUND OFFSHORE LIMITED
© 2007 - 2013 Frontaura Capital LLC
Most of the world’s stock exchanges are frontier
Frontier markets are stock markets, categorized by country, that leading index providers
typically do not classify as either “developed markets” or “emerging markets”
MSCI World Countries
MSCI Emerging Countries
MSCI Frontier Countries
Other countries with stock exchange
Countries with no stock exchange
70% of countries with stock exchanges are
not represented in the
MSCI All-Country World Index
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Frontier = 30% of world’s population;
13% of world’s GDP, but <3% of global market cap
World Population
(6.9 billion total)
World GDP
($83 trillion total, PPP)
5%
13%
6%
World Market Capitalization
($50 trillion total)
1%
1%
1%
6%
14%
23%
12%
46%
41%
75%
56%
Frontier Potential
MSCI Developed Countries
MSCI Frontier Countries
MSCI Emerging Countries
Other Countries w/ Stock Exchanges
Countries w/ No Stock Exchanges
Source:
IMF World Economic Outlook October 2012 for 2012 population and GDP estimates.
Market capitalization data through 11 October 2012 if present on Bloomberg. World Bank World Development Indicators database 2011 used to supplement Bloomberg.
Market cap shown is the total market cap for all of the countries in each group, not just the total market cap for the companies within the MSCI index.
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Why invest in frontier markets?

Participate in the world’s fastest growing economies
 23 of 25 fastest growing countries over next 5 years are frontier

Capture additional returns by exploiting market inefficiencies
 Volatility and inefficiency allow for favorable entry and exit points

Benefit from favorable return characteristics
 Dividend yields are high
 Low PEs are plentiful as there is a wide dispersion in valuations
between and within countries
 High Return on Invested Capital companies with favorable earnings
growth exist

Complement existing developed and emerging market positions
 Frontier countries comprise 30% of the world’s population, 13% of
the world’s GDP, but <3% of the world’s market capitalization
Today’s frontier markets are tomorrow’s emerging markets
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The fastest growing economies are frontier countries
The end of the Cold War, a step change in communications
infrastructure, and significant cost advantages are allowing
the least developed countries to grow the fastest
Real GDP Growth and Trends
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
Advanced economies
Emerging and developing economies
Of the 25 countries with local stock markets that
are projected to grow fastest in 2012 - 2017, the
MSCI All-Country World Index only captures 2
Source: International Monetary Fund October 2012
25 Fastest Growing Economies 2012 - 2017
Libya
Mongolia
Bhutan
Iraq
Sierra Leone
China
Papua New Guinea
Laos
Niger
Mozambique
Ghana
Zambia
Côte d'Ivoire
Rwanda
Cambodia
Burkina Faso
Tanzania
Panama
Nigeria
Bangladesh
Sri Lanka
Indonesia
Vietnam
Myanmar
Uzbekistan
0%
5%
10%
15%
20%
25%
MSCI Emerging Countries
MSCI Frontier Countries
Other countries with stock exchanges
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Frontier markets are inefficient
Frontier markets are inefficient. Limited information coupled with limited liquidity
drive major price / valuation swings.
Monthly Returns
40.0%
30.0%
20.0%
Ghana
10.0%
Croatia
Vietnam
0.0%
Bangladesh
-10.0%
S&P 500
Index
-20.0%
-30.0%
Source: Bloomberg
Volatility presents favorable entry and exit opportunities
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Frontier markets have favorable return components
Stock market returns are attributed to capital appreciation due to earnings growth and
change in valuation multiples, plus dividend yield
Total Return = ∆ Earnings + ∆ P/E + Dividend Yield
Return
Component
Frontier Market Attributes
∆ Earnings
 High GDP growth
 Growing middle class and integration of informal economy can provide
market growth > GDP growth for listed companies
∆ P/E
 Inefficient security pricing provides excellent entry and exit
opportunities
 High risk-free rates limit P/E ratios, but over time these rates will
decline and P/E ratios will rise
Dividend Yield
 Frontier markets feature high dividend yields
 Frontier market companies often have high ROIC/ROE, allowing for
both high earnings growth AND good dividend yields
Frontier Markets offer potential for outsized returns
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MSCI Frontier
MSCI Emerging
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
Frontier PEs often lower than emerging, developed
Trailing Price to Earnings
30
25
20
15
10
5
0
MSCI World (Developed)
Source: MSCI data on Bloomberg
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MSCI Frontier
MSCI Emerging
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
Frontier price/book ratios also lower
Trailing Price to Book
3.0
2.5
2.0
1.5
1.0
0.5
0.0
MSCI World (Developed)
Source: MSCI data on Bloomberg
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MSCI Frontier
MSCI Emerging
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
Frontier companies pay much higher dividends
Trailing Dividend Yield
9
8
7
6
%
5
4
3
2
1
0
MSCI World (Developed)
Source: MSCI data on Bloomberg
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MSCI Frontier
MSCI Emerging
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
Highest ROEs in emerging, frontier
Trailing Return on Equity
20
18
16
14
12
10
8
6
4
2
0
MSCI World (Developed)
Source: MSCI data on Bloomberg
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Frontier markets total return 2.4x since 2003
MSCI FM, EM, and Developed Returns
(Monthly, USD, Total Return Net Dividend)
600
500
400
300
200
100
MSCI Frontier
Source: MSCI
MSCI Emerging
Jan-13
Sep-12
May-12
Jan-12
Sep-11
May-11
Jan-11
Sep-10
May-10
Jan-10
Sep-09
May-09
Jan-09
Sep-08
May-08
Jan-08
Sep-07
May-07
Jan-07
Sep-06
May-06
Jan-06
Sep-05
May-05
Jan-05
Sep-04
May-04
Jan-04
Sep-03
May-03
Jan-03
0
MSCI World (Developed)
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Frontier markets underperforming since GFC
MSCI FM, EM, and Developed Returns
(Monthly, USD, Total Return Net Dividend)
120
100
80
60
40
20
MSCI Frontier
Source: MSCI
MSCI Emerging
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
0
MSCI World (Developed)
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Current environment may provide additional benefits
Developed world macro events will continue to impact frontier markets, but
frontier markets have some structural advantages:
Developed Markets
Frontier Markets
Corporate Deleveraging
Low corporate leverage
 Reduced ROE as capital structures are
normalized
 Drag on GDP growth as banks
normalize balance sheets
 ROEs are high due to competitive
advantage, not unsustainable leverage
 Banks in many frontier countries are well
capitalized and conservatively run
Consumer retrenchment
Emergence of consumers
 Falling asset values, economic fears,
and reduced credit likely lead to a thrift
mindset
 Growing middle class becoming first time
consumers
 Consumer credit is in its infancy
Increased government role in
private sector
Privatization & growth of free
enterprise
 Increased government ownership in
the financial services industry coupled
with fiscal policy could reduce
innovation and productivity
 In most frontier markets, governments
are adopting free market policies and
privatizing state-owned companies
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How do we think about and manage risk?
We aim to invest in countries that are stable or improving; however, country
diversification is ultimately the main tool to manage general market risk.
The two specific risks we actively manage are sudden currency devaluation and
incorrect securities valuation.
Risk
Mitigating Action
Currency devaluation
 Country Score of macroeconomic indicators
helps identify high-risk countries
 Company valuation models account for
projected devaluations based on inflation
differentials
Incorrect securities
valuation
 We select only securities trading at a discount to
intrinsic value, providing a margin of safety
 We strongly prefer relatively simple businesses
that we are confident in valuing
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Investors have these common concerns…
Concern
Factors to consider
Corruption, political, and macro risks
 We monitor a number of indices that quantify macro risks.
Generally, the risk metrics for frontier markets are similar to,
not worse than, emerging markets.
Financial information quality; fraud
 Many countries have adopted or are in the process of
adopting the IFRS standard for financial reporting.
 Most of the publicly traded firms we invest in are audited by
the Big 4.
Counterparty risk
 Most of our securities are held through our global custodian
or local subsidiaries of leading global banks. We do not use
a prime broker, and thus do not have prime broker
counterparty risk.
Taxation and capital controls
 Frontier markets are similar to, but perhaps slightly better
than, emerging markets in this area. Frontier markets
typically do not have capital controls or levy taxes on capital
gains. Many frontier countries have no dividend withholding
taxes, but if dividend taxes are withheld, rates tend to be
10% – 15%.
Risks and investor issues faced in frontier markets are generally no
worse than emerging markets
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Frontier investors must choose a fund type…
Larger Funds
Pros
 Brand name manager; safe choice
 No performance fee
 Frequent fund liquidity
 Often available without high minimum
Boutiques
Cons
 Unless you know manager personally, you
probably have not heard of them
 High fee
 Lockups
 May have high minimum
 Business continuity of manager less certain
Cons
 The trade off for large fund size, superior
liquidity terms are investing liquidity constraints
that eliminate many countries and shrink
universe to a few hundred stocks
 The most-liquid stocks often trade at higher PEs
 Manager may need to buy what they can
instead of what they want
 Personnel not always exclusive to fund
Pros
 Investable universe is a few thousand stocks
Conclusion
 Larger frontier funds may behave similar to
frontier index, for better or for worse
Conclusion
 Boutique frontier funds can perform significantly
different from an index, for better or for worse
 Outperformance necessary to overcome high
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fees
 A broad range of valuations is available within
universe
 Best values and opportunities more likely to be
investable
 Managers live and breathe frontier markets
Frontier markets are illiquid;
a potential source of return
Recent Ibbotson research shows:





Illiquid stocks outperform liquid stocks significantly (see table)
This liquidity effect is present in every size quartile and every value quartile (not shown)
The liquidity effect appears stronger than the well-known small-cap effect
The liquidity effect exists globally (US, UK, Europe, and Japan)
Not only do illiquid stocks outperform, they do so with less volatility
Quartile
Geometric Mean
Standard Deviation
1 – Illiquid
15.46%
19.81%
2
13.57%
20.08%
3
11.66%
22.91%
7.11%
27.32%
4 – Liquid
US data from 1972-2008. Source: Zhiwu Chen and Roger G. Ibbotson, Zebra Capital Management, LLC. All rights
reserved. www.zebracapm.com. Cited in Ibbotson SBBI 2009 Classic Yearbook, Chapter 9.Liquidity Investing.
Chicago: Morningstar, 2009.
We experience this liquidity effect firsthand in frontier markets and it can work for
us or against us. Double-digit percentage discounts or premiums are common
when no one else is willing buy or sell.
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Example of an actively managed frontier portfolio
Industry
Holding
Country
Holding
Country
Holding
Banks
32%
Vietnam
13%
Qatar
3%
Consumer Staples
17%
Nigeria
13%
Lebanon
3%
Industrials
15%
USA (cash only)
8%
Rwanda
2%
Consumer Discretionary
12%
Tanzania
7%
Romania
2%
Cash
9%
Zimbabwe
5%
Kazakhstan
2%
Telecommunication Services
6%
Iraq
5%
Cote d’Ivoire
1%
Specialty Finance
3%
Ukraine
5%
Ghana
1%
Materials
2%
Serbia
4%
Oman
1%
Energy
2%
United Arab Emirates
4%
Laos
1%
Diversified
1%
Pakistan
4%
Papua New Guinea
1%
Cambodia
4%
Montenegro
1%
Estonia
3%
Cyprus
1%
Botswana
3%
Zambia
<1%
Senegal
3%
Kenya
<1%
Portfolio Statistics
Portfolio Price to Earnings
6.2
Portfolio Price to Book
1.1
Portfolio Dividend Yield
5.1%
Return on Ending Equity
21.7%
Market, portfolio, and most recent 12 months of reported fundamental data as of January
31, 2013. Portfolio PE and PB are the harmonic means of all positions, weighted by position
size. Portfolio dividend yield and return on ending equity (ROEE) are the means of all
positions, weighted by position size. The yield on Frontaura Global Frontier Fund is less
than our portfolio dividend yield due to cash held, withholding taxes, management fees, and
operating expenses. At present, we retain all income, rather than distribute it.
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Characteristics of companies we invest in
 Intelligent capital allocation
– High return on invested capital
– Track record of using free cash flow wisely
 Reasonable growth prospects
– Ample expansion opportunities
– Product or service that benefits from growing middle class
 Franchise characteristics
– High market share or growing market share in fragmented market
– Low competition and low threat of new entrants
– Reasonable pricing power over customers
 Low risk
– Positive free cash flow, often in excess of net income
– Predictable business model that can be forecasted easily
– Margin of safety: valuation at a discount of our estimate of intrinsic value
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Past Investment Example: Millat Tractors
MTL PA Price and Dividend Chart
Thesis:
Leading tractor assembler in
Pakistan, selling Massey
Ferguson brand.
• In 2008, relatively unknown.
No research on the
company; local brokers had
never met management.
• Management buyout during
privatization
• Favorable cash cycle; 100%
upfront cash payment
required when order placed.
• At time of initial purchase:
- LTM P/E: 8.2
- Dividend Yield: 8.8%
- 5-year ROE: 25%
900
Exit
800
700
600
Pakistani Rupees
Business
Description:
500
400
300
200
Partial Sale
Buy
100
0
Source: Bloomberg
MTL PA price and running sum of dividends received
MTL PA price
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Past Investment Example: Kingdom Hotels
Thesis:
KHI LI Price Chart*
Owns and operates luxury
hotels in primarily emerging
and frontier markets.
• Unlike many real estate
investments:
- Low debt
- Book stated at cost
- Portfolio largely complete
and generating revenue
• Stock oversold in 2008 due
to misperceived exposure
to Dubai real estate due to
HQ location. Over 90% of
operations actually outside
Dubai.
• At low, traded at $1.00
(0.15 book)
• Acquired at $5.00
10
9
8
7
US Dollars
Business
Description:
Acquisition
and delisting
6
Frontaura
accumulates
position
5
4
3
2
Weighted
avg.
purchase
price
1
0
Source: Bloomberg
*Kingdom Hotels was listed in Dubai as KHI DU and also in London as KHI LI.
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Current Investment Example: Swissport Tanzania
Leading airport baggage and air
cargo handling service in
country of 47 million.
Valuation
Price:
1,740 TZS
Intrinsic Value:
2,821 TZS
Market Cap:
$39 million
LTM P/E:
8.4
Price / Book:
6.3
Dividend Yield
9.4%
ROE:
74.6%
Debt / Equity:
35%
Investment
Thesis:
• Global carriers gradually
increasing flights to Tanzania.
• High returns on capital and
oversight of multinational
parent.
SWISSPOR TZ Price and Dividend Chart
2400
2200
2000
1800
Tanzanian Schillings
Business
Description:
1600
1400
1200
1000
Frontaura
accumulates
position
800
600
400
Source: Bloomberg
SWISSPOR TZ price and running sum of dividends received
Market data current through 31 January 2013, and fundamental data current
through 30 June 2012.
SWISSPOR TZ price
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Disclaimer
This document is confidential and is for the exclusive use of the original recipient only. No portion of
this document may be reproduced without the written permission of Frontaura Capital LLC.
This document does not constitute an offer to sell, or a solicitation of an offer to buy the membership
interests described herein. No such offer or solicitation will be made prior to the delivery of a
definitive offering memorandum and other materials relating to the matters herein. Before making an
investment decision with respect to the LLC, potential investors are advised to read carefully the
offering memorandum, the LLC operating agreement and the related subscription documents, and to
consult with their tax, legal, and financial advisors.
This document contains a preliminary summary of the purpose and principal business terms of the
LLC; this summary does not purport to be complete and is qualified in its entirety by reference to the
more detailed discussion contained in the private offering memorandum and the actual text of the
LLC operating agreement. The LLC managing member has the ability in its sole discretion to change
the strategy described herein.
This document is being provided to you on a confidential basis solely to assist you in deciding
whether or not to proceed with a further investigation of an investment in Frontaura Global Frontier
Fund LLC. Accordingly, this document may not be reproduced in whole or in part, and may not be
delivered to any person without prior written consent of Frontaura Capital LLC.
FRONTAURA CAPITAL LLC
FRONTAURA GLOBAL FRONTIER FUND LLC
© 2007-2013 Frontaura Capital LLC
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