April 2024 – CC&L Financial Group Ltd.

The strategy focuses on investing in frontier and emerging market companies that our team expects will benefit from demographic trends, changing consumer behaviour, policy and regulatory reform, and technological advancements.

Below, we explore some of the key factors influencing returns and share observations on the portfolio and the markets.

Financial Services Portfolio

The strategy saw strong returns from financial services, driven by the financial technology portion of the portfolio. The primary driver of returns at the security level was Kenya’s Safaricom PLC, the country’s leading telecommunication and mobile money services provider, whose share price appreciated by nearly 60% in US dollars in the quarter. This strong share-price performance is largely attributed to a decline in the risk premium attached to Kenyan assets.

Like many frontier and lower-income emerging markets, Kenya’s fiscal and balance of payments position was severely compromised over the last four years as it grappled with a host of global challenges, including high and volatile commodity prices, supply chain tightness, rising interest rates, and a strong US dollar. Domestically, successive droughts and the election of a new government in August 2022 created further uncertainty and negatively impacted consumer confidence (note: agriculture contributes over 30% to Kenya’s GDP and employs over 40% of the total population). Consequently, Kenya was all but shut out of international capital markets, impairing its ability to issue hard currency debt to finance its growing liabilities and leading to a 20% depreciation in the Kenyan Shilling against the US Dollar in 2023. The country’s fortunes began to turn around at the beginning of 2024 as it took advantage of a window of opportunity to issue its first Eurobond since 2021. Kenya enticed investors by offering a relatively lucrative yield of 11.0%, which was oversubscribed five times and ultimately raised US$1.5 billion at a tightened yield of 10.375% with a 10-year maturity. The government’s decision to pay up for capital has so far proven to be the right one as concerns quickly abated over the level of FX reserves and the country’s ability to service a US$2.0 billion Eurobond maturing in June 2024. The result was a compression in yields across the curve and a restored confidence in the Shilling, which, as of the date of writing, is the world’s best-performing currency versus the US dollar (~19% appreciation in the quarter). The significant appreciation in the currency is bringing imported inflation down, and with the start of the rainy season and a better harvest, it should serve to further subdue inflation through lower food prices.

As would be expected, the improvement in Kenya’s economic prospects was swiftly reflected in the share price of Safaricom as well as the broader market. Through M-Pesa, Safaricom is particularly geared to economic activity as it is the dominant platform through which its ~32 million active customers (~60% of Kenya’s population) transact using services like peer-to-peer transfers, bill payments, remittances, and borrowing and saving. In the year ending December 2023, M-Pesa facilitated ~$280 billion of transaction value (nearly 3x Kenya’s GDP), a number that is expected to grow as economic activity picks up and as many of the use cases that management is rolling out are adopted by its large and scaled base of customers and merchants.

Another notable contributor to the period’s returns from the financial technology portfolio was Kazakhstan’s Kaspi.kz, a company we have written extensively about in a previous post. Over the last three years, Kaspi’s management team have been working on a plan to move the company’s share listing venue from London (LSE) to the Nasdaq. Kaspi’s shares have been relatively illiquid on the LSE, with one-year average daily traded value of US$2.8 million, a low percentage of the free-float market capitalisation of over US$3.0 billion. Management have long made the case that the LSE listing undervalued their shares and that the right home for Kaspi as a technology company is the Nasdaq. True to their word, management pulled off the listing in January this year to become the first Kazakh company to list on the Nasdaq (the shares were subsequently delisted from the LSE). Since the listing, daily traded value averaged US$43.0 million, ~15x what it used to trade on the LSE. It is too early to say whether that liquidity boost will underpin a higher multiple on the shares as management hopes, but we are confident in their ability to execute operationally and believe that this will ultimately drive long-term shareholder value. The Nasdaq listing has also been celebrated by the President of Kazakhstan, which we believe should only help reinforce Kaspi’s national champion status and strategic importance to the country’s ambition to draw in foreign direct investment.

Consumer Portfolio

The strategy’s consumer portfolio delivered good performance this quarter, driven by the Philippines’ Century Pacific Food Inc. and Indonesia’s Sido Muncul (Sido). Century Pacific is the largest canned food company in the Philippines, with an 85% and a 52% share in seafood (tuna and sardines) and meat, respectively. Over the last few years, Century’s management have successfully executed an entry into the dairy category, with market share as of end of 2023 reaching ~28% in powdered milk (from 2% in 2016), a strong number two and lagging only behind Nestle, the market leader with a ~60% share.

The milk category is in its infancy in the Philippines, with annual consumption per capita at the bottom of the list among Asian countries. Management believes that milk consumption is at an inflection point and have positioned the company strongly to benefit from the growth in the category over the next decade. The diversification and resilience of Century’s portfolio have served it well in the last twelve months; Filipino consumers have experienced considerable pressure on their disposable incomes from a rise in rice prices and high interest rates which has led them to trade down to categories that offer more value for money. Simultaneously, softer input prices allowed Century to increase its gross profit margins and invest in advertising and promotions to drive demand and reinforce the equity of its brands while thoughtfully increasing dividend payout to shareholders. Momentum seems to also be building in other parts of the Century portfolio, including coconut water where the company announced an expansion of its agreement with The Vita Coco Company, alternative meats where it is now in 1,800 Walmart locations in the US, and pet food where it is making inroads in modern retail doors in the Philippines.

Sido, the herbal medicine company that we have discussed extensively in the past, emerged from a difficult 2023 with a strong exit performance in the last quarter of the year and a promising outlook for the first half of 2024. Sido is one of the most profitable consumer health companies in the world, with EBITDA margins above 44% and return on capital ratios that are consistently in the range of high 20%s to low 30%s. This profitability underpins high cash conversion and allows the company to continually run a zero-debt balance sheet. More recently, the controlling shareholder Irwan family bought out the full 17% stake of Affinity Equity Partners, a private equity investor that had come to the end of its investment cycle in the company. The transaction was done at a 30% premium to the three-month average price, signalling confidence from the family in the prospects of the business, and removing the overhang on the shares that typically arises with late-stage private equity ownership of public companies in our markets.

Outlook

After three difficult years, we are observing an improvement in the environment for the strategy. We sense more optimism in our discussions with the majority of portfolio companies on their operations and outlook for their businesses. We also see a growing opportunity set for the strategy as investability returns to markets like Kenya, Egypt, Pakistan, and Bangladesh. We also see more opportunities emerging out of ASEAN markets like Malaysia and Thailand, and Middle Eastern markets like the UAE. This has been reflected in the strategy’s cash levels, which have reached a three-year low as of the end of the quarter.

We look forward to continuing to update you on the strategy over the rest of the year.

MENA equity markets rounded up the first quarter of 2024 with returns of 3.2% (for the S&P Pan Arabian Index Total Return), ahead of the MSCI Emerging Markets Index, which was up 2.3% in the same period.

While Index-level returns were fairly muted, underlying performance and market activity levels remained robust. In Saudi Arabia, the performance divergence theme that we discussed in past letters picked up pace in the quarter, with the MSCI Saudi Midcap Index gaining 10.1%, outperforming the broader MSCI Saudi Index by ~8.0%. Accompanying this performance was a significant increase in liquidity on the exchange, with average daily traded value (ADTV) in the quarter reaching ~US$2.4 billion, higher by 68% (or nearly US$1.0 billion) compared to the ADTV for the full year of 2023. This surge in liquidity appears to be driven by a combination of domestic and foreign institutional flows, increased primary market activity drawing in new capital, and perhaps most interestingly, the emergence of high-frequency trading (HFT) as a new type of market participant. Estimates from HSBC suggest that HFT contribution to ADTV reached ~15% in March 2024 compared to low single digits in 2023. HFT contribution in our opinion is likely to materially grow in the mix over the next few quarters, driven by the stock exchange’s initiative to provide co-location services and an increase in the market’s capacity to accommodate additional liquidity through increases in free float and new listings. For comparison, HFT’s contribution to Turkey’s stock exchange volumes currently ranges between 25% and 30%. Capital market development in the region, and particularly in Saudi, is a powerful theme that the strategy has expressed through various position sizes depending on valuation through Saudi Tadawul Group, the stock exchange holding company which itself is a listed company on the market.

Another theme the strategy has been building exposure to over the last few quarters is Qatar’s liquified natural gas (LNG) value chain, which received a boost from Qatar Energy’s announcement in February of a capacity expansion plan that will add 16 million metric tons to annual capacity, taking it to 142 million tons by 2030. As the world’s lowest-cost producer of natural gas, with a lifting cost of US$0.30 per MMBTU compared to a range of US$3.0 to US$5.0 globally, Qatar is well-positioned to capitalize on its reserves over the next decade. Emboldened by this cost advantage and the US government’s decision to pause LNG export approvals until after the 2024 elections, Qatar seems intent on getting the most out of its reserves in the next decade. By keeping production high, Qatar will reinforce its position as the lowest-cost supplier to growing Asian markets and secure its role as a key player in the recalibration of energy supply chains that is taking place following the Russia-Ukraine war.

Qatar Gas Transport Company Ltd. (QGTS), the owner and operator of the world’s largest LNG shipping fleet, is a primary beneficiary of this theme. This was recently validated by the awarding of a contract for the addition of 25 conventional size LNG carriers (to an existing fleet of 74 vessels) by Qatar Energy following February’s capacity expansion announcement.

A key event in the quarter was the devaluation of the Egyptian Pound (EGP) in the first week of March. The Central Bank of Egypt (CBE) and the government of Egypt finally capitulated and devalued the currency from just above 30/USD to 50/USD after having held the rate at the former level since January 2023. The devaluation came two weeks after the government sealed a mega property deal with one of Abu Dhabi’s sovereign wealth funds that broadly involved a land sale in exchange for US$35 billion, of which US$14 billion would be in direct cash transfers and US$11 billion in a debt swap on existing UAE debt to Egypt. This substantial deal, equivalent to nearly 10% of Egypt’s GDP, has the immediate effect of reducing Egypt’s external debt by 7%. The floatation of the EGP following the Abu Dhabi deal has unlocked further funding from the IMF, which upsized its loan agreement with Egypt from US$3 billion to US$8 billion. The devaluation and improvement in Egypt’s external balances have opened up the foreign exchange market and cleared the backlog that had built up over the last 12 months. This should bring Egypt back from the brink of an MSCI reclassification from “Emerging” to “Frontier” or “Standalone” as we had seen from FTSE, which removed its special treatment classification following the devaluation.

While there is a lot to cheer about, those familiar with Egypt have seen this scenario before. Our recent conversations with companies suggest there is still a high degree of uncertainty among businesses and consumers. High interest rates (12-month T-bills are ~26% as of the date of writing) and limited progress on the reform front from the government will likely weigh on real earnings growth and keep valuation multiples fairly low. Egypt needs to demonstrate a willingness to make bold reforms that stimulate growth and attract foreign direct investment to break its cycle of reliance on friendly governments and multilateral agencies. In the absence of such reforms, the prospects for a multi-year earnings growth cycle in Egypt seem remote. That being said, we do see a window to potentially generate returns in Egypt in the next six to twelve months as US-dollar returns are likely to be protected over that timeframe given the recent devaluation. We believe the UAE’s Al Ansari Financial Services is an interesting way to play the reopening of the FX market in Egypt through the recovery in remittance flows from the UAE to Egypt. At its peak, Egypt was the third-largest FX corridor for Al Ansari, and thus the potential for an earnings recovery in the second half of 2024 is strong as volumes recover from a near halt in 2023. Under the right conditions, we also anticipate the strategy increasing our ownership of Egypt-listed businesses, details of which we will share if we make material investments there.

We look forward to continuing to update you on the strategy throughout the year.

UK house prices were an estimated 52% expensive relative to history at the end of 2023, based on a comparison with rents and the real yield on index-linked gilts, a competing inflation-protected asset.

The degree of overvaluation is below previous extremes and does not imply that house prices need to fall by an equivalent magnitude, or even at all – the deviation could be eliminated by rental growth and a reversal of the recent rise in real yields.

The ratio of the average house price to average earnings is conventionally used to assess valuation. Chart 1 shows an economy-wide version of this ratio – the estimated value of the housing stock divided by aggregate household disposable income.

Chart 1

The secular rise in the ratio is usually ascribed to such factors as increasing credit availability, population growth and undersupply due to planning and other constraints.

The use of earnings as a yardstick is questionable: it would be odd to assess the valuation of an equity market by reference to the income of investors. A better approach is to compare house prices with the value of services provided – proxied by rents – using an appropriate discount rate.

A simple valuation metric based on this approach is the gap between the rental yield on housing and the real yield on longer-term index-linked gilts. Index-linked rather than conventional bonds are the appropriate reference because housing is expected to provide inflation protection over the longer term.

The rental yield series, shown in chart 2, is derived from national accounts data by dividing the sum of actual and imputed rents by an estimate of the value of the housing stock*. The measure, therefore, is comprehensive, including owner-occupied and public housing as well as private rented accommodation.

Chart 2

The index-linked yield series starts in 1983 – the first such gilt was issued in 1981 – so the rental / index-linked yield gap has 41 years of history. In contrast to the house price to income ratio, the gap appears to be stationary / mean-reverting. The average (mean) gap over this period was 4.96 pp. The deviation from this average is the basis of the estimate of over- / undervaluation in a particular year.

The gap indicates that housing was undervalued as recently as in 2021 but only because index-linked yields had fallen to a record negative.

The drop in the yield gap to an estimated 3.27% at end-2023 – implying housing overvaluation of 52% – was driven by index-linked yields returning to positive territory. The rental yield was little changed between 2021 and 2023.

Current overvaluation compares with prior extremes of 74% in 2007 and 105% in 1988 – chart 3. These extremes marked peaks of the 18-year housing cycle, with another top due around 2025.

Chart 3

The suggestion is that, unless index-linked yields revert to negative, housing will perform poorly relative to history over the longer term, although prices may be supported over the next 1-2 years as the housing cycle upswing crests.

*The current series for actual and imputed rents begin in 1985; earlier numbers were estimated by linking to previous vintages. The value of the housing stock was calculated by adding the value of dwellings and an estimate of the value of associated land. The latter estimate was derived by applying the ratio of land value to dwellings value for households to the value of dwellings owned by all sectors. The resulting series begins in 1995; earlier numbers were estimated by linking to a previous vintage series for the value of the residential housing stock including land.

One of the 17 Sustainable Development Goals (SDG 6) established by United Nations (UN) is Clean Water and Sanitation, which aims to ensure the availability and sustainable management of water and sanitation for all.

The water crisis is unprecedented

In 2022, 2.2 billion people (27% of world’s population) lacked safely managed drinking water – meaning water that is accessible at home, available and safe. Additionally, 3.5 billion people lacked safely managed sanitation – meaning access to a toilet or latrine that leads to the treatment or safe disposal of excreta. Two billion people did not have access at home to a handwashing facility with soap and water. Demand for water has outpaced population growth due to urbanization and increasing water needs from agriculture, industry and the energy sector. Climate change has exacerbated water scarcity. According to the UN, global freshwater demand is predicted to exceed supply by 40% by 2030.

Water sustainability is complex

Water is at the core of sustainable development and critical for socioeconomic development, healthy ecosystems and human survival itself. Water sustainability refers to the availability of freshwater for human consumption and use in agriculture and industrial processes.

Substantial efforts are required from all stakeholders, including legal and regulatory measures, water pricing and funding. Investments are needed for both water infrastructure and technologies that result in healthier ecosystems, climate-resilient irrigation, improved water storage and higher water reuse rates.

Water investment opportunities are enormous

According to the World Bank, to meet the SDG 6 by 2030, investments must increase sixfold from the current level. Global investment in the water sector needs to exceed $1.37 trillion.

In the US, the Bipartisan Infrastructure Law, passed in 2021, delivers more than $50 billion to the Environmental Protection Agency (EPA) to improve the nation’s drinking water, wastewater and stormwater infrastructure – the single-largest investment in water that the federal government has ever made.

The European Investment Bank, one of the largest lenders to the global water sector, has invested more than €86 billion in over 1,700 projects, making water security and climate change adaptation a priority. In 2023 alone, it invested about €4.1 billion in the sector.

At Global Alpha, we invest in a few pure plays in water treatment and distribution.

Kurita Water Industries Ltd. (6370 JP)

Founded in 1949, Kurita Water is Japan’s largest industrial water treatment company, offering water treatment facilities, water treatment chemicals and maintenance services. It has over 20,000 customers in Japan. Overseas expansion is progressing well in the US and China, driven by favourable demand and the company’s excellent reputation.

Kurita Water is a technology-driven company with a strong intellectual property portfolio that boasts over 4,000 patents in various water treatment technologies. Core technologies include anticorrosion, dispersion (to absorb and disperse fine crystals in water to prevent them from sticking to the water system), agglomeration (to aggregate fine dirt particles and impurities in water into larger sized particles that are easier to treat), sterilization and antibacterial, biological treatment, adsorption (using activated carbon and other materials to adsorb and remove ions, organic matter and other impurities dissolved in water), deionization, membrane separation and surface treatment (for semiconductor and LCD manufacturing).

Metawater Co. Ltd. (9551 JP)

Formed in 2008 through the merger of the water environment divisions of NGK and Fuji Electric, Metawater is a leading engineering firm in Japan for water treatment, sewage treatment and waste treatment facilities. It is the first company in Japan to integrate machinery and electricity design in the water treatment field, to achieve optimal efficiency.

Most of Metawater’s customers are public entities. A growing number of its projects are based on Public-Private Partnership (PPP). In fact, Metawater has over 40% market share in such PPP projects in Japan. Outsourcing opportunities through PPP are huge. For example, among Japan’s 4,000 public water treatment plants, only 10% are outsourced. Among 2,000 public sewage treatment plants, only about half are outsourced.

Mueller Water Products (MWA US)

Founded in 1857, Mueller Water Products is a leading manufacturer of water infrastructure, flow control, metering and leak detection products in water and gas distribution networks in North America. Its main products are valves, hydrants, pipe fittings and ductile iron pipes.

The company has one of the largest installed bases of iron gate valves and fire hydrants in the US. The entry barrier is high due to the large switching cost for municipal customers. The business is very resilient, because about two-thirds of its sales are related to utilities repair and replacement.

Primo Water Corporation (PRMW US)

Founded in 1952, Primo Water is a leading North America-focused water solutions provider that operates largely under a recurring revenue model in the large format water category (defined as three gallons or greater). Its water dispensers are sold through approximately 10,800 retail locations and online. It offers water delivery services direct to customers. Customers can also exchange empty bottles at its recycling centres or refill at self-service stations. Primo Water not only provides high-quality water, but also helps reduce landfill waste. One five-gallon Primo Water bottle is sanitized up to 40 times and then recycled, saving over 1,500 single-serve bottles.

Zurn Elkay Water (ZWS US)

Zurn Elkay Water, founded in 1892, is another brand you might be familiar with. In 2022, Zurn Water Solutions and Elkay Manufacturing merged to form Zurn Elkay Water. While Zurn is strong in providing engineered water solutions mainly for the construction market, Elkay’s drinking water solutions include water fountains and the more popular water bottle fillers seen at airports, hospitals and schools. In 2023, two billion gallons of safe, clean filtered water were delivered by its filters, equivalent to the elimination of 18 billion single-use plastic water bottles. Elkay water filters have industry-leading standards and are certified to NSF/ANSI 42, 53 and 401 for the reduction of harmful contaminants, including lead, PFOA/PFOS, microplastics, cysts and Class I particulates.

Is water the new gold?

In Turkmenistan, where 80% of its land is desert, “A Drop of Water Is a Grain of Gold” is a national holiday observed annually on the first Sunday in April. It was established in 1995 to raise awareness about the nationwide water crisis and encourage the development of long-term sustainable solutions.

We believe the water sector presents significant and long-term investment opportunities due to increasingly favourable regulations and innovative new technologies.

Connor, Clark & Lunn Infrastructure (CC&L Infrastructure) is pleased to announce that it has completed its previously announced acquisition of an 80% equity interest in the Sharp Hills wind farm (Sharp Hills, or the Project), from EDP Renewables Canada Ltd. (EDPR Canada), a subsidiary of EDP Renewables, a leading global renewable energy producer. With this investment in Sharp Hills, CC&L Infrastructure now owns approximately 1.8 GW of renewable power across Canada, the U.S., and Chile, with overall assets under management of approximately $6 billion.

At approximately 300 MW of capacity, Sharp Hills is one of the largest onshore wind farms in Canada, representing clean energy generation equivalent to the amount of power used by more than 160,000 Alberta homes. The project completed construction and reached full operations in early 2024, and is fully contracted under a 15-year power purchase agreement with a high-quality counterparty.

“This investment in Sharp Hills marks our first wind investment in Canada, further diversifying our infrastructure portfolio across sector and geography,” said Matt O’Brien, President of CC&L Infrastructure. “We are pleased to once again be partnering with EDPR and look forward to owning and operating the Sharp Hills project together over the coming years.”

This transaction is CC&L Infrastructure’s second partnership with EDPR, having previously acquired a 560 MW portfolio of U.S. wind and solar assets in 2020. On a combined basis, CC&L Infrastructure’s partnership with EDPR totals more than 800 MW of operating renewable energy projects across Canada and the U.S.

About Connor, Clark & Lunn Infrastructure

CC&L Infrastructure invests in middle-market infrastructure assets with attractive risk-return characteristics, long lives, and the potential to generate stable cash flows. To date, CC&L Infrastructure has accumulated approximately $6 billion in assets under management diversified across a variety of geographies, sectors, and asset types, with over 90 underlying facilities across over 30 individual investments. CC&L Infrastructure is a part of Connor, Clark & Lunn Financial Group Ltd., a multi-boutique asset management firm whose affiliates collectively manage over $127 billion in assets.

Contact
Kaitlin Blainey
Managing Director
Connor, Clark & Lunn Infrastructure
(416) 216-8047
[email protected]

A modest upside inflation surprise in March has been portrayed as confirming that inflationary pressures remain sticky, warranting further delay in policy easing.

The stickiness charge is bizarre in the context of recent aggregate data. The six-month rate of change of core consumer prices, seasonally adjusted, has fallen from a peak of 8.4% annualised in July 2023 to 2.4% in March – see chart 1.

Chart 1

Six-month momentum, admittedly, has moved sideways over the last four months. This mirrors a pause in the slowdown in six-month broad money growth in early 2022, with the relationship suggesting a resumption of the core downtrend from around May.

Claims of stickiness focus on measures of core services momentum. Such measures gave no forewarning of the inflation upswing and are unsurprisingly also lagging in the downswing.

“Monetarist” theory is that monetary conditions determine trends in nominal spending and aggregate inflation, with the goods / services split reflecting relative demand / supply considerations.

Global goods prices have been under downward pressure because of rising supply and falling input costs (until recently), resulting in a diversion of nominal demand and pricing power to services.

So a monetarist forecast is that a recovery in goods momentum is likely to be associated with faster services disinflation within a continuing aggregate inflation downswing.

A subsidiary argument to the sticky inflation view is that the MPC can afford to be cautious about policy easing because the economy is regaining momentum.

Monetary trends have yet to support a recovery scenario. Of particular concern is a continued contraction in corporate real money balances, which chimes with weakness in national accounts profits data and suggests pressure to cut investment and jobs – chart 2.

Chart 2

The latest labour market numbers hint at negative dynamics. LFS employment (three-month moving average) fell sharply in December / January and is now down 346,000 from a March 2023 peak. Private sector weakness has been partly obscured by solid growth of public sector employment – up by 140,000 or 2.5% in the year to December.

Ugly unemployment headlines have been avoided only because of a sharp fall in labour force participation. The unemployment rate of 16-64 year olds would have risen by 1.2 pp rather than 0.3 pp over the last year if realised employment had been accompanied by a stable inactivity rate – chart 3.

Chart 3

Claims of labour market resilience rest partly on the HMRC payrolled employees series but this fell for a second month in March, although numbers are often revised significantly. (A previous post argued that this series has been distorted upwards by rising inclusion of self-employed workers in PAYE.)

A recent revival in housing market activity, meanwhile, could prove short-lived unless mortgage rates resume a downtrend soon. The latest Credit Conditions Survey signalled that banks plan to expand loan supply in Q2 but the balance (seasonally adjusted) expecting stronger demand fell back sharply – chart 4. Majorities continue to report and expect higher defaults, consistent with gathering labour market weakness – chart 5.

Chart 4

Chart 5

I recently spent six weeks in Asia, including four weeks travelling to Sapporo and Tokyo in Japan to attend two major investor conferences hosted by SMBC Nikko and Daiwa and meet with over 50 Japanese-listed companies.

My trip also included two weeks in China to celebrate the start of the Year of the Dragon, plus a week in Shanghai and nearby Jiangsu province visiting various companies and doing due diligence on existing and prospective holdings.

Japan’s investment appeal

Many may be surprised to learn that our highest country allocation is to Japan at over C$2.3 billion of our approximately C$9 billion total AUM. Across our Global, International and sustainable strategies, we own around 25 Japan-based companies in 10 different sectors, from Asics and Sega Sammy (Sonic) to Hoshino Resorts and Sakata Seed.

Year-to-date, the Nikkei Index is one of the top-performing developed market, up 13% in JPY or 3% in US$. The Nikkei recently broke its previous record set in December 1989. Yes, over 34 years ago. Was Warren Buffett onto something when he invested in Japan’s five largest trading companies back in August 2020?

Skepticism about the country due to its apparent structural weaknesses suggests that this rally is unsustainable. However, as anyone who reads our weeklies knows, we are optimistic on Japan and have made a point of visiting many times over the years. In the past year alone, five of us have travelled there for onsite company visits and conferences.

A resurgence in corporate Japan

Our January 25th weekly explored Japan’s improved corporate governance. Corporate reforms are gaining significant momentum. Since mid-January, 54% of listed companies have disclosed initiatives to reduce capital costs and enhance valuation. This topic was often on the first page of investor presentations at the two conferences I was at.

Companies announcing buybacks exceeded 1,000 in 2023 and amounted to over ¥9.6 trillion, with dividend payments also seeing notable increases to more than ¥15 trillion last fiscal year and growing. Stock splits are becoming common, cross-shareholdings are being sold and M&A is on the rise, albeit with private equity players still having a small role (less than a quarter of all transactions).

The Nippon Individual Savings Account (NISA) boost

The revamped NISA now allows for an annual contribution limit of ¥3.6 million (US$24,300) per person, up from ¥1.0 million, and a total balance of ¥18 million to be permanently tax exempt. As of June 2023, there were 19.4 million NISA accounts, a modest number given Japan’s population and that households were holding a record ¥2,115 trillion in financial assets, more than half of it in cash. Approximately 1 million NISA accounts are opened each month.

Foreign investment and demographic shifts

Japan is experiencing a considerable wealth transfer set to continue over the next decade due to its aging population, especially notable among Gen-Z (1997-2012) who are more open to equity investments compared to older generations. Foreign investors are still underweight.

Deflation forever?

Japan seems to have finally escaped deflation. Core inflation rose to 2.8% year-on-year in February and should continue to stay above 2% if the latest wage increase is an indication. In March, Japan’s union group announced its biggest wage hike in 33 years at 5.85%. We believe that higher wages will ultimately encourage consumption. Most companies we met told us that their reluctance to raise prices to their customers is no more, with many now doing just that or walking away from low-margin businesses. As an example, the country’s largest beer and beverage company, Asahi, raised its prices for the first time in 14 years in October 2022 and three times since for a total increase of around 20%.

I encourage you to re-read some our previous comments on Japan as far back as 2009:

December 9, 2009: Global Alpha manager commentary
September 13, 2019: Japan’s standards of corporate governance
November 22, 2019: Japan’s work style reform
July 22, 2021: Japan: Land of the rising ESG
December 1, 2022: Time to visit Japan
May 5, 2022: The myth of inflation in Japan
October 13, 2023: Japan’s long-awaited recovery

Japan’s visa policy changes and their impact on immigration

Another was about Japan’s updated visa policy, from August 3, 2018: Japan’s new visa policy. We touched on the view that Japan was closed to immigration and that its low birth rate would lead to a significant population decrease and inexorable decline.

What struck us visiting Japan this time was how many non-Japanese people work in the hospitality industry. They hail from many countries, including China, India, Sri Lanka and Vietnam and all speak Japanese and English. Back when we wrote the comment in 2018, there were 1.3 million foreign workers in Japan, compared to 486,000 a decade earlier and the goal was to increase by 500,000 by 2025. Japan achieved this goal much sooner, with 2.1 million foreign workers there in 2023. The country is entering an era of mass immigration and half of Japan’s prefectures saw net population increases last year. According to the Japan International Cooperation Agency, Japan needs 6.8 million foreign workers by 2040 to meet its growth targets. New immigration and visa policies being introduced this year will make it much easier for foreign workers to permanently settle in Japan and eventually obtain citizenship.

Observations from China

Turning to China, we believe the negative sentiment towards the country is at an extreme. India’s market capitalization recently surpassed China’s despite having an economy a sixth of the size.

We see emerging market funds exclude China and the geopolitics are at their worst in my career as an investor.

Yet, the sentiment in China is slowly improving. I spent a month there last May when the shock of the COVID-19 lockdown was fresh in people’s memory. This February, although still subdued, sentiment seemed slightly better.

Economic indicators like the PMI Composite Index – now above 50 – are improving. CPI is still negative, but with rising commodity prices, China will likely avoid a deflationary spiral. Industrial production and exports are also on the rise and retail sales are growing faster than GDP.

The property market will probably never be an engine of growth again, but the service sector, led by healthcare and hospitality, may very well take the baton.

The negative news cycle about China that we see in North America is much different than in Asia. Japan’s relations with China are improving and China’s trade with its neighbours is increasing rapidly. Indonesia’s president-elect, Prabowo, visited China in early April, mentioning the importance of maintaining good ties with China and the US and condemning the China bashing. China is now the largest trading partner to over 120 countries, including Indonesia and also Japan, South Korea, Taiwan and Vietnam.

Despite the Western media’s negative rhetoric, China is a very important market for many large US and foreign multinational brands, including Apple, BMW, Uniqlo and Zeiss. In the past few weeks, many American CEOs have visited China and met with President Xi. Janet Yellen was also there recently and President Biden is scheduled to talk to China in the coming days. Let’s hope that they can restore the productive dialogue.

China’s green revolution

China’s spent 40% more on clean energy in 2023 compared to 2022, or $890 billion – equivalent to the GDP of Switzerland or Turkey.

Also last year, China installed 217 GW of solar power, up 55% over 2022 and more than the US has in its entire history. Total solar power capacity in China is now over 609 GW. Canada has 4.4 GW; the US, 179 GW. Wind power installation increased 21% to more than 441 GW. Canada has 19 GW and the US has 141 GW.

BYD overtook Tesla as the largest NEV car company in 2023 and Xiaomi has now reclaimed a #2 position in the Chinese smartphone market.

So, regardless of the negative news, we are generally constructive on China, have made a number of investments in the country and continue to find attractive investment ideas there.

Reflecting on a phase of resilience and renewal

Our travels through Asia reinforce an evolving narrative not just of growth but of transformation. The confluence of Japan’s market performance and its emerging immigration landscape paints a picture of a nation redefining itself. Meanwhile, China’s quiet resurgence, often obscured by geopolitical noise and prevailing sentiments, is creating an environment of untapped opportunities that invites a deeper understanding beyond surface-level perceptions. We are ready to embrace the potential of these markets to generate alpha for our clients.

Calling for the turn in EM performance has long been dismissed by sceptics as investing’s tribute to Samuel Beckett’s play, Waiting for Godot. The story centres on two strangers who both happen to be waiting for a man named Godot to appear, and pass the time by contemplating the meaning of life in a seemingly endless cycle of anticipation and uncertainty.

Defenders of the asset class argue this is too harsh for such a diverse subset of countries and companies, providing ample room for stock pickers to seek out alpha. On the other hand, EM investors have largely struggled to escape the gravitational pull of a dollar bull market that has lasted for over a decade, illustrated in the charts below.

USD has been both a key signal and driver for emerging market equities

Source: NS Partners & Refinitiv Datastream

Was October 2022 a USD secular peak? The recent rally has yet to breach that high

Source: NS Partners & Refinitiv Datastream

US equities have been ascendant for nearly a decade and a half, led by the superior earnings growth and profitability of the tech titans. Many large EMs have had to work through sharp recessions, deleveraging, balance of payments issues, foreign capital exodus and related currency weakness. The dynamics create a reflexive vicious circle where these negatives feed on each other, providing a poor backdrop for EM equities.

The result is global allocators herding into US stocks at the most concentrated levels since at least 1929 (see chart below), and within that weighting to the US, we saw the seven largest stocks in the S&P500 grow from 21% of the index to 30% by the end of 2023.

The current concentration of US stocks helped to drive an exceptional period of market returns

Source: Goldman Sachs, February 2024. Universe consists of US stocks with price, shares, and revenue data listed on the NYSE, AMEX, or NASDAQ exchanges. Series prior to 1985 estimated based on data from the Kenneth French data library, sourced from CRSP, reflecting the market cap distribution of NYSE stocks.

Going long US equities has been the winning trade for a long time. However, sticking solely with what has worked can risk falling into the behavioural trap of recency bias, and letting opportunities slip by.

Emerging markets have been left out in the cold, and we have hardly been banging the table over the last year or so. Everyone has heard the contrarian bull case of troughing EM economies, earnings, currencies and valuations.

Valuations are compelling

Source: NS Partners & Refinitiv Datastream

EM currencies look cheap (Brazil and Mexico are outliers)

Source: NS Partners & Refinitiv Datastream

We have emphasised their superior money numbers and better inflation management by EM central banks, providing plenty of room to ease from very high levels of real rates.

However, the clincher in our view is a potential shift globally to positive excess money growth (real narrow money growth in excess of economic growth). This “double positive” condition of stronger money growth in EM than DM combined with positive global excess money has historically been correlated with EM outperformance.

This dynamic is illustrated in the charts below, the first mapping our two monetary indicators to periods of EM out- and underperformance (shading highlights double positive readings), while the second reinforces this with a hypothetical EM portfolio that moves to cash whenever either of the monetary indicators is negative.

Excess money measures mixed, double positive soon?

Source: NS Partners & Refinitiv Datastream

Hypothetical performance of excess money switching rule

Source: NS Partners & Refinitiv Datastream

As you can see, that blue line for global excess money has been trending less negative and could be about to enter positive territory.

While it may be some time yet for the money and dollar signals to fall firmly in favour of emerging markets, our view is that point is getting closer.

With EM positioning plumbing the depths, catching the upswing in sentiment will reward those non-conformists with the stomach to embrace the uncomfortable.

Despite ongoing macroeconomic uncertainties and some softness in business activity, financial results published from our holdings for 2023 reassured us. On average, both margins and earnings held up relatively well. Here are two examples of holdings that contributed positively during the first quarter of 2024.

Sopra Steria Group:

Sopra has historically managed mid-single digit organic growth in addition to consistent quality M&A to enhance topline growth. Its historical margins, however, have lagged larger peers like Accenture or CapGemini due to the acquisition of Steria in 2014 which was dilutive to margins [Steria was 350 basis points (bps) below Sopra’s margin], as well as some segments and geographies where management has somewhat sacrificed margins for growth. In 2023, despite additional margin dilution from recent acquisitions, Sopra achieved a 9.4% operating margin, its highest since 2011, and much closer to the 10% to 12% expectation for a major European IT service firm. This was driven by increased pricing, operational efficiencies and scale. We expect Sopra to reach and maintain this improved margin profile in the next couple of years, while maintaining a defensive end-market profile than peers. As such, we remain optimistic on the name.

Melia Hotels International:

After the initial collapse of travel in 2020, when Melia saw its sales drop 70% year over year, the resort hotel operator enjoyed explosive revenue growth due to what analysts coined “revenge travel.” While 2023 saw more normalized 14% topline growth after two years of high double-digit growth, there is still plenty of room for sustainable growth on both the top and bottom line. Despite reaching peak EBITDA from 2018, margins remain a full 200 bps before pre-COVID and there is no reason to believe pre-COVID margins cannot be reached again as the inflationary environment normalizes. Furthermore, the company announced earlier this year the sale of 38% of three of its hotels to Santander for €300 million, strengthening Melia’s balance sheet through deleveraging, while highlighting the bank’s confidence in Melia’s growth prospects. Overall, the company appears quite confident in its 2024 outlook. Despite concerns that inflation could impact discretionary spending including travel and lodging, Melia expects low double-digit RevPAR growth driven equally by price and occupancy, which seems supported by strong January and February data.

Over the next weeks, European companies will start publishing their Q1 revenues, and with it, their outlooks for 2024. The comparison basis with Q1 of 2023 could prove challenging, but we are still projecting companies to generate positive earnings growth for this calendar year. Here are some observations that tend to support our view that the economic improvement could continue:

Real wage growth and savings rates are supportive: After experiencing negative mid-single digit growth in 2022, the Eurozone and the UK are now back to positive real wage growth. As a result, saving rates have started to climb and the gap with the US has widen. As shown below, EU and UK gross savings rates are very supportive compared to the US. The economic activity could react positively to a scenario where households decide to shift a portion of that disposable income into consumption.

Savings rates across the US, the UK and the Eurozone

Source: Berenberg.

European optimism is growing: Business surveys and confidence indices are showing early signs of recovery, as indicated by the latest release on the German business outlook. Although it may not immediately translate into new orders, it could play an important role in how the second half of this year develops.

The housing market is stabilizing: Mortgage approvals in the UK bounced back in February to a level not seen since September 2022. A similar picture can be observed in Germany after two years of excessive contractions. Although corporate loans were still declining in the first quarter of 2024, we are starting to see credit conditions easing for mortgages, a first since 2021.

The destocking cycle is coming to an end: The destocking cycle that started in early 2023 has contributed to a very low level of stocks. Some industries might even carry too low a level of stocks in the event that pent-up demand returns in the second half. Any uplift in order intake would require a higher level of stocks, which would revitalize the manufacturing sector.

Valuation discount: The wide valuation gap that exists between Europe and Global could be narrowing as economic indicators and confidence improve. As shown by the 12-month forward earnings index below, small and mid-cap stocks are still trading at discount vis-a-vis Global. A potential rate cut, expected in June, combined with a reacceleration of demand, would likely drive small and mid-cap companies.

Forward 12-month earnings for European companies vs. the Global market

Source: Berenberg.

In a world where the unexpected has become the norm, our holdings’ resilience through last year’s ups and downs offers a sense of stability and growth potential amid uncertainty – and an opportunity to think beyond the immediate to what could be on the horizon.

In February, we travelled to Saudi Arabia and Dubai to meet with a long-time holding in Jeddah, attend the second instalment of the Saudi Capital Markets Forum in Riyadh, and visit a newer addition to the portfolio in the United Arab Emirates (UAE).

1. Company visit in Jeddah

Our last research visit to Jeddah was in 2019, a time when the world looked remarkably different, and markets were not accounting for the successful execution of Saudi Arabia’s Vision 2030 transformation.

Located on the country’s Western coastline, Jeddah enjoys a more temperate climate and serves as both a gateway to the holy cities and a bustling commercial port. It has historically been more liberal than the capital, Riyadh, which has recently advanced at the forefront of the Kingdom’s social and cultural evolution.

The Saudia Dairy and Foodstuff Company (SADAFCO), established in 1976 in Jeddah, manufactures and sells Long-Life (UHT) milk, tomato paste, and ice cream under its flagship brand, Saudia. Leading the market in Long-Life Milk (64% market share), tomato paste (56%), and ice cream (31%), the company boasts strong distribution channels with three factories, 23 depots, and almost 1,000 trucks, generating annual revenues of $700 million.

SADAFCO factory, Jeddah.

During our visit, we toured the ice cream and milk factories within the HQ compound, built in 2020 and 1976, respectively. Both facilities impressed us with their high levels of automation and operational efficiency, producing over 50,000 ice cream products and 10,000 litres of milk per hour. The company’s approach to reconstitute milk from skimmed milk powder (SMP) instead of producing fresh milk is advantageous in Saudi Arabia due to limited renewable water resources and recent subsidy removals on cattle feed. Water consumption for UHT milk production is significantly lower compared to fresh milk (under 1.9 litres of water per litre of UHT milk versus over 600 litres for fresh milk). Management have been proactively economising water usage through a water recovery system that collects hot water, cools it to an ambient temperature, and recirculates it in a closed system. This has led to savings of 45 million litres of water per year at an average cost of over $200,000.

Total water withdrawl/production volume

Source: Sustainability Report.

Competitors relying on fresh milk have seen their production costs increase, leading to pressure to raise prices. This situation, along with recent SMP price declines, has supported SADAFCO’s margins.

Gross margins vs. average SMP price vs. product prices

Source: Company, CIAL.

The business has diversified over the years, with the ice cream segment showing rapid growth and recent extensions into out-of-home (OOH) markets, doubling the potential addressable market. We are confident in the brand’s strength, the company’s wide distribution reach, and a strong management team focused on long-term value creation.

2. Saudi Capital Markets Forum in Riyadh

We spent three days in Riyadh, attending the second Saudi Capital Market Forum (SCMF), and conducting site visits across retail, fitness centres, and pharmacies.

The 2024 SCMF hosted twice the number of investors as in 2023, indicative of the growing interest in the market. Many participants were new to the country, and the diversity of the attendees was a notable shift from previous years. On recent flights to Riyadh, we have noticed more tourists visiting for music and sporting events, as well as creatives capitalising on the boom in media spending and domestic tourism – a distinct experience from past trips when we saw mostly business travellers and locals.

There is an appetite to accelerate the learning curve on the country given Saudi Arabia’s weighting in the Emerging Markets (EM) index and historically low involvement with the region. Saudi is not your typical EM, with a per capita GDP comparable to Czechia and Slovakia and a modest population of 36 million people.

GDP per capita (purchasing power parity)

Source: World Bank.

From a socioeconomic perspective, the country lags in terms of human development measures, especially relative to income per capita levels as shown in this chart:

Beyond the country’s cross-sectional nuances, there are well-documented economic and social changes taking place, underpinned by Vision 2030. Each of our visits to the country serves as a snapshot of the remarkable transformation taking place. Even with all the commentary about it, nothing compares to seeing the changes firsthand.

Notable developments in civil liberties include the dilution of the religious police’s power as early as 2016, allowing music concerts, female gyms, and cinemas since 2017, and 2018’s lifting of the ban on women driving. Whilst evident in 2019, it is only more recently that cumulative change alongside growing internal conviction in the country’s evolution have aided a lighter and more liberated atmosphere.

Female participation in the workforce has increased (up to 40% vs. 33% in 2016), impacting sectors differently. Since many women live with their husbands or parents, the rise in disposable income is largely discretionary. Concurrently, growth in leisure options is cannibalising the time previously spent in shopping malls. There is huge excitement for the tourism sector given the government’s willingness and fiscal capability to drive the industry. In healthcare and education, the government once held both regulatory and provisional roles, but is now focusing on the former and setting ambitious privatisation targets.

So, while the typical analyses of conventional EMs may not fully apply to Saudi Arabia, there are plenty of industries with promising growth prospects reflecting the leadership’s long-term goals.

3. Company visit in Dubai

Our final stop was Dubai, where we visited Taaleem, a recent addition to the portfolio.

Taaleem is one of the UAE’s largest K12 school operators, with 16,500 students across 14 private schools offering British, International Baccalaureate, and American curricula. Positioned in the ‘Premium’ market segment, with tuition fees from $15,000 to $20,000, Taaleem also partners with the government in operating 18 schools comprising 19,000 students, where the company earns fixed fees per student as well as variable fees based on academic attainment.

Greenfields International School (GIS).

Unlike Saudi Arabia (16% private education penetration), the UAE has a high private education penetration, driven by a large expat population. The market is expanding, with private enrolments expected to reach 570,000 by 2027. The demand for high-quality schools is increasing as more expats establish roots in the country.

Private education market in KSA is still the lowest in GCC

Source: NCLE Presentation 1Q24.

We visited Greenfields International School, a 1,500 student International Baccalaureate (IB) school in Dubai Investment Park. A substantial proportion of the students are expats from within the region, yet the school is home to 75 different nationalities, reflecting the IB diploma’s broad appeal. Fees average $15,000 but vary widely, ranging from $8,900 for pre-school to $21,400 for the upper grades. Contributing 10% to Taaleem’s total revenues, the school (est. 2007) has improved its performance and ratings under new leadership.

Historically, Greenfields underperformed the rest of Taaleem’s portfolio in Dubai’s Educational Ratings, earning a ‘Good’ and scoring IB exam results below the UAE average. Since a new Principal took over in mid-2021, IB scores and pass rates have improved, and the school’s rating is now ‘Very Good.’ Most recently, Greenfields was recognised as one of Dubai’s top-5 IB schools.

GIS average IB score & pass rate (%) vs. UAE average IB score

Source: KHDA.

Our experience suggests that for private education providers, financial results often correlate with academic achievement and student/parent satisfaction. In the first quarter of this year, the school increased its utilisation rate to 98% from the mid-70% range pre-2023. Construction is underway to add 500 more seats for the next academic year and management feels confident about filling this increased capacity.

GIS utilisation (%)

Source: Company/KHDA.

We believe there is embedded average fee growth as the student base graduates to higher grades from pre-school. The main cash costs for the business are staff, and there is more interest from teachers in the UK and Europe due to lifestyle and earnings advantages. Taaleem benefits from government partnerships and is playing a role in improving education standards. Land is scarce in both Dubai and Abu Dhabi but as an education provider, Taaleem benefits from the government’s earmarking of space for schools and hospitals.

Despite potential risks, such as the UAE’s shifting appeal as an expat destination, we are confident in the quality-price ratio of Taaleem’s schools and expect them to be less impacted, so long as academic achievement and parent satisfaction remain high.

From the strides in Jeddah’s industrial sector to Riyadh’s evolving market landscape and Dubai’s educational innovation, our trip illuminated the swift changes and emerging opportunities within these economies and how tradition and modernity are coming together to shape the future.