Since the global COVID-19 pandemic began 17 months ago, we have seen a dizzying parade of investment themes (and memes) that have caught the imagination of investors big and small. From Electric Vehicles (EVs) to the latest canine-inspired crypto currency, and now NFTs (Non-Fungible Tokens) and the metaverse, where one can escape the harsh inflationary realities of post-pandemic life. At Global Alpha, we are not thematic investors, but we do rely on themes to offer tailwinds to companies that have been carefully vetted around our investment process.

Themes themselves can be broad-based and structural, or narrow and niche, fueled by the latest fad or trend. We tend to favour the former, which tends to last longer and influence a broad swath of the economy, cutting across sectors. Within emerging markets (EM) for example, a broad structural theme that is currently playing out is the increasing formalization of their economies. As per the International Monetary Fund (IMF), over 60% of the world’s adult labour force participates in the informal economy and accounts for around 35% of the GDP of emerging economies.

Also, informality is not evenly spread across the EM world; Latin America and Africa have higher levels of informality in comparison to East Asia. Emerging markets with large informal sectors tend to underperform and punch much below their weight. Several countries within our EM universe have been actively trying to remedy the situation in order to increase their overall economic productivity, increase the size of their tax base, and lift the living standards of their populations. One country that has really stood out in its push towards greater formalization of its economy has been India.

In the last five years, India has enacted three key measures to push its economy towards greater formalization. Firstly, demonetization of Rs 1,000 and Rs 500 notes in 2016 forced many informal workers to join the formal work force. Secondly, the implementation of Goods and Sales Tax (GST) forced unregistered firms operating in the cash economy to get registered and enter the formal economy. Finally, the first two measures acted as a tailwind for the rapid adoption of digital payments via the Unified Payments Interface (UPI) platform rolled out by the government. The net result, as per a recent report by the State Bank of India (SBI), is that the informal economy has now shrunk to 15-20% of GDP in 2020-2021, versus 52% of GDP in 2017-2018.

This recent shift towards formalization is a generational change and is impacting every sector of the economy. For the discerning investor, it offers an opportunity to identify winners and losers of this massive shakeout that is leading to consolidation and an increase in market power of a select few companies. A great example of this consolidation is the luggage industry in India, which is estimated to be worth around US$3 billion, of which only 25% is organized. The Indian luggage industry is projected to grow in the high teens, and this growth outlook is propelled by four interesting underlying trends.[3]

1. Indians are travelling more and are making on average three trips every year as air traffic grew in double digits up to 2018.
2. There is a rise in brand consciousness and luggage is now seen as a fashion statement rather than a mere utilitarian product.
3. There is a higher spending on Indian weddings, where luggage is now included as part of the wedding trousseau.
4. Replacement cycles have been reduced, with Indians replacing their luggage in four to five years (vs 10 years earlier) and their backpacks in two years (vs three to four years earlier).[5]

VIP Industries (VIP IN)

For us, a clear beneficiary of this trend has been VIP Industries (a portfolio holding), which, along with Safari Industries (SII IN; not a portfolio holding) and Samsonite (1910 HK; a portfolio holding), control more than 90% of the organized luggage space. VIP, however, is the clear market leader with a 52% market share, having been the number one brand in India for the last 50 years. VIP started in the 1970s, making briefcases for office goers, and the name VIP was meant to give its customers an aspirational tag. The company now makes hard and soft luggage, backpacks, and handbags.

With the entry of Samsonite in India, VIP was forced to rebrand and reinvent itself to cater to a younger and trendier demographic. The company decided to mimic Samsonite’s own successful international turnaround by focusing on clearly segmenting their brands, expanding distribution, cutting costs, and spending heavily on branding. In addition to this, the company decided to switch from a promoter-led entity to hiring professional management.

The combination of these company-specific changes and macro tailwinds, coming from the shift to the organized sector, has led to remarkable results for VIP. If one were to look at their financial performance from 2016, which marked the acceleration of the shift towards formalization, up to the end of 2019, before the pandemic, we see that the company’s EBITDA and net income has more than doubled. With zero debt, their return on invested capital (ROIC) grew from 19.5% in 2016 to 25% in 2019, as VIP decided to rely less on imports from China, and invest in their own manufacturing units in India and low-cost Bangladesh.

While the pandemic disrupted travel and led to a sharp drop in business at VIP, our discussions with management indicate that demand has rebounded sharply with pent up demand for travel and discretionary spending, such as weddings, leading to higher volumes. VIP intends to take advantage of the dislocations in Chinese manufacturing resulting from power outages by leveraging its new manufacturing capacities while launching new SKUs to capture the market share across segments. As the market and the Indian consumer slowly moves away from the unorganized market, we see VIP further consolidating its position as a market leader.

At Global Alpha, we remain committed to separating themes from memes and identifying winners who can clearly benefit from these once-in-a-lifetime shifts in emerging economies.

Have a nice day.

The Global Alpha team

[3] Ambit Capital Research

[5] Ambit Capital Research

Real Estate in Emerging Markets: Unlocking sustainable growth opportunities.

Emerging markets have had difficult times during COVID-19, however, we have seen that in several cases, the recovery has been faster than expected. Not only is this recovery due to higher vaccination rates, but also because of secular trends, especially in the emerging lower middle class where growth opportunities are just beginning. In our universe, one of the sectors where we see a great growth opportunity is in real estate. The main variables that drive tailwinds for the sector are:

• Sustainable growth of the country, which implies that the emerging lower middle class can climb the ladder;  
• Low interest rates, inflation, and unemployment; and
• A consolidated industry with players who have good balance sheets and are focused on profitably.

In this environment, our largest overweight in the real estate sector is in India and Indonesia. One could argue that interest rates and inflation are currently on the rise in many countries, which is true. However, the rate hike process in Asian countries has been much slower, and structural growth remains intact. For example, in the case of India, current mortgage rates are at record low levels of under 7%, compared to more than 10% a decade ago. Indonesia rates are also likely to maintain low, which continues to favour growth in the real estate sector.

India’s last real estate cycle ended in 2013 and has not been able to recover since, due to several disruptions, such as demonetization in 2016, the roll-out of the Real Estate Regulatory Act in 2017, and the Non-Banking Financial Companies (NBFC) crisis of 2018. Likewise, India hasn’t experienced real price increases since 2013. Prices have increased 3-4% on average, below inflation each year and also below growth in income levels of around 8% per capita. So, what would make this cycle effectively sustainable from 2021 onwards? Some of the reasons were explained above. Moreover, In India, the real estate sector has experienced an industry consolidation that has driven inventory reduction (around 20%). With rising demand (also boosted by additional space required driven by the work-from-home scenario) and shrinking supply, price increases are most likely to occur for the following years; a phenomenon we haven’t seen in India for the last decade. Some factors that have contributed to the real estate sector’s boom include low interest rates, rising salaries, and explosive hiring’s (i.e., Infosys has hired close to 350,000 employees this year and salary hikes have been close to 120%). With government support to housing such as stamp duty cuts by the government of Maharastra, or Gujarat government measures in December 2020 such as the possibility of agricultural land being acquired for affordable housing, this support has changed sentiment and boosted demand.

In relation to housing affordability, mortgage installments in relation to monthly income have also been improving, changing the sentiments with all the other more favourable conditions. For example, in Mumbai, this index has improved from 93% in 2010 to 61% in 2020. In cities such as Ahmedabad, the index has improved to 24% in 2020, from 46% in 2010. This means that in this city, an average household needs to spend 24% of its income to pay monthly installments for the respective loan. Mumbai remains the most expensive market, but levels are improving.[2]

Another relevant variable to monitor are launches and inventory. Companies need to increase launches overall in order to capture increasing demand in a sustainable way. In 2015 and 2016, launches were approximately between 475 and 501 million square feet, decreasing to 135 million square feet in 2021.[3] Launches decreased progressively during these years, essentially due to inventory levels being too high. Inventory months hovered around 40-45 days between fiscal year (FY) 2016 and FY2020, and lowered 40 days in FY2021. In noting this, companies reinforced their efforts to liquidate their inventory first, with prices barely increasing at a 1% compound annual growth rate (CAGR) over 2015-2021, far beyond inflation. Inventory levels have lowered to 916,195 units in FY2021, to the lowest levels in 7 years.[4] Moreover, as FY2021 was a COVID-19 impacted year, the decline in new launches was steeper than normal, as H1FY2021 was virtually a wash-out and H2FY2021 was all about monetizing existing unsold inventory.

Moving forward, we should expect launches to pick up again. We foresee that the most relevant Indian developers are well positioned to capture this window of opportunities, considering good cost of funding, low leverage (as several raised equity during 2019-2020), liquidity access, lower inventory levels, and market share gains are likely to remain consistent due to the consolidation of the industry.

The real estate sector is behaving quite well in terms of volume increases, although sustainable price increases that can also mitigate the hike in raw material prices remain as a key challenge. The real estate market in India is very important for the country’s development as it is worth USD 150-180 billion, or 6-7% of the GDP, and is expected to reach 13% of the economy by 2025. It is the second highest employment generator in the country, after agriculture.[5]

In terms of the non-residential market, in 2019, the Indian office market closed with a record high of transactions, increasing by 27% to levels of 60 million square feet during the year. In 2021, new completions surpassed transactions for the first time since 2013. During FY2021 to FY2022, in the organized market, tech-related companies accounted for around 40% of office transactions in India, with renewed massive hiring and positive business forecasts anticipate their vacancy will remain low.[6]

We still can see some work-from-home effects lowering absorption levels, nevertheless, tech and other related sectors have lowered vacancies, which we expect to maintain at reasonable levels. Their expansion plans are also likely to improve net absorption. In the first nine months of 2021, transactions increased by 13% and completions by just 6% in relation to the same period last year, showing that the levels of activity are increasing to a great extent. Likewise, projects set for completion in 2021 and 2022 are pre-leased by multinational companies. Capitalization (cap) rates in key areas such as Mumbai remain very healthy at 6-8%. Economies, such as India’s, with a young workforce and without adequate infrastructure (possess separate spaces for work from home and also lacks air conditioning) favour a hybrid model, although with less working from home than in developed markets. Considering all the aforementioned, office demands and vacancies are expected to remain at healthy levels in the medium term. Bangalore, Mumbai CBD, and Pune maintain the lower vacancy levels in the main cities, hovering around between 5 and 10%.[7]

Prestige Estates Projects (PEPL IN)

In Indian real estate, Prestige Estates Projects is one of our key holdings. Over the last decade, the Prestige Group has firmly established itself as one of the leading and most successful real estate developers in India across all asset classes. The company currently has its principal presence in South India (Bangalore) and is the main developer to boast such a widely diverse portfolio, covering the residential, commercial, retail, leisure, and hospitality segments. During 2HFY2021, Prestige signed a term sheet with Blackstone to divest its entire stake in six operational office assets (6.6 million square foot), an 85% stake in nine retail malls (3.3msf) and a 50% stake in four under-construction office assets (7.4msf), along with two hotel assets – Oakwood and Aloft. The enterprise value, as per the term sheet, was settled at Rs 92 billion, with a cap rate of 8.5%. Part of the transaction will be used to clear the debt of the company’s annuity portfolio while the remaining inflow is likely to be utilized for expanding a residential pipeline (new joint venture/joint venture development agreements) and also accelerating capex for the annuity portfolio. The yield on cost expected for the new developments is 15-20%, much higher than the cap rate of the sold portfolio. Prestige will have almost 0.2x net gearing after completing the transaction, which is much better than 1.5x before the deal, which can foster re-leveraging in new projects, giving much higher yields as recently explained.

The company is one of the few Indian real estate developers with sound geographical expansion projects, ready to capture many growth opportunities in the rising emerging low-middle class. They are characterized for their good track record in Bangalore in terms of their execution and expansion capabilities. Prestige has almost doubled its sales since 2005 and has done so every 4-6 years following, and we expect the expansion to continue with all the new projects in Mumbai. Such expansion makes the company one of the more geographically diversified developers in India and they are mainly focused in Mumbai, where opportunities are huge.

The company is setting up four office complexes in Mumbai – two in BKC: one at Mahalaxmi and one in Jijamata Nagar. They have not yet started pre-leasing any of them as they have yet to receive all approvals (construction has not yet started). All of these are prime office markets, and HDFC has been the lender in these projects prior to acquisition by Prestige, continuing to remain as the lender. These three projects are with a single local developer, DB Realty. This month, they also launched their inaugural residential project in Mumbai – Jasdan Classic, located in Byculla. Once entering the market, execution risks should be lower. Mumbai has a more “local” culture where a younger population, living in small apartments, favours a work-from-office philosophy.

Management raised FY2022 presales guidance from Rs 65 billion to Rs 70-80 billion, and targets reaching presales of Rs 100 billion in the next three years (from Rs 55 billion in FY2021) and rental income of Rs 28-30 billion per annum in the next 7-8 years (versus Rs 2.6 billion now). To achieve such growth, it is essential that the company invests in new project acquisitions and capex. In a period of five years, Prestige expects Mumbai sales to be around 25% of their consolidated revenues. Such an important figure outside its home region (Bangalore) is relevant for an Indian developer and can be the second most important diversification success case besides Godrej Properties. For the long term, their non-real estate portfolio could be transferred to a REIT.

In Indonesia, we have seen a massive rebound to robust presales and high take-up rates at launches, which implies that demand for property remains very high, whereas prices seem to have bottomed up from previous years. Launches during the year have performed well, being concentrated IDR two billion (with a tapering off of take-up rates, as prices exceed this level) and located within reasonable vicinities of large cities, fulfilling their roles as satellite suburbs serving the working population of a metropolitan area. The Government has also taken measures to boost the real estate sector. The main measure was to provide temporary rebates until December 2021, in value-added tax (VAT) for property purchases (up to 50%) if they are priced below INR 5 billion and 100% rebate if they are priced below INR 2 billion. However, developers are lobbying to extend this program into 2022.[8]

Another important issue was the relaxation on the loan-to-value (LTV) for developers. Similar to India, the last real estate cycle in Indonesia ended in 2013. Before that, leverage was not an issue for developers, as many of the properties were self-funded and banks were willing to issue mortgages for at least 80% of the value of properties. Some mortgages included some buy-back clauses from the developer, effectively protecting the bank in case of any default. After the 2013 boom cycle (which ended in 2015), one of the ways the Bank of Indonesia tightened up was by limiting LTV requirements. As a matter of fact, after 2013, for houses larger than 70 square meters, the loan-to-value was approximately 70% and 60% for first and second homes.[9] The LTV has continuously been relaxed between 2015 and in 2020, driven by a COVID-19 stimulus LTV of 100% (in practice, it is around 90%). Moreover, disbursements of funds to developers was also limited and linked to the construction progress. For example, prior to 2013, the disbursement for developers was 80% linked to the signing of the mortgage deed. In 2013, this percentage was reduced to 0%, in 2018 to 30%, and in 2021 part of the government easing measures was increasing this percentage to 100%.Such relaxations are very important for developers’ balance sheets, as construction costs hover around 50% of the selling price, helping significantly with the deleveraging of the sector.[10] 

Considering the aforementioned, we are assuming growth in presales of 45% this year, 38% of which occurred in the first nine months of 2021, and was positively impacted by the VAT exemption. We also expect 10-15% for 2022-2023, which would be the first multi-year growth after the decline between 2018 and 2020. We don’t expect price increases similar to those in the 2010-2013 cycle; nevertheless, there is a probable scenario next year for prices to start rising after seven years, if the COVID-19 pandemic ends favourably and structural demand stays intact. Despite some tough years, Indonesia’s real estate prices have been extremely resilient, avoiding any declines as developers have usually preferred to sell less volumes, while not making discounts.

In summary, we think the Indonesian real estate market is ready for another positive cycle, driven by a combination of developers’ efforts, such as better presales, capex discipline, providing housing financing through hybrid mortgages and in-house installments, together with favourable policies from regulators, such as declining debt costs, lower inventory costs and lower debt rates. Rates can hike in the medium term, but should remain low in relation to previous cycles. All of the abovementioned has helped the main developers to strengthen their balance sheets.

Another phenomenon we could start to see, especially next year, is a return from investors to the real estate markets. This situation is by far not comparable to the massive boom of the 2010-2013 cycle. In those years, yields where roughly 9-10%, and currently, they are around 5-6%, similar to a government bond yield. Nevertheless, banks’ liquidity remains very high (supported by high CASA growth), with very low LDRs, and together with strong balance sheets, most developers are good enough to continue to provide hybrid mortgages and in-house installments. This in turn will make easier roads for investors who can also expect some revaluation of their properties if the positive cycle continues.

Regarding launches, those done in August and September, post the latest mobility restrictions, were all sold out, which is a good indication of demand status. The amount of launches this year has been around 5,000 units.[11] In Indonesia’s case, we have seen a greater proportion of launches in relation to inventory cleanup in India. The main reason for this is that Indonesia’s property mix is more oriented towards landed house projects. New launches are done after most of the units are sold, and therefore, inventory is not a high concern. In order to continue growing, companies have been much more dependent on new launches, and demand has responded well.

After the cycle of 2013, the Bank of Indonesia’s double-tightening measures made developers look at external ways of financing. Hybrid mortgaging was one of the most common alternatives, being a combination of installment and mortgages, where there was an option to put a 30% down payment by instalments of up to 36 months. At the end of period, the buyer has to pay the remainder of the purchase, which can be done in cash, but this is usually done by mortgage. For the developer, as the house is under construction, these instalments are booked as liabilities as customer advances. Considering down payments are usually the hardest milestone for homebuyers, hybrid mortgages have helped their affordability. Extended down payments can also improve the buyer’s approval rates for loans because they provide more time for buyers to improve their credit profile, and also lower their LTVs. Currently, this mechanism is used in a lower extent, considering required down payments are lower (10-15% as market conditions have improved).

Regarding non-residential real estate, mall and office owners have begun reducing rental discounts, as traffic and occupancies have been recovering, and are likely to continue accelerating. Majority of shopping centres started the year with an average discount to tenants of 50%, and after the reopening in the third quarter, foot traffic recovered much more quickly than expected, so the discount has been lowered to 40%. By the second half of next year, it is most likely that we should see pre-COVID-19 rental income for malls. The office market has continued under oversupply since 2014, thus rents are not expected to rise, while also considering the work-from-home environment.

Ciputra Development (CTRA IJ)

One of the primary beneficiaries of the property market recovery in Indonesia is our holding Ciputra Development. Ciputra Development is one of Indonesia’s leading property developers, and is involved in both residential townships, as well as mixed development. Landed houses account for a major portion of Ciputra’s projects. The company also develops and operates a range of investment properties (i.e., malls, hotels, hospitals, and offices). In 50% of its projects, Ciputra employs an asset light business model, with revenue/profit share agreements with various local developers, providing the company with additional development opportunities in a balance sheet efficient manner. It currently has over 75 projects in 33 cities across the country. The company has one of the most extensive land banks in Indonesia (2,300 hectares), which implies over 15 years of assured developments and high margins in the medium term. This company fits very well in this article thesis about secular trends in emerging markets due to its huge potential in mid- and low-market segments, which are heavily underserved (total addressable market (TAM) of around 120 million people (middle-to-low income bracket), including 65 million millennials). The affordable housing business (average selling price (ASP) under Rs2 billion) has a massive potential, driven by the extensive population.

Ciputra is also tapping into geographical diversification across the major markets of the country, and has established developments in Greater Jakarta and Borneo, expanding to Semarang, Surabaya, Manado, Palembang and Makassar, currently present in 33 cities.

The urbanization trend (which has increased from 49% in 2009 to 56% in 2019) and the availability of mortgage facilities, represents strong tailwinds for the mid-long term. In relation to its residential business, even though the majority of its 55 residential projects are focused on low- to mid-income segments (65% of its 1H21 presales are priced at less than Rp 2 billion), 8 of its projects target upper income segments. In the commercial business, a Possible REIT or other method exit of portfolio of properties at good cap rates and re-allocation of capital at better yields on cost is always an alternative. Ciputra is enjoying a healthy 9M21pre-sales recovery over 33% year over year and 86% of the company’s target for the full year. For 2022 and 2023, we expect low-digit growth, with 2022 being very dependent when the VAT benefit will end.  Overall, Ciputra has superior margins, a good balance sheet, and low debt, and we expect the company to continue operating at strong levels.

In terms of recurring revenue (i.e., shopping centres, offices, and hotels), we expect it to contribute 18-19% 2021E and increase to 25-27% in FY2022-2023E. Recurring revenue brings stability to cash flows, and their normalization and acceleration in the following years is positive for the company and the stock. Ciputra expects normalization of tenant rates (to pre-COVID-19 levels) from FY2022 and its latest development, Surabaya mall, phase two, started reopening in the second quarter of 2021, where occupancy rates are expected to be around 90% by year end.

In emerging markets, it is important to be able to identify secular trends because it’s related to the fact that emerging lower-middle segments can gradually increase their purchasing power, well-being, and quality of life. However, in order to add value to our clients, we are constantly looking for the companies that can capture the best growth opportunities in this favourable environment. In this sense, we pay close attention to the quality of balance sheets, growth prospects, cash flow generation and management quality, among other things. Ciputra Development and Prestige Estates Projects are two good examples of quality companies enjoying favourable tailwinds.

Have a nice day.

The Global Alpha team

[2] Knight Frank Research

[3] ICICI securities and Liases Foras

[4] Jefferies presentation

[5] https://www.businessinsider.in/

[6] Knight Frank Research

[7] ICICI Securities and Cushman Wakerfield

[8] Just to quantify VAT Is 10% so the waiver for projects below INR 2billion is INR 200 MM, enough for buying a mid-high end car

[9] Mandiri

[10] Mandiri

[11] Citibank

Investing in Emerging Markets (EM) equities never gets boring. One of the main reasons why we love our job is that every day presents us with a dynamic set of challenges and opportunities. In our September 16 commentary, we discussed the crux of the ongoing regulatory changes in China from a local perspective, the impact on different sectors of the economy, and the steps we are taking to position our portfolio accordingly. However, China is not the only country in our investable universe where the government decided to step in and attempt to fix some areas where the free market’s invisible hand allegedly failed.

In August, we witnessed a regulatory crackdown on technology companies spread to South Korea. Many investors in that country reacted rapidly and rushed for the exits, likely spurred by their wounds sustained in China, where tech giants lost 30-50% of capitalization from their peak levels. As a result of the low tolerance of undergoing the same experience, they wiped tens of billions of United States dollars (USD) off the local tech titans’ market value.

Unlike the Chinese government ambitiously reshaping nearly every sector of their economy, the Korean regulators appear to be highly focused on addressing issues in the technology business. Leading internet platforms, both foreign and domestic, have been thoroughly scrutinized and repeatedly criticized by politicians from different parties for abusing their dominant market position and hurting competition in the pursuit of profits, aggressive expansionary business practices, personal data usage, and high commission rates, putting pressure on small and medium-sized enterprises (SME). For instance, Kakao is one of the leading Korean big tech companies, and until not so long ago was the third domestic company by market capitalization. Kakao started as a messaging platform and expanded into consumer finance, payments, gaming, and ride-hailing businesses, among others; with nearly 120 affiliates Kakao has been compared to an octopus by critics. While commenting on the topic, the leader of the ruling Democratic Party of Korea said, « Kakao must not follow the steps of the country’s other conglomerates that ignored fairness and coexistence in the sole pursuit of profit. »

Furthermore, some critics and lawmakers have advocated to adopt measures to prevent big tech companies from monopolizing online services, making it more difficult for larger platforms to acquire smaller peers. Senator Chung, from the People Power Party, suggested further enforcing the Telecommunications Business Act to restrict larger platforms’ M&A activities. He also pointed out that Korean internet is a winner-take-all market with quite grim consequences for the vanquished, likely reminiscent of the Netflix show Squid Game, as larger platforms have over 90% market share. Other lawmakers are pushing to allow smaller companies to gain access to user data accumulated by dominant platforms, creating an ecosystem where big tech companies and emerging operators can grow and innovate together and ultimately benefit consumers and the economy as a whole.

Let’s review the chronology of the main regulatory events:

• On August 19, Coupang, the dominant e-commerce platform in South Korea was fined $2.8 million over allegations of pressuring suppliers to provide goods at a lower price than its rivals.
• On August 31, the National Assembly passed the so-called « Anti-Google Law », forcing tech platforms, such as Google and Apple, to open their app stores to allow alternative payment methods. South Korea is the first country in the world to enact such a law.
• On September 7, the Financial Services Commission and Financial Supervisory Service, stated that investment product comparison services provided by online financial platforms are brokerage and not advertising activities, and therefore violate the Financial Consumer Protection Act.
• On September 10, the Korea Fair Trade Commission (KFTC) opened a probe for alleged unfair business activities by Kakao and Coupang.
• On September 14, KFTC fined Google USD $177 million for forcing smartphone makers to use its Android operating system on their devices.

One can argue that the upcoming March 9, 2022 presidential election in South Korea is the main reason why politicians are bringing up issues and bills targeting big tech companies. Coincidentally or not, five years ago, it was the family-run conglomerates (also known as « Chaebol ») that came under attack, and were accused of enriching themselves by abusing their dominance and applying unfair practices. Also, lawmakers traditionally pressured telecom companies on pricing plans as an efficient way to gain publicity.

Amid growing scrutiny and accusations from lawmakers and regulators, several big tech names pre-emptively announced action plans to appease critics by abandoning some business segments, providing support to SMEs and scrapping plans to compete with small mom-and-pop businesses. For example, Kakao announced their plans to withdraw from the hair salon, flower, snack, and salad delivery businesses. The company also created a $255 million fund for suppliers’ support in addition to other steps aimed at strengthening its corporate social responsibility.

Although the new rules announced by the government so far have limited impact on business fundamentals, the concerns of further regulatory tightening affected the market sentiment and put pressure on the technology sector. By and large, small-cap companies are less prone to the current regulatory headwinds as they usually do not exercise overwhelming market dominance, nor do they employ aggressive expansionary business practices similar to Kakao and Naver, and remain out of sight from the politicians and general public. Moreover, we believe some of our holdings are in a relatively safer position or can even come out as net beneficiaries when the dust settles.

NICE Information Service (030190 KS)

NICE Information Service is the leading credit bureau (CB) in Korea, providing consumer and corporate credit information, risk management consulting, and debt collection services. It has the largest number of members in both the financial and non-financial sectors. The company is poised to benefit from structurally higher demand for retail credit checks due to the ongoing expansion of near- and sub-prime markets, increased competition among Korean lenders (leading to higher turnover of existing loans), a greater focus on unsecured lending, deregulation (enabling more product launches), and retail customers (who are becoming increasingly careful about their credit scores).

NICE Information Service is the only CB in Korea with exposure to consumer and corporate fields, with the most robust financial big data capabilities accumulated over 30 years (database of 43 million consumers and 2.2 million corporates). It has also secured non-credit and non-financial data, such as telecommunication, rental, and social info by collaborating with numerous partners. Consumer CB and big data businesses are expected to be the primary growth drivers of the company. We believe NICE Information Service should be one of the primary beneficiaries of the lawmakers’ initiatives to allow smaller companies to gain access to user data from dominant tech platforms.

NKN KCP (060250 KS)

NHN KCP (« Korea Cyber Payment ») is the leading online Payment Gateway (PG) service provider with a 24% market share. PG is a settlement service that authorizes credit card payments for online retailers. It encrypts credit card information and sends transaction data directly to credit card companies, bypassing merchants’ systems, and thus keeping credit card information confidential. PG also withholds payment until the merchant fulfils the transaction, allowing online shoppers to avoid fraudulent sellers. NHN KCP also runs online and offline Value-Added Networks (VAN) and Online-to-Offline (O2O) businesses. Online VAN service, connects online merchants with credit card companies through secure communication networks to approve credit card transactions. Offline VAN service, connects offline merchants with credit card companies through secure communication networks to approve card transactions. The O2O business empowers SMEs and facilitates payment processing in offline channels.

NHN KCP serves over 150,000 domestic and global merchants. The company is one of the key beneficiaries of the ongoing structural growth of e-commerce and digital content consumption, credit cards’ share gains from other payment methods, and growing overseas transactions. NHN KCP provides Korean merchants with frictionless payment processing capabilities by charging highly competitive take rates (e.g., in the range of 0.10-0.12% for domestic PG). In general, the current PG take rates in South Korea are among the lowest globally and do not catch the eyes of lawmakers as being predatory. For instance, in the e-commerce business, Coupang charges its merchants take rates as high as 8-10%, which has been seen as taking advantage of mom-and-pop companies with no alternative. Also, the food delivery platforms charge take rates of 8-12% of total transaction volume. One of the main market concerns in the investment case of NHN KCP is the risk of its largest clients following the suit of eBay Korea and Naver Pay, to build their in-house PG capabilities and bypass third-party PG companies. The government push against big tech’s aggressive expansion in different verticals might cool down these potential intents and lower the risk of clients’ attrition for NHN KCP. Moreover, the company can gain extra business if one of the tech giants decides to outsource PG capabilities.

AfreecaTV (067160 KS)

AfreecaTV (« anybody can freely broadcast ») is the most prominent Korean live streaming platform, where anyone can broadcast gaming, sports, and various entertainment content free of cost. Instead of paying a subscription fee, the viewers show their appreciation by donating virtual gifts (Star Balloons) to broadcasters (Broadcast Jockeys or BJs). AfreecaTV takes 35% commission from these gifts donated to its BJs. In addition, it sells advertising products (branded content, banner ads, video ads and other solutions) to various brands. The platform has over 17,000 active BJs and hosts over 20,000 live streams per day. AfreecaTV is one of the few available options in the EM universe, providing exposure to e-sports. Gaming content drives over 60% of traffic, while around 30% of its gifting revenue and 50% of advertising revenue are derived from e-sports content.

The company enjoys a substantial supply of top BJs while supporting them financially and via collaboration in creating unique content and providing facilities for professional production and e-sports events. A BJ support department is available 24/7 and top BJs are locked in through exclusive agreements with AfreecaTV. A deep bench of highly popular broadcasters and exclusive content keeps its viewer base sticky. We expect the platform monetization to improve on the back of investments in content and BJ support. Rising content quality should drive a steady user base growth, enhance engagement, and lift the proportion of paying users and average revenue per paying user. In addition, AfreecaTV ad revenue is becoming the long-awaited second source of growth. It is poised for solid expansion, from nearly 20% of the mix to 50% in five years, primarily driven by branded content. Democratization of the data accumulated by large platforms can bring new opportunities for AfreecaTV’s ad business.

Have a great day.

The Global Alpha team

We recently launched our Emerging Markets (EM) Small Cap fund. Comprised of over 11,000 companies, the EM Small Cap universe presents plenty of very sound investment ideas. One of the main challenges we have encountered since launching the fund more than a month ago has been the strong Chinese government regulations in various sectors, mainly technology and education. While we do not have investments in these sectors in China, we have seen a climate of increasing uncertainty in other economic sectors.

From a local perspective (which can differ from Western perspective), Chinese policy-makers are aiming for common prosperity, which fundamentally entitles a policy shift towards reducing wealth inequality. The concept is not new; it has been a long-term goal of the Chinese government that has become more relevant recently. The Central Party and State Council jointly announced the plan on June 10, establishing Zhejiang province as the pilot zone. The 14^th five-year plan (2021-2025) called for an “action plan” to be fully implemented by 2050 to become an advanced, modern economy. Among common prosperity goals are narrowing the income gap, tackling the increasing real estate prices, promoting higher household income growth, increasing public services, such as healthcare and education, and improving living conditions of rural residents, among many others. These common prosperity initiatives will likely rebalance the economy from investments to consumption, targeting the mid-low-income population. Moreover, the state’s role in public and private sectors is likely to become more relevant.

It is worth noting that the Chinese government seems to have downplayed the importance of paying too much attention to short-term growth. They indeed have a short-term buffer, considering the 2021 GDP target is “above 6%”, and the country is likely to grow in the range of 8% this year.^[1] The current outlook is more focused on solving structural problems, which may have short-term collateral consequences, but the vision is to improve the long-term perspective. Indeed, President Xi has emphasized a couple of times that the aforementioned long-term goals are not just an economic objective, they are about the Party’s “governing foundation”. The foregoing is still interesting, since, as previously mentioned, the Western vision is often different. Billions of dollars have been lost in market capitalization of Chinese assets, driven by strict regulatory policy in the after-school tutoring sector, together with anti-monopoly and cybersecurity rules in the internet sector. The government has also tightened property policies. Currently a blanket of uncertainty persists regarding « which sector will be regulated next ». For example, almost one month ago, a state media article equated the gaming industry, which has many companies that trade on the stock market, to “opium”.  Although the government quickly quashed this article and there were no official statements, it caused a rapid slump of shares linked to the gaming sector, reflecting the prevailing nervousness among investors. The government recently released new regulations for the industry, including limiting the amount of time children can play video games to three hours a week, and last week state media mentioned that companies should avoid the sole focus of pursuing profit, in order to prevent minors from becoming addicted to games. This sentiment led to another round of losses in gaming-related stocks.

Again, different perspectives come into play. We believe China is trying to improve its society in the long term, but are not very concerned about the effect this may have on investors in the short term. The question then is; how can we better cope and adjust to these policies for the benefit of our clients? China accounts for around 10% of the MSCI EM Small Caps index, making it an important investment for our fund. Our approach to this new environment is to understand the domestic perspective and invest in companies/sectors that are subject to less regulation and more likely to benefit from the new trends that we see emerging in the future. Each scenario presents a new opportunity and the trends include:

• greater self-reliance on government-fostered technology (semiconductors, artificial intelligence);
• renewable energy;
• fitness;
• consumption favouring local brands/companies; and
• manufacturing industry and robotics for products designed mainly to support and strengthen the Chinese  economy. 

In manufacturing and robotics, Estun Automation (002747 CH) is one of our key holdings. The company is the largest domestic industrial robot-maker in China and one of the best-positioned stocks in the A-share Small-Cap automation sector. Estun also produces several key components itself, which gives the company a strong competitive advantage in relation to competitors who rely on external suppliers. For example, Estun is one of the few robot-makers that can manufacture servo systems and controllers in-house. It has also managed to gain cutting-edge technologies, like robot 3D vision and micro-servos via a number of acquisitions. In short, Estun has the capabilities to manufacture almost all of the core parts it needs, with the exception of reducers, although they still procure the basic mechanical parts and semiconductor chips. They also have production plants across the globe. The two key plants are UK-based Trio, acquired in 2017, a top 10 global player in motion control systems, and Germany-based Cloos, acquired in 2019, making the brand a cutting-edge welding robot. In light of this, supply chain management has become a key issue for Estun.

The latter is definitely a big advantage. For industrial automation, all the key core technology is in upstream components, like servos, motion control systems, and reducers. Thus, without access to upstream components, a company is merely one of many system integrators, which face a significantly lower entry barrier, intense competition, and lower margins. In fact, now that the Estun brand is better known, more external system integrators are starting to integrate Estun’s robots into their product portfolio, which is why Estun shifted resources away from their system integration department. Back in 2019, the revenue contribution of industrial robot manufacturing and sales, and system integration sub-segments was 50:50, but from 2020 onward, it’s been skewing towards robot sales. As of the first half of 2021, the proportion has shifted to 80:20 for sales of robots to system integration.

Nowadays, Estun’s main end markets are lithium-ion batteries, computers, communications, and consumer electronics (known as the 3C industry in China) applications, solar, welding robots (primarily for heavy machinery), and metal forming (processing). Smaller, fast-growing contributors include woodwork, home appliances, and packaging. Meanwhile, the core markets for the Cloos robot brand are medium- and heavy–plated 6-axis welding robots. Currently, this brand is gaining market share in China’s heavy machinery segment. Cloos is also developing their medium-plated welding robots, which are commonly used in heavy-duty trucks.

Industry-wise, according to the MIR database, a Chinese based, high-end, hardware-focused research, the China automation market size grew 26.9% year over year to approximately RMB153 billion in the first half of 2021. The market is continuously experiencing robust demand from new-economy manufacturers, notably industrial robots, electric vehicle batteries, wind turbines/solar panels, as well as 3C and logistics, and some of the more niche markets (e.g., tobacco, wood engraving), which are dominated by Japanese players. However, this represents a huge upside potential for players like Estun, who are narrowing their technology gap with international peers. Moreover, machine exports drove some of the automation demand in the first half of 2021. Estun (and peers like Innovance) have experienced continuous market share gains. The company is also well positioned to maintain its domestic industrial robot leadership position, especially in 4-axis and 6-axis industrial robots, which contributed to approximately 85% of their shipment volume in the first half of 2021.

Estun’s focus on the new-economy manufacturers, coupled with their expected market share gains, should ensure a secular growth trend in the long term. Although there has been plenty of uncertainty around the Chinese economy since the start of the second half of 2021, we continue to view industrial automation (IA) demand as among the highlights of local dynamics, given the favourable demand outlook and strong policy support for an industrial upgrade. Estun is a perfect example of a company that can position Chinese automation, robotics, and industrialization on par with the leading international players. We believe the company will get ongoing government support for achieving these targets in the mid/long term, so the company is unlikely to be exposed to any material regulation risk. In light of its quarterly politburo meeting outlining the drive to “encourage enterprise to scale up technological upgrade investment”, we expect the manufacturing industry to step up investing pursuit of robotization.

Estun has experienced short-term pressure driven by COVID-19 in China (primarily in Nanjing and Jiangsu, Estun’s headquarters and production base) and lower-than-expected results in Q2 2021 are likely to remain so for the rest of the year. The difficult quarter was driven by:

• price hikes of parts, base metals and chips;
• Estun prioritizing market share over margins in 2021; and
• hikes in raw material transportation fees.
• the delayed shipping of Trio motion controllers

We feel this situation is temporary and expect margin reversal from next year (or before), driven by ongoing operating leverage, improvements in internal cost control, and more import substitution from domestic parts. In fact, in their 2Q earnings results conference call, the company maintained 2021 revenue guidance of RMB 3.5-4.0 billion, with its 2021/22/25 industrial robot sale targets of 10k/15k/50k units unchanged. Estun management also expects profit margin to rise notably as its business expands.

Despite the short-term headwinds, we hold a positive view toward Estun, as we believe in the sustainability of industrialization and automation, on the back of a solid secular growth trend in the coming years in China. As the local market leader, Estun is now already directly competing with big foreign players, like Japan-based FANUC. Their acquisition of Cloos has significantly contributed to the positioning and diversification of Estun’s robots in China. We expect Estun’s market share to increase from for 3-4% to approximately 10% by 2025, meaning Chinese factories will increasingly shift to domestic rather than foreign brands. We believe Estun has the potential to emerge as one of the leader industrial robot manufacturers globally. This could be a similar story to other emerging domestic players in China, such as excavators, where domestic market leader Sany holds an approximate 25% market share. 

As bottom-up investors, fundamentals drive our stock selection. We look for companies growing faster than their industry, with good margins and cash flows. We also need to understand local dynamics and invest accordingly. China’s recent policies are a good example of a divergence in timing and perspectives between local interests and foreign investors, as detailed above. The road has been bumpy, but opportunities are also emerging, especially in small-cap companies, that will likely have more room to grow in the long run. Government-encouraged manufacturing and robotics companies also present good opportunities in this scenario, which supports our preference for our holding Estun.

[1] www.dw.com