Asian traveler with suitcase next to row of luggage carts at airport.

Summary

  • A bounce in unloved Chinese equities led a positive month for EM stocks, with the MSCI EM Index up nearly 5% in USD terms.
  • Among the leaders was portfolio holding Trip.com, which surged over 25%, reflecting a recovery in consumer demand for travel in China.
  • Korean stocks continued a run of strong performance fed by enthusiasm for the government’s proposed Corporate Value-up Program (covered in detail in last month’s commentary: Super-cheap Korean equities rally on market reform talks).
  • With around a third of South Korea’s population actively participating in the stock market, the reforms have boosted the ruling Democratic Party’s legislative election prospects, its approval rating reaching 40% against 33% for the opposition. The chart below from CLSA shows the turnaround in fortunes since the program was announced earlier in the year.

Korea general election poll
Line graph showing election polling results in Korea, July 2023 to February 2024.Source: Gallup Korea &  CLSA, March 2024.

  • With less than one month before the election, re-election of the Democratic Party with a mandate to press forward with the reforms could be a catalyst for further outperformance by Korean equities.

 

AI boom exposes supply chain bottlenecks

The global rush is on to harness an explosion of AI innovation, with investment by hyperscale cloud and consumer tech giants only the first wave of adoption powering demand for the technology.

Waves of AI adoption

Source: Nvidia Corporate Presentation, 2024.

 

What unleashed this step change? While some more complex neural network architectures and algorithms have emerged in recent decades, the real shift has been the rapid advances in brute processing power that enables machine learning.

The chart below illustrates the yawning gap which has opened up between the power of GPUs (green line) and conventional CPUs (blue line), with the former now capable of executing many trillions more operations per second (TOPS).

Explosion in power of high-end chips
Line graph showing increasing GPU computing performance relative to CPUs.Source: Nvidia/Arteris, 2023.

 

The chart also hints at one of the key bottlenecks to scaling AI applications like ChatGPT – aside from the difficulty of meeting the sheer scale of demand for Nvidia’s high-end GPUs –  which is “memory wall.”

To illustrate the concept, one useful analogy we have heard is to imagine an AI server as a steam train, with the GPU being the engine, data being the coal, and the network being the person shovelling the coal. Getting all the juice out of the massive GPU engine depends in large part on how quickly that coal (data) can be shovelled into the furnace.

This is where High Bandwidth Memory (HBM) comes in. HBM is physically bonded to the GPUs in stacked layers via thousands of pins which enable “massively parallel data throughout” (The Pragmatic Engineer: Five Real-World Engineering Challenges).

HBM stack
Source: Semiconductor Engineering, 2023.

 

This tech enables the data transmission at a speed of about 3TB/second, around 100 times faster than conventional data transfer architecture powering PCs. This speed is crucial given the massive amounts of data that need to be fed into large language models like ChatGPT.

The issue (and opportunity) is that this wave of demand for leading-edge computing tech to power AI is far outpacing supply. HBM costs around five times more than conventional memory, with Korean memory giant SK Hynix controlling half of global supply, and the remainder split between Samsung and Micron. Hynix is set to enjoy a margin boost driven by premium memory products such as HBM, which it forecasts to grow at a 60-80% CAGR for the next five years.

Emerging markets are home to a host of companies like Hynix, which dominate their respective niches in the AI supply chain. Opportunities exist across multiple segments including fabrication, design, and testing capabilities, as well as key components (like HBM) that form the foundations of hyperscale computing that powers AI.

Chinese stocks outperform as stimulus efforts kick into gear

Chinese stocks are plumbing the depths, now trading at a CAPE of around 10X (from 21X in 2021) discounting a deflationary outlook. While Premier Li Qiang attended the World Economic Forum meeting in Davos earlier this year to announce that China met its 5% GDP growth target for 2023, investors were fretting about steepening consumer price declines. The stock market is signalling an increasing risk of corporate bankruptcies (BBC – Evergrande: Crisis-hit Chinese property giant ordered to liquidate) and financial instability in the absence of decisive monetary and/or fiscal intervention.

Will the authorities blink? It is certainly within the Party’s wheelhouse to pivot, especially given the risk that further economic malaise stokes political instability. The abrupt end to zero-COVID policy in 2022 is the most recent pragmatic policy turn under Xi. Could he reprise Deng Xiaoping’s dictum that “to get rich is glorious” alongside an announcement of fiscal stimulus?

That is doubtful to say the least, but recent activity suggests the authorities understand there is a problem. SOE and SOE-linked names outperformed through February on the back of the “national team” (state-backed financial services companies) ploughing US$57 billion into Chinese equities so far in 2024 (China ‘national team’ ETF buying reaches $57bn this year, says UBS). The chart below from fund data provider EPFR shows flows from local Chinese investors into domestically domiciled China funds (blue line) of just under $100 billion over the 12 months to 31st January 2024. Contrast this with negative flows for foreign-domiciled China funds (i.e. for foreign investors) over the same period.

Line graph comparing domestic and foreign investment in China-based equities, March 2023 to March 2024.
Source: EPFR

 

During the month, Xi Jinping was briefed by the China Securities Regulatory Commission (CSRC), coinciding with the replacement of the Commission’s chief Yi Huiman in favour of former banking regulation veteran Wu Qing (known as the “broker butcher”). Bloomberg noted that the move echoed government efforts in 2016 to boost market confidence by dismissing financial regulators amid a market rout (China Replaces Top Markets Regulator as Xi Tries to End Rout).

A visit to the central bank by Xi last year preceded record levels of lending from the PBoC to the banks in Q4, followed by an earlier and larger than expected cut in the reserve requirement ratio (RRR) in January, which suggests the central bank is now back on an easing track.

Money rates responding to liquidity injection

Interest rate movements in China, 2020 to 2024.Source: LSEG Datastream.

 

On the fiscal side, the government revealed a GDP target of “around 5%” at its National People’s Congress, suggesting further modest stimulus is on the way.

We have flagged in previous commentary the risk that deteriorating institutional quality under Xi appears to be crushing the animal spirits of entrepreneurs and consumers. Indeed, we saw Xi tighten the CCP’s grip over the private sector, announcing new anti-corruption crackdowns across a host of key sectors in January.

Tone-deaf policymaking amid a fragile economic backdrop is causing economic paralysis and interferes with the credit impulse. No one is complaining about a shortage of credit. The real issue is a shortage of confidence among consumers and businesspeople. Consumers are hoarding cash in time deposits, while banks aren’t looking to borrow short and lend long to businesses to invest. While all of this is structurally negative for China over the long term, continued policy easing at these valuations could be the catalyst for a large trading rally in Chinese equities.

MSCI China at record discount to rest of EM
Line graph comparing the MSCI China Index and MSCI EM ex. China Index price-to-book and 12-month forward earnings.Source: LSEG Datastream.

Our strategy is to maintain a modest underweight to China and position defensively while waiting for further confirmation that liquidity is improving.

Hands holding freshly roasted aromatic coffee beans.

Coffee is one of the most valuable agricultural commodities and the most widely used socially acceptable drug, yet few people take the time to understand its significance in modern society and human history. Originating from an Ethiopian mountainside a couple of thousand years ago, today’s coffee market sustains roughly 125 million jobs. With its total addressable market estimated at $468 billion, it’s on track to outpace global GDP, fueled by rising per capita consumption in emerging markets.

Medicinal luxury to cultural staple

Initially, coffee in Europe was a medicinal luxury for the elite. As it became more accessible, it gradually became the favoured drink of both blue- and white-collar workers, embedding itself in Western culture. The first English coffeehouse opened at Oxford University in 1650. By 1700, there were over 2,000 coffeehouses paying more rent than any other trade at the time. Coffee’s exploding popularity can be attributed to the historical British reputation for alcohol consumption; coffee presented a healthier alternative that still offered a communal space for socializing – and it helped with hangovers.

Coffee’s political and economic influence

In 18th century Germany, its popularity even led Frederick the Great to ban it to curb the outflow of money abroad and promote beer, Germany’s traditional beverage. This prohibition spurred a flourishing black market and large-scale protests that lasted four years before being revoked. The impact of coffee in England and Germany, however, pales in comparison to its role in shaping American culture and history.

Coffee and the American Revolution

The famous Boston Tea Party is often cited as the tipping point of coffee in the US. Americans were already avid consumers of tea, coffee and beer at the time and most taverns and coffeehouses offered all three options to their patrons. In an act of defiance against King George’s tea tax, Americans embraced coffee as a symbol of independence, significantly boosting its consumption. From 0.19 pounds per capita in 1772 to 1.41 pounds by 1799, coffee became intertwined with the fabric of the nation, a trend that has only grown stronger with time.

Why coffee captures our attention

So, why is Global Alpha excited about coffee? Are we investing in coffee beans? If you’ve been reading our commentaries for a while, you’ll know that we often seek creative and sometimes indirect exposure to secular themes that we favour. Like most commodities, coffee is a volatile and hard to predict market prone to oversupply and weather events – areas outside our expertise. Instead, we are invested in a company that provides tools for coffee enthusiasts to enjoy their drinks precisely as they want to.

Brewing success in the coffee appliance market

De’Longhi SpA (DLG IM) is an Italian global leader in the production of small domestic appliances, with a market-leading position among European coffee makers. The company designs its premium products in-house and its brand appeal is best-in-class, boasting a 35% global market share in the espresso coffee machine segment. It’s fitting that a company like De’Longhi originated in Europe, where per capita coffee consumption is the world’s highest.

Local success to global expansion

De’Longhi’s initial success lent strong credibility to its brands and has helped accelerate its global expansion in the last decade, especially in the US and Far East markets. Historically, the company sold professional coffee makers through its Eversys brand, but in December it announced the acquisition of La Marzocco to accelerate its leadership in the professional segment. The professional coffee-making market alone is a $5 billion industry growing at approximately 5% annually, driven by a long-term shift from making coffee at home to buying it from coffee shops. Starbucks for example plans to expand its current 38,000 stores to over 55,000 by 2030. This acquisition enables De’Longhi to cover virtually the entire coffee machine space, from budget-friendly to luxury household and high-output professional machines.

De’Longhi SWOT analysis

Strengths

  • Brand recognition in espresso machines (De’Longhi) and food preparation (Kenwood/nutribullet).
  • Strong distribution partnerships globally and owned manufacturing capacity.

Weaknesses

  • The household appliance market is highly competitive.
  • Consumer habits and preferences for coffee consumption are continuously evolving.

Opportunities

  • Expansion of the professional coffee segment following the acquisition of La Marzocco.
  • Opportunities for product innovation.

Threats

  • Consolidation of the distribution market.
  • Valuation of potential M&A targets.

Brewing beyond the bean

Most of our weekly readers, much like ourselves, are probably coffee consumers, yet many of us spend little time thinking about this beverage we crave each morning. This “taken-for-granted” product represents exactly the kind of space Global Alpha aims to invest in for the long term.

Source: Pendergrast, M. (2010). Uncommon Grounds: the history of coffee and how it transformed the world.

East Indian female pediatrician and mother measuring the weight of baby girl during a routine medical check-up.

When it comes to our wealth, we often think about assets or money that we own. However, when we’re sick, we realize our health represents our real wealth and the importance of investing in it.

Population surge meets healthcare hurdle

With its rapidly growing population, India faces significant challenges in providing adequate healthcare services to its citizens. The World Health Organization (WHO) projects India’s population to reach 1.5 billion by 2030, making it the most populous country globally. This growth puts immense pressure on the healthcare system to meet increasing demand for medical services and facilities.

India’s bold step with the world’s largest insurance plan

In 2018, India’s Prime Minister, Narendra Modi, launched Ayushman Bharat Pradhan Mantri Jan Arogya Yojana (AB-PMJAY), the world’s largest universal health insurance plan often referred to as the National Health Protection Scheme. The program aims to help India’s most vulnerable population by offering Rs. 5 lakh (~CDN$8,000) per family per year. The plan is estimated to support 550 million citizens across the country, allowing cashless benefits at any public or private impaneled hospital nationwide. This significantly increases access to quality healthcare and medication for almost 40% of the population, covering almost all secondary and many tertiary hospitalizations. It also addresses the previously unmet needs of a hidden population that lacks financial resources. The plan helps to control costs by providing treatment at fixed, packaged rates.

A flourishing market, billions in the making

Since 2015, India’s healthcare sector has been growing at a CAGR of 18%, currently valued at ~USD$450 billion. Narayana Health’s CEO, one of India’s largest hospital chains, estimates the market to be worth USD$828 billion by 2027. This growth is mainly driven by increased spending from both public and private sectors.

India’s healthcare market value (USD)

Bar chart showing projected increase of CAGR of 12% to 14% starting from 2023.

Source: Frost & Sullivan; Aranca Research; Various sources (LSI Financial Services, Deloitte).

Foreign direct investment and pharmaceutical export

It’s not surprising that drugs and pharmaceuticals comprise a large percentage (63.4%) of foreign direct investment, as Western countries outsource generic drug manufacturing to India to benefit from reduced labour costs. This is followed by investment in hospitals/diagnostic centres (26.6%) and medical/surgical appliances (9%).

India remains the world’s largest provider of generic drugs, exporting $25.4 billion worth in 2023. We view this market as attractive as the competitive landscape has forced new players to innovate as patents expire.

Ajanta Pharma – a beacon of innovation in India’s pharmaceutical sector

We continue to own Ajanta Pharma (AJP IN). It has high exposure to branded generic markets and a leading position in niche categories, with a superior margin and return profile. The company operates across India, the US and more than 30 emerging countries in Africa and Asia, focusing on cardiology, ophthalmology, dermatology and pain management.

Despite being a smaller player in the space with a 0.7% market share, Ajanta maintained this position during the lockdown and outperformed industry growth by 200 basis points. Owned by its founder, with the family retaining close to 70% of the business, Ajanta benefits from over four decades of experience and we believe continues to be in capable hands.

This growth story is a testament to how investment can translate into tangible health benefits, weaving a new narrative of prosperity and the true value of wealth in health.

Namdaemun gate at night, Seoul, South Korea.

Summary

  • A down month in EM equities was led by continued investor pessimism in China, down by over -10% in USD terms. Further commentary below.
  • Bucking the trend were securities in India across healthcare, communications, real estate and consumer staples.
  • Stocks in Taiwan with AI exposure also outperformed.

Korea adopts Japan’s playbook to boost equities

Bottoming Korean exports growth from October has been led by a recovery in the semiconductor sector, reflected by the outperformance of equities with exposure to the AI supply chain, which posted strong returns through 2023.

South Korea Exports YoY Index

Line graph showing South Korea year-over-year exports from 2019 to January 2024.

Source: Bloomberg

The market pulled back during the month before bouncing on news that Korean regulators are looking to emulate Japan’s efforts to pressure companies into improving governance and driving higher valuations. These proposed measures look set to boost market laggards trading at below 1x price/book – or around half of the Kospi 200.

While yet to be finalised, terms of the proposal include:

  • A requirement that listed companies disclose valuation improvement measures.
  • Financial authorities will publish a name-and-shame list of companies that have not announced valuation improvement plans.

Efforts by listed Korean companies to improve payouts, repair balance sheets and buy back shares could see super-cheap stocks lead the market higher. According to CLSA, Korean stocks are under-owned by GEM investors with the Kospi trading at 0.88x P/B as of 18 January.

Strong retail presence

The catalyst for the move is clear. Parliamentary elections loom in April for deeply unpopular president Yoon Suk Yeol, who is looking to improve his prospects by adding further fuel to an export-led economic recovery via the stock market. The move looks savvy given over 30% of the voting age population invests in single stocks in a market that is dirt cheap.

Bar chart comparing Korean investors to Korean homeowners and the voting population from 2014 to 2022.

Source: CLSA (Feb 2024)

Our playbook is to stick with our quality names in Korea, across semis giants Samsung and Hynix, autos and financials. Preferred shares for a number of companies also look attractive given massive discounts to ordinary shares. For instance, Samsung preferred shares are trading at a c.20% discount. Pref shares could be bought back at a discount by the parent companies as a cost-effective way to boost shareholder returns.

Economic recovery and reforms to benefit rising automaker KIA

KIA is a brand on the rise, continuing to execute on a premiumisation strategy led by the launch of a series of popular EV models that are on track to reach 40% of sales by 2030.

Illustration showing KIA EV sales plan projections to 2030.

Source: Kia Investor Presentation, 2022

The stock is trading around 2024E 4.2x PE for a 5.6% dividend yield and return on equity of 18%. This qualifies KIA for laggard status in our view, as it trades below its Japanese peers despite much better returns and margin profile. The company appears to embrace the drive to improve stock performance, having committed to buying and cancelling Won 2.5trn worth of stocks over the next 5 years (6% of outstanding shares).

KIA enjoys strong brand recognition and growing market share in the US and Europe, along with other growing markets such as India. Average selling prices are set to rise as EVs take a greater share of sales, attracting customers on higher incomes (i.e., KIA’s average customer in the US earns over US$150k per annum) who tend to opt for the more expensive trim options. The company has launched a series of premium EVs, which include a number of SUV models (the EV9 is pictured below) that have been especially popular in the US. They boast fast-charging, battery range, performance and looks (KIA’s chief designers hail from the likes of Audi, Lamborghini and VW), rivalling the best EV offerings from premium European brands.

Picture of a KIA SUV.

Source: evo.co.uk

Rising vehicle financing costs and recession risks in the US and Europe could slow progress, but recent results have been strong. Declining raw materials costs and the higher SUV mix allowed the company to raise operating profit margin guidance to above the 2023 level (11.9%) and higher-than-market forecasts, putting KIA well ahead of Tesla (9%).

Former general set to clinch presidency in Indonesia

Former Indonesian general Prabowo Subianto is the favourite to win the country’s presidential election in February. The election marks the end of Joko Widodo’s decade in power, stepping down with a remarkable 80% approval rating. Having run against Widodo in the 2014 and 2019 elections, Prabowo now has the backing of the president, along with his 36-year-old son Gibran Rakabuming Raka as a running mate.

The latest polling suggests Prabowo has a chance of winning 50% of the vote needed to avoid a second round run-off. The former military strongman now dubbed the “dancing grandpa” by his young base of supporters has pledged continuity with the policies of Widodo. This includes encouraging investment in industries such as nickel processing to capture more of the battery value chain, along with boosting GDP from the pedestrian 4-5% under Widodo up into the high single digits.

Mexico now the #1 source of imports to the US

Mexico overtook China as the top source of imports to the US in 2023, fuel for the narrative that “friend-shoring” supply chains will gradually screen China out of the Western trading bloc.

Bar chart comparing China and Mexico exports to the US between 2011 and 2023.

Source: US Census data

The real story isn’t quite so simple – US import data understate Chinese exports, with the total recorded in Chinese data being c.25% higher. This seems to reflect systematic tariff avoidance. In addition, many Chinese firms are investing aggressively in Mexico to take advantage of the North American Free Trade Agreement and gain frictionless access to the US market. As the Wall Street Journal illustrates in a recent piece, China’s exporters can access the US duty-free with Made in Mexico labels:

The participation of Chinese companies in this shift attests to the deepening assumption that the breach dividing the United States and China will be an enduring feature of the next phase of globalization. Yet it also reveals something more fundamental: Whatever the political strains, the commercial forces linking the United States and China are even more powerful.

Chinese companies have no intention of forsaking the American economy, still the largest on earth. Instead, they are setting up operations inside the North American trading bloc as a way to supply Americans with goods, from electronics to clothing to furniture.

Kingdom of Saudi Arabia, Riyadh, King Abdullah Financial District.

MENA equity markets finished the fourth quarter with returns of 5.9% (for the S&P Pan Arabian Index), rounding out a reasonably strong year with an Index return of 10.2%.

2023 marked the third consecutive year of outperformance for the S&P Pan Arabian index against Emerging Markets (the MSCI EM Index). Over that period, MENA outperformed EM by a remarkable 59.2%. Despite this, an EPFR survey cited by JP Morgan of key EM managers indicates most are staying bearish on the region (as measured by the median exposure relative to the region’s MSCI EM Index weight as of January 8, 2024).

Morgan Stanley’s MENA equity sales desk notes that ~50% of GEM funds have zero exposure to Saudi Arabia, which has a 4.1% weight in the MSCI EM Index. While foreign institutional ownership of Saudi stocks has risen dramatically over recent years (the latest weekly data from the Tadawul shows foreign institutions own 12.5% of the free-float market capitalisation), positioning remains relatively conservative.

Without speculating on the reason(s) why EM managers have taken this view, we continue to believe it demonstrates a knowledge gap from the years when markets like Saudi were all but shut to foreign investors. This presents an opportunity for specialised managers with an early mover advantage in these markets to operate and invest with an edge that is difficult to establish in other well-trodden EMs.

Since the end of the first quarter of 2023, we have become more vocal about our concern on valuation levels in Saudi. During this period, we’ve seen an increase in geopolitical risk, persistently high interest rates, and lower oil prices. None of those factors seem (for the time being) to temper local and regional investor enthusiasm for Saudi stocks, particularly mid-caps and IPOs. We believe it is prudent to avoid being overly exposed to situations where, by our estimates, investor positioning and expectations are excessively high. While we remain constructive on the quality of the Saudi-based businesses we own and the country’s structural growth story, especially in the consumer, healthcare, and education sectors, we enter 2024 with lower exposure to these stocks. The Saudi market is highly dynamic, and we expect there will be opportunities to rebuild our exposure to those stocks throughout year.

We are relatively more bullish on the UAE, focusing primarily on banks and quasi-monopoly businesses like utilities and infrastructure. Benign liquidity conditions and strong economic growth favour UAE banks with a solid deposit franchise and strong lending opportunities in 2024. We have already seen at the beginning of this year that banks are signalling confidence in their outlook by significantly upgrading their dividend payout ratios for the profits from last year. Our UAE banks portfolio is yielding over 6% on average (as of the date of this letter), an attractive level as the interest rate cycle begins to turn.

In other markets, we continue to back Morocco-based companies in the retail and technology sectors and have expanded our portfolio with a new investment in healthcare, a sector set to grow significantly from a universal health scheme that will materially improve access to much-needed medical services. We expect Morocco to perform better in 2024 as inflation pressures ease and the country continues to develop a competitive base for manufacturing and services that we believe will unlock growth this year and beyond. (In a recent Bloomberg article, Morocco, alongside Mexico, Poland, Vietnam, and Indonesia were identified as key “economic connectors” that will benefit from supply chain reshuffling.)

In Qatar and Kuwait, we remain selective, with growth remaining constrained, though we see potential in Qatar’s liquified natural gas value chain and are more optimistic about Kuwait following the appointment of a reformist royal as the new Emir in late 2023.

Egypt remains a wildcard, with an imminent devaluation likely to be the first step in a long journey towards rebuilding policy credibility with investors. That said, we remain open to increasing our ownership in our preferred Egyptian healthcare and technology businesses if opportunities arise later this year.

We wish you a prosperous 2024 and look forward to sharing updates on our strategy with you.

Palace of Culture and Science & city skyline at night, Warsaw, Poland.

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.

Internet

The strategy saw strong returns from the internet portfolio in the quarter. We capitalised on share price weakness in Allegro.eu (ALE), Poland’s leading online marketplace, following a partial sell down by its private equity majority shareholders. Allegro boasts over 14.5 million active buyers in Poland and generated ~$13 billion in gross merchandise value in the last twelve months, securing a clear market lead with a ~35% share of online retail. Under new management over the last 18 months, the company has demonstrated an impressive capacity to enhance commercial terms with merchants and suppliers, increase advertising revenue contribution, and instil much-needed cost and capital allocation discipline. Furthermore, the company is growing its market share and improving engagement through a heavier focus on its SMART! program (akin to Amazon’s Prime). These efforts have driven a noticeable increase in the take rate to 11.9% as of Q3 2023 (a top-quartile take rate amongst EM e-commerce peer group) and underpinned a sustainable operating margin profile of nearly 20% in the nine-month period ending September 2023. While we acknowledge that the overhang from its private equity owners will remain for some time, we plan to take advantage of opportunities to add to our Allegro position as those sellers continue to divest their stake in the business.

Continuing with Emerging Europe, the strategy also saw strong returns from BCG Classifieds Group (BCG), the leading online classifieds group in the Baltics with a dominant position in auto, real estate, jobs and services, and generalist marketplaces in Lithuania and Estonia. BCG’s shares reacted positively to a strong set of results in the second half of 2023, with revenue and operating profits growing 20% and 36% year-over-year (y-o-y), respectively. BCG exemplifies the dominant, unassailable position of a leading classifieds business. In Lithuania, it is six times and 21 times larger than its closest competitor in auto and real estate classifieds, respectively. In Estonia, it is 29 times and 16 times larger than its closest competitor in those categories. This dominance only grows with time, as buyers and sellers find that the largest opportunity to transact (i.e., marketplace liquidity) is with the clear market leader. Management has effectively reinforced the company’s leadership position whilst making prudent capital allocation decisions, including share buybacks and reducing capital throughout the year.

Healthcare

The healthcare portfolio delivered strong returns in the quarter, led by Medikaloka Hermina (HEAL), the Indonesian healthcare provider. HEAL’s share price reacted positively to a strong third-quarter earnings report that showed 22% and 72% y-o-y growth in revenue and EBTIDA, respectively. The profit margin expansion at HEAL reinforced our belief in the company’s potential for profitable growth from its 47 hospitals, whilst scaling up the network to take advantage of the vast opportunity that Indonesia’s 250 million population provides. That said, we took advantage of the strong share price reaction and reduced our exposure to HEAL on account of valuations.

We also saw positive contributions from Integrated Diagnostics Holdings (IDHC) in Egypt due to insider buying, and AGP Pharma (AGP) in Pakistan owing to the country’s improving macroeconomic outlook. We acted on the positive share-price movement at both companies, reducing exposure in Egypt, and exiting Pakistan.

Additionally, we invested in a Thai healthcare provider focused on medical tourism (~70% of revenue). Thailand, ranked as the eighth most popular tourist destination globally, has developed a formidable medical tourism infrastructure over the last 20 years. The company we invested in has established a reputable brand among relatively affluent patients from the Gulf countries, Cambodia, Laos, and parts of the subcontinent.

Financial services

The strategy experienced weak performance from the financials portfolio in the quarter, affected by Indonesian microfinance and UAE banks and financial services. In Indonesia, persistent asset quality pressures continue as low-income households face considerable challenges with disposable income and their ability to make good on loans. Although we anticipated election-related spending to trickle down to this segment, it appears unlikely to significantly change the outlook for these households. There may be more clarity after the Indonesian presidential elections, expected to conclude in June 2024. Accordingly, we decided to scale back our exposure to this theme until more policy clarity emerges after the elections. In the UAE, we remain bullish about the financial services opportunity set and have been adding to our exposure there throughout the quarter.

Consumer portfolio

The strategy’s Asian consumer staples portfolio performed poorly in the quarter. Weakening consumer purchasing power is adversely affecting demand across a range of consumer categories, including health supplements in Indonesia, beer in Vietnam, paints in Thailand, and tiles and sanitary ware in the Philippines. The region’s consumers are generally cautious, and we expect this to continue until inflationary pressures subside. We have been reducing our exposure to consumer stocks in the region but remain invested in our highest-conviction consumer companies, as their valuations appear very attractive to us.

Outlook

As we move into 2024, our team feels confident in the portfolio, buoyed by a powerful combination of expectations of strong earnings growth and attractive valuations. While the environment remains challenging for many economies we invest in, emerging green shoots make us more optimistic about the future. We look forward to updating you on the strategy as the year progresses.

Aerial view of downtown Taipei, Taiwan. Financial district and business area with intersection or junction with traffic.

Summary

  • EM underperformed US and international markets through 2023 – posting a 10.3% return in USD terms versus 26.3% for the US, 18.9% for EAFE and 22.7% for Europe ex-UK.
  • China was down 11% for the year, while Taiwan was up 31.3%, India 21.3%, Brazil 31.5% and Mexico 41.6%.
  • EM equities trade at 11.9x next 12m P/E against a 20-year average of 12.6x, while China trades at 9.3x against a 20-year average of 12.5x.
  • Brent crude closed the year at US$80 per barrel, pulling back sharply from its spike above US$90 in October following the outbreak of conflict between Israel and Hamas.
  • China held its Central Economic Work Conference in December, with top officials and economic advisers meeting to set growth targets for 2024. Government advisers have told the press that officials are targeting a range between 4.5% and 5.5%, with most favouring around 5% (the same as for 2023). The official target is set to be officially endorsed at the Two Sessions in March.
  • As reported in the Financial Times, BYD sold a record 526,000 battery-only EVs to Tesla’s 484,000 during the fourth quarter of 2023. This is the first time BYD has surpassed Tesla in quarterly sales.

“Goldilocks thinking”

Earlier this year, we emphasised our caution with respect to market expectations for the economy and inflation, warning that a Wile E. Coyote moment was a real risk for investors lured into the idea of a “miraculous disinflation” or “no landing” scenario. Bets on the combination of falling inflation, a resilient economy and rate cuts in 2023 were the fuel for a Santa rally propelling tech stocks and cyclicals.

In line with our forecasts, inflation has fallen rapidly as suggested by broad money growth with the usual two-year lag. What has surprised us is the resilience of the US economy despite monetary tightening, which appears partly to reflect consumption driven by savings built up during the pandemic. Improvements in the global supply chain have also supported industrial production.

G7 inflation rates fell by more than most expected during 2023, mirroring a big decline in money growth during 2021 – inflation heading for an undershoot by end 2024

Line graph comparing the path of consumer prices to broad money growth from the 1960s to 2023.

Source: NS Partners & Refinitiv Datastream.

Better inflation news has allowed the Fed to stay on hold since July despite strong Q3 GDP growth and a still-tight labour market. With inflation likely to continue to fall, investors are more hopeful of a soft landing coupled with rate cuts in 2024 and have rerated risk assets accordingly.

Based on the monetary and economic data that we track, our view is that market sentiment is excessively bullish and at risk of a correction. In his latest memo, Easy Money, published on January 9, Oaktree’s Howard Marks struck a similar tone, warning against “Goldilocks thinking”:

“At present, I believe the consensus is as follows:

  • Inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2%.
  • As a consequence, additional rate increases won’t be necessary.
  • As a further consequence, we’ll have a soft landing marked by a minor recession or none at all.
  • Thus, the Fed will be able to take rates back down.
  • This will be good for the economy and the stock market.

Before going further, I want to note that, to me, these five bullet points smack of “Goldilocks thinking”: the economy won’t be hot enough to raise inflation or cold enough to bring on an economic slowdown.”

We certainly agree. While our analysis suggests that inflation has further to fall and rate cuts should be coming this year, global manufacturing PMI new orders are likely to decline further. Additionally, money trends are yet to suggest a significant subsequent recovery.

Economic “resilience” partly reflected pandemic catch-up effects, but is consistent with historical experience following monetary tightenings, suggesting greater H1 weakness

Line graph comparing the year-over-year change between industrial output and real narrow money over 2023.

Source: NS Partners & Refinitiv Datastream.

G7 annual real narrow money momentum led industrial output momentum by an average 12m at major lows historically, suggesting that the full impact of recent weakness won’t be apparent until mid-2024.

We continue to believe that hard landings are possible in the US / Europe, with resilience to date not inconsistent with historical lags for monetary weakness and yield curve inversion. Against this backdrop, we expect quality and defensive sectors to outperform in the near term on a view that hopes of a soft landing may prove to be premature.

Taiwan’s DPP returned to the presidency but lose the legislature

Taiwan held elections on January 13, with William Lai Ching-te of the Democratic Progressive Party (DPP) winning the presidency, taking 40% of the vote against 33% for Hou Yu-ih of the Kuomintang (KMT) and 26% for Ko Wen-je of the Taiwan People’s Party (TPP).

Credibility on management of cross-strait relations to safeguard Taiwan’s democracy was a key issue, and the key factor behind the DDP presidency win. However, voters (particularly younger generations) expressed their dissatisfaction with the DDP on a host of domestic issues that cost the party its hold over the legislature, now controlled by the KMT. Issues include prohibitively expensive property prices, a rapidly ageing population (see chart below), stagnant wage growth and debate over the length and quality of military conscription.

Taiwan faces demographic headwinds

Bar graph showing Taiwan's population by age, with the most people in the 40-44 age group and above.

Source: CIA Factbook 2024.

In addition, a host of DPP officials have been caught up in scandals in recent years, including misuse of party funds, academic plagiarism by a legislator subsequently promoted by President Tsai to vice president of the government and an extramarital affair forcing another legislator to step down.

What does China make of it? While China has repeated the rhetoric that “reunification is inevitable”, the election result is unlikely to provoke any material military response from Beijing in the near term, although some PLA muscle-flexing is to be expected in the coming months. Predictably, the Party is claiming the result as a win from its perspective, pointing out that the result signals voter dissatisfaction in the electorate after eight years of DPP rule, with Lai’s win in part owing to Taiwan’s first past-the-post electoral system. The majority of voters went for the KMT (Beijing’s favoured candidate) and political upstart TPP.

Perhaps the most notable development was the rise of the TPP, founded less than five years ago by prominent surgeon and quirky political pragmatist Ko Wen-je. Clever rhetoric and deft use of social media was key for Ko to connect with younger voters, to foreground domestic issues in his campaign over relations with China, effectively counter-positioning with the DPP and KMT.

On China, Ko has shifted over the years from alignment with the DPP towards the KMT, arguing that Taiwan is part of a greater China while disagreeing with Beijing over which state should rule the territory.

Over the next term, Ko and his party have eight seats in the legislature, setting the TPP up as kingmaker to either the KMT with 52 seats or DPP with 51, and a pivotal player on issues such as energy policy, defence expenditure and kickstarting wage growth in the service sector.

Looking further ahead, the TPP may signal the breakdown of old, inherited voting patterns and the emerging base of young voters who identify primarily as Taiwanese but, at least for now, are more focused on domestic economic, social and political issues.

Buenos Aires Financial District.

Summary

  • Treasury yields retreated through the month on inflation data that undershot market expectations (in line with our forecasts), with stocks and bonds celebrating the news.
  • We remain cautious and view the exuberance with scepticism, and expect a weakening global economy and earnings downgrades to test the bulls.
  • On a brighter note, rapid disinflation and the prospect of rate cuts in 2024 will precipitate a recovery in money numbers that could be the signal to tilt away from current defensive positioning.

Institutional quality is key to unlocking development

Analysis of qualitative macro factors in emerging markets is a cornerstone of our process, which is critical to identifying the potential for downside shocks that can wipe out investor returns (irrespective of how attractive a company’s fundamentals may appear). Given the relative fragility of institutions in EM, politics can have an outsized impact on a country’s progress up (or down) the development ladder, with elections often serving as critical junctures.

This month we saw the conclusion of national elections in Argentina, with right-wing libertarian and economist Javier Milei crushing the incumbent Perónists on a platform of radical economic reform. While markets have celebrated the development, does Milei’s election truly represent a structural turning point given the institutional forces that stand in his way?

Argentina a case study of the vicious cycle

A hundred years ago, Argentina was one of the richest countries on the planet, with the young and dynamic South American country outstripping the likes of even France and Germany. The rise and dominance of the left-wing populist Perónists in the 20th and 21st centuries (interrupted by a succession of military juntas in the 1970s and 80s) put an end to this.

For us, Argentina’s downward spiral from such an enviable position to today underlies the importance of institutional quality as the key determinant of whether a country climbs or slides down the development ladder. Vicious and virtuous circles of development (where political and economic institutions become either more extractive or inclusive) can form momentum that is hard to break. For EM investors in particular, who deal with countries with relatively more fragile institutions than DM counterparts, it pays to be mindful of what kind of cycle is at play in a country.

The book “Why Nations Fail” by Acemoglu and Robinson provides an excellent summary of these vicious/virtuous circles:

“Rich nations are rich largely because they managed to develop inclusive institutions at some point during the past three hundred years. These institutions have persisted through a process of virtuous circles. Even if inclusive in a limited sense to begin with, and sometimes fragile, they generated dynamics that would create a process of positive feedback, gradually increasing their inclusiveness. England did not become a democracy after the Glorious Revolution in 1688. Far from it. Only a small fraction of the population had formal representation, but crucially, she was pluralistic. Once pluralism was enshrined, there was a tendency for institutions to become more inclusive over time, even if this was rocky and uncertain process.” (Why Nations Fail, p364)

Clearly nothing of the sort occurred in Argentina over the last century. Instead, a confluence of economic and political crises from the 1930s onwards saw the country follow nearly half a century of growth with a lapse into domestic upheaval, the rise of Perónism and extreme political choices that fuelled a vicious circle causing Argentina to backslide.

Rise of the Perónists

While it is possible for countries to grow under extractive institutions, this will begin to falter at more advanced levels of development. Improving institutional quality is essential to break through to the next level.

“It is true that Argentina experienced around fifty years of economic growth, but this was a classic case of growth under extractive institutions. Argentina was then ruled by a narrow elite heavily invested in their agricultural export economy … [involving] no creative destruction and no innovation. And it was not sustainable.” (Why Nations Fail, p385)

Becoming Minister of Labour in 1943 following a military coup, Juan Domingo Perón was elected president in 1946. He then set about attacking Argentina’s institutions much as the previous military junta had done before him. He started by gutting the Supreme Court to remove any checks to his power, and sidelined the main opposition party by arresting its leader. The Perónists emerged as a new elite which shaped extractive institutions to their benefit.

“The Perónists won elections thanks to a huge political machine, which succeeded by buying votes, dispensing patronage, and engaging in corruption, including government contracts and jobs in exchange for political support. In a sense this was a democracy, but it was not pluralistic. Power was highly concentrated in the Perónist Party, which faced few constraints on what it could do, at least in the period when the military restrained from throwing it from power.” (Why Nations Fail, p385)

Is Milei’s election a critical juncture?

Following 28 of the last 40 years under Perónist rule, the country today battles its worst economic crisis in two decades as inflation spirals, poverty rates climb and – in the words of President-elect Javier Milei – the peso “melts like ice cubes in the Sahara.” Such is public frustration for perpetual economic catastrophe that Argentinian voters dumped the incumbents for libertarian rockstar economist Milei, who attracted 56% of the second-round vote, the most votes garnered by any candidate since 1983.

Argentina Consumer Prices, Broad Money & Peso vs. US Dollar (% yoy).

Source: NS Partners & LSEG Datastream

Milei campaigned on the promise of radical change and economic shock therapy. This includes dollarising the economy and eliminating the politicised central bank, putting the “chainsaw” to public spending, privatising state-owned companies, along with a host of controversial conservative social and libertarian reforms. Clearly, breaking the vicious cycle in play in Argentina will require radical policy change. Well implemented dollarisation could indeed work (with a deep recession) to restore economic order, working to reduce inflation, increase consumer buying power, and stabilise the economy in a way that enables better long-term economic planning while attracting foreign investment.

This sounds great in theory and markets have cheered the election results, but can Milei actually translate his victory into policy that passes through parliament when his party holds just 39 of 257 seats in the lower house and 8 of 72 in the senate? An alliance with centre-right former president Macri and his Republican Proposal party still won’t constitute a governing majority, but it will boost the chances of pushing through the reform agenda. For this to happen, however, it is likely that compromises will need to be made with Macri’s moderates and other neutrals. Will Milei, a libertarian firebrand who has gained so much popularity from demonising the political elite, be able to stomach a watered-down agenda?

How do we implement development theory in EM investing?

Our approach to macro analysis is not to place bets on such uncertain outcomes, but instead to assess the direction of travel and mark conviction in that country up or down accordingly. If Milei can beat the odds, then Argentina may gradually emerge as a hunting ground for investment opportunities.

For now, the reality is that powerful structural forces suffocate the country’s potential and make for a fragile environment that can easily wipe out investors lacking a robust approach to accounting for macro risk.

Dubai marina in the evening.

MENA equity markets posted negative returns in the quarter (-1.3%) as indicated by the S&P Pan Arab Composite Index. However, they still managed to materially outperform emerging markets, which declined by -3.7% (as measured by the MSCI Emerging Markets Index). There was a high degree of performance dispersion in the quarter, with the Dubai Financial Market General Index up 11.2% and the Tadawul All Share (Saudi) Index down 3.5%. Year-to-date, the performance spread between the best-performing market (Dubai) and the worst-performing one (Kuwait) is a remarkable ~32%. This performance divergence theme is also evident within individual markets. Saudi mid caps, for example, outperformed the broader country index by a staggering ~16%, as seen in the difference between the MSCI Saudi Arabia Midcap and the MSCI Saudi Arabia Index.

This degree of performance dispersion in the region is unusual during periods of high oil price, which have typically raised all boats, so to speak. We attribute this phenomenon to several key factors that we believe will continue to influence return dispersion:

  • Banks are no longer the only conduit between fiscal surpluses and the non-oil economy. Governments are now channelling more surpluses to sovereign wealth funds and directly funding their own economic programs. This is reducing the deposit opportunity set that was historically available for the banks. This is especially apparent in Saudi, where liquidity conditions are tight, evidenced by a headline loan-to-deposit ratio (LDR) of 96%. Conversely, UAE banks are enjoying an abundance of liquidity, with a headline LDR of 75%. This marked difference in balance sheets reduces the correlation in earnings between the two countries (given banks are the largest sector in both) and is partly responsible for the ~13% performance spread between Saudi and UAE banks on a year-to-date basis in favour of the latter as evidenced by the S&P country bank indices.
  • Economic policies among Gulf countries are diverging more than ever. Kuwait’s political deadlock continues to be a drag on government spending and economic growth, a stark contrast to the Saudi pro-growth agenda that is being galvanised by a single vision and strong political will. The UAE is further solidifying its regional competitive advantage through ongoing economic liberalisation (more recently creating a federal authority to regulate the gaming industry), while Qatar appears to be experiencing stunted growth and a hangover from infrastructure investments made to prepare the country for the World Cup. These economic policy outcomes have obvious ramifications for sector-specific corporate earnings growth. At oil prices of $80 and above, earnings growth has a more pronounced impact on equity returns than sovereign fiscal health, in our opinion.
  • The structure of equity markets is changing, with liberalisation and issuance activity attracting a new investor base, mainly institutional, to the region. Consider Saudi: the number of listed issuers increased from 188 in 2017 to 228 in 2023, and its weight in the MSCI Emerging Markets Index climbed from 0% to just over 4%. The deeper opportunity set and increased foreign ownership has reduced the contribution of highly correlated sectors like banks and materials in the Index (from 56% in 2021 to 43% today according to Morgan Stanley; note: this has certainly been aided by performance), which has contributed to reducing regional intra-correlations.

Lower market intra-correlations, higher return dispersion, and a deeper and less cyclical opportunity set is a powerful combination that will make stock picking in the region even more interesting, and possibly more rewarding.

Having witnessed the evolution of MENA markets over a long period (since 2005), we are in a unique position to understand the impact of the developments the region is undergoing on equity returns. Our historical understanding complements an adaptive and disciplined investment process rooted in a clear philosophy and focused solely on fulfilling our return promise to investors.

Vergent Asset Management LLP

Aerial view of Tam coc at sunrise in Vietnam.

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 advancement.

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

Information Technology

The strategy saw strong returns from the technology portfolio in the quarter. A significant contributor was Vietnam’s FPT Software (FPT), which featured prominently in agreements between Vietnam and the United States following the upgrade of their relations to a Comprehensive Strategic Partnership. This development signals that the US views Vietnam as a strategic alternative in diversifying its technology supply chain away from China. FPT’s technology-focused educational institutions are instrumental in building the human resources necessary for Vietnam to ascend the global manufacturing value chain. They also strengthen the company’s human capital advantage in its ~$1 billion annual IT outsourced services business in key global markets like Japan and the US.

We also saw strong performance from HPS Worldwide, the Morocco-based payment technology software company. Despite being in a heavy investment phase, the company maintained stable margins and grew its revenue by 17% year-over-year in 1H 2023. HPS recently won a major Canadian bank client and subsequently opened an office in Montreal to support that contract. By virtue of its global presence, HPS is a long USD business which provides a hedge against a rising US dollar.

Financial Services portfolio

The strategy experienced mixed performance from the financials portfolio in the quarter. Kazakhstan’s Kaspi.kz continues to deliver exceptional results, (~50% EPS growth in the first nine months of 2023), demonstrating the uniqueness of its super app product, which continues to record globally leading levels of engagement (65% of its 13.5 million average monthly users transact daily) driven by leadership in e-commerce, payments, and lending. We added to our investment in Kaspi at the beginning of the quarter following the company’s strong second-quarter results.

We’re also optimistic about developments at CTOS, Malaysia’s leading credit reporting agency. The company’s recent acquisitions in Indonesia and the Philippines in the area of alternative data, such as phone bill payment history, are expected to enhance the proprietary database used by its institutional lending clients. CTOS has affirmed its guidance for revenue growth of 28% and EBITDA of 23% for the lower end of the range in 2023. These acquisitions and affirmed guidance reinforced our confidence and led us to add to our investment in CTOS this quarter.

On the other hand, Kenya’s Safaricom underperformed in the quarter due to challenges related to its 2022 expansion into neighbouring Ethiopia, which have complicated the investment case at a time when its home market of Kenya is experiencing macroeconomic headwinds. While we acknowledge that Ethiopia’s 100-million-person population is a blue ocean for communication and financial services (Safaricom’s forte through the M-PESA app), the capital investment required is considerable and likely to weigh on margins for the next few years. With an enterprise value of approximately $4.5 billion and an EV/EBITDA of ~5x, we believe the shares are undervalued and reflect concerns over the Kenyan Schilling and the impact of the Ethiopia investment.

Consumer portfolio

It was a difficult quarter for the strategy’s consumer portfolio, punctuated by an earnings miss from Sido Muncul, the Indonesia-based herbal medicinal consumer company behind the Tolak Angin brand. Sido’s second-quarter results reflected a challenging environment for a large majority of Indonesian households, who are experiencing pressure on their incomes and are down trading or deferring non-essential purchases. Despite this, Tolak Angin’s market share grew in the first half of 2023 from an already high 75%, although the total profit pool for the category was down significantly. We reduced our exposure to Sido Muncul in recognition that the consumer environment is likely to remain challenging. However, we continue to own the company given its debt-free balance sheet, brand equity, and dominance in a category that is culturally entrenched. Rising health awareness post-COVID and a potential income recovery next year should eventually revive demand for its products. Indonesia will hold general elections in 2024 and we expect that economic activity and consumer demand will start picking up in the fourth quarter as election-related spending kicks in.

On the positive side, Century Pacific Food Inc., the Filipino food and beverage company, was included in the country’s main market index, reflecting its increased free float market capitalisation. This inclusion led domestic fund managers to bid up the shares, offering us an opportunity to reduce our position given the non-fundamental nature of the event, and the valuation opportunity it presented.

Healthcare portfolio

Quarterly returns were negative from the healthcare portfolio, mainly due to the weak share price performance of laboratory and diagnostics company, Integrated Diagnostics Holdings (IDH). The deteriorating outlook in Egypt is having an adverse impact on IDH’s margins, and the increased risk premium associated with Egyptian assets is also impacting the company’s valuation. That being said, we did see the CEO step in and buy shares in the market in October, a move we interpret as a positive signal regarding the valuation.

At the end of the quarter, we invested in Hermina Hospitals, Indonesia’s largest healthcare provider, which operates a chain of 47 hospitals in a country of around 250 million people. We are bullish about the healthcare reforms being implemented in Indonesia, and the large demographic opportunity that should support visible growth for years to come. While these are long-term drivers, Hermina’s investment in upgrading its operational systems through technology and improvements in patient experience is enabling significant near-term margin expansion, positioning the company for profitable growth in the next five years. Hermina was removed from the FTSE Emerging Small Cap Index in September, which resulted in selling pressure from index funds. We took advantage of this non-fundamental event and invested at what we deem to be attractive valuations.

Outlook

While the environment globally remains challenging, we see openings to deploy capital at attractive valuations. The fundamental metrics of the portfolio remain healthy: our companies are unlevered, generate high EBITDA margins of around 25%, and deliver returns on invested capital of approximately 18%. These metrics are the output of a dynamic research process that aims to identify high-quality companies exposed to secular themes that offer our chosen companies opportunities to sustain strong earnings growth over the next five years.

Vergent Asset Management LLP