The strategy saw strong contributions from holdings in ASEAN (Indonesia, Malaysia, and the Philippines) and the Middle East in the quarter. However, this was offset by losses in the Africa portfolio. As we have written about in previous letters, we have been actively reducing the strategy’s exposure to Africa (specifically Egypt and Kenya) and increasing it in ASEAN and the Middle East (Saudi Arabia and the United Arab Emirates). African economies are undergoing severe macroeconomic headwinds that have overwhelmed equity returns and exerted pressure on earnings. Conversely, ASEAN and Middle Eastern economies have been performing reasonably well, allowing us to harvest healthy USD equity returns through earnings growth and multiples expansion.  

Continuing with the above theme, we decided to fully tender out the strategy’s shares in East African Breweries Ltd. (EABL) to Diageo PLC at a price of Ksh192/share (compared to the Ksh170/share price as of the date of this letter). While Diageo paid a premium of 35% versus the one-year average (at the time of the “intention to acquire” announcement in October 2022), the deal multiples were highly favourable to Diageo at ~14x 2023 earnings, a substantial discount to emerging and frontier market brewers. We tendered out at these low multiples due to two factors: first, there are limited incremental buyers for EABL given the macroeconomic environment and stock market illiquidity in Kenya; second, the Diageo bid presented a relatively lucrative way for us to reduce exposure to Africa, in line with our strategy. Following the deal, EABL will remain listed on the Nairobi Stock Exchange with Diageo’s ownership now up to 65%, from just over 50% pre-tender. We will continue to monitor EABL and potentially re-enter the stock once the economic environment in Kenya settles.  

The strategy was very active during the quarter in both ASEAN and the Middle East. In ASEAN, we invested in CTOS, Malaysia’s leading private credit reporting agency, which holds over 70% of the country’s credit reporting market. Due to the high barriers to entry in this industry, market leaders like CTOS are likely to sustain their position as they continue to compound their data sets and create new use cases for their customers. Malaysia is a particularly underpenetrated market for credit reporting, as financial institutions still rely heavily on their internal data to underwrite credit. Malaysia is interesting because financial inclusion is high at around 95%, yet 65% of the population still does not have a regulated credit account. As financial sophistication grows and credit compliance requirements tighten, demand for CTOS’s services should increase significantly. With scale and technology that enables it to generate operating income margins of ~40%, we expect CTOS to achieve ~20% growth for the next few years. We have followed CTOS since it listed on the Bursa Malaysia in July 2021, but had reservations on its valuation and the previous management team, who we thought were brought on just to list the company rather than the focus on generating long-term value. When the previous CEO left the company, we went to Kuala Lumpur to meet with the new CEO, Erik Hamburger, a former executive at Experian, who articulated a growth strategy around product development, digital strategy, and sales initiatives that we thought, if well executed, would unlock tremendous value for shareholders. With a positive view on the company and management, it was a case of waiting for a valuation opportunity to open, which finally happened in this quarter.  

The strategy also invested in Al Ansari Financial Services (AFS), a UAE-based remittance and currency exchange house. AFS is a leader in the second-largest market remittance market globally (after the U.S.). The company generates revenues from facilitating the remittance of money flow from the UAE to countries in Asia (example: Philippines), Sub-continent (India and Pakistan), and the Middle East and North Africa (Jordan and Egypt). AFS focuses primarily on small ticket remittance, a market that banks are strategically not interested in, and that fintechs have found difficult to penetrate. For context, the company reports that 67% of the remittances it facilitates are less than $400 per transaction. AFS has a robust offline network in 226 carefully selected locations across the UAE, which captures monthly remittance flows from blue-collar and underbanked white-collar workers. This offline network is supported by a strong online presence, where it has a top ranked app that processes 41% of personal digital outward remittances among exchange houses. AFS’ management have executed well, deepening the company’s competitive advantage, and translating that to operating margins of ~50%, on healthy mid-teens top line growth.  

Despite the softer performance during the first quarter, we remain constructive on the strategy’s outlook. We believe the current environment is ripe for stock pickers, with valuations as attractive as they’ve been since we launched the strategy in 2018. Moreover, the economic environment is expected to deepen the competitive edge of portfolio companies in their respective markets.

As we have done in previous letters, we sign off by reminding our investors that our objective is to deliver differentiated returns that are attributed to investing skill (alpha) rather than market directionality (beta). We believe there are abundant alpha opportunities in frontier and emerging markets, which we choose to express through a concentrated but geographically diverse portfolio of companies with idiosyncratic earnings drivers and share-price catalysts. Naturally, this should result in significant deviations from global and emerging market indices in certain periods, but hopefully provide a superior risk-adjusted return profile to investors in the long term.

Vergent Asset Management LLP

Gulf equity markets underperformed their emerging market peers (as measured by the MSCI Emerging Markets Index) for the second consecutive quarter. This weaker market performance can be attributed to some of the same factors we highlighted in the Q4 2022 Manager Letter namely, higher interest rates and lower oil prices. These factors present a headwind to earnings growth for the banking, energy, and materials sectors, which together constitute 69% of the S&P Pan Arab Composite Index. Banks have been a particularly sore area for the market, with profitability ratios starting to crack under the pressure of higher rates and concerns about capital allocation and corporate governance at two large banks in Saudi Arabia and the UAE. The news of indirect exposure to Adani Group companies and a potential acquisition of Standard Charter Group at First Abu Dhabi Bank, combined with the write-down of the unfortunate Credit Suisse investment at Saudi National Bank, provided further reasons for the sector’s underperformance this quarter.   

However, if we look beyond the Index’s major sector constituents, the overall market sentiment is clearly bullish. For example, in Saudi Arabia, out of the 229 stocks comprising the Tadawul All-Share Index, 174 stocks generated positive returns in the quarter. In the UAE, IPO activity has been robust and share prices of recent entrants such as Salik Co., Emirates Central Cooling Systems Corp. and ADNOC Gas are well above their offer prices. While the performance divergence between the broader market and the Index is easy to attribute, the magnitude of the divergence (in favour of the former) is noteworthy. It is evident that investors are increasingly reducing their exposure to banks and materials while increasing their exposure to other sectors, such as consumer, healthcare, and technology, where liquidity is relatively less accommodative and therefore prone to larger stock price moves.    

The context is important in partially explaining the strategy’s outperformance in the quarter. The aforementioned dynamics led to meaningful valuation multiples expansion for the strategy’s key portfolio companies. However, we also anticipate a robust earnings growth outlook for many of our core portfolio companies. For example, National Co. for Learning and Education (NCLE), a prominent Saudi K-12 school operator, reported year-on-year revenue and net income growth of 48% and 50%, respectively, in its last quarterly reporting period. Our team spent a day touring various NCLE-operated schools with the CEO in Riyadh and we were thoroughly impressed with the quality of the staff, facilities, and unique culture preserved by management dating back to NCLE’s roots as a family-run enterprise. 

The strategy’s returns also benefited from a sizeable position we have been building in Saudi Telecom Co. (STC), Saudi Arabia’s leading telecommunications provider. Our thesis on STC has been largely driven by valuation, which has been developing since the Public Investment Fund (PIF) offloaded a 6% stake in STC in December 2021. This event stoked fears of future sell-downs in the stock from the PIF, which currently owns 64% of the company. While we cannot be sure that the PIF will not sell more shares of STC in the future, we found that valuations were becoming increasingly attractive for such a dominant business, with free cash flow yields exceeding 10% for 2023. Our thesis received a strong boost from STC collecting nearly $4bn of outstanding receivables from government clients in the fourth quarter of 2022, which represented 8% of its market capitalisation at the time. We met with STC’s management at an investment conference in Dubai and were encouraged by their efforts to improve disclosure and transparency for the investor community.  

As mentioned earlier in the letter, banks have lagged Gulf equity markets. This is a phenomenon that also played out in the strategy, with five of the eight negative return stocks in the quarter coming from the sector. While we have a significant underweight in banks, the strategy’s absolute returns experienced a drag from Saudi and Qatari banks, where pressures on profitability are building up as cost of funds increases at a higher rate than yields on assets.   

The strategy also experienced underperformance in its North African portfolio, and particularly in Egypt, where severe macroeconomic headwinds have overwhelmed USD equity returns. We have been reducing the strategy’s exposure to Egypt over the last year but opted to keep a level of investment in our highest conviction portfolio companies there. 

Looking ahead, we continue to see favourable opportunities for the strategy. The macroeconomic backdrop remains supportive, with healthy FX reserves and balance of payments positions across most of the Gulf. While still early days, the Saudi-Iranian reproachment is a key event that warrants our attention, as any progress there can lead to a lower geopolitical risk premium on regional assets. OPEC+ is committed to maintaining high oil prices to support government spending plans, which could benefit equity markets. We also note that positioning from global emerging market funds remains light and governments in the region are intent on growing their share in the emerging market capitalisation, which we believe will end up manifesting itself in a quasi-short squeeze on those funds.  

The environment is highly dynamic in the region, and as active managers, we are willing to make bold decisions to ensure that the strategy continues to provide investors with attractive opportunities in the MENA region.

Vergent Asset Management LLP

 Gulf equity markets rolled over in the fourth quarter and materially underperformed emerging markets. This marks a stark but predictable (as we wrote in our last Q3 letter) reversal in fortunes, with tailwinds of the outperformance in the last 18 months turning to headwinds. We summarize the key drivers of the weakness in Gulf equity markets in the fourth quarter below:

1.  Lower oil price and a different transmission mechanism – Gulf economies are highly levered to oil prices. While a Brent oil price of $80 is healthy for most Gulf economies, surpluses will naturally be lower as prices come down and barrels produced and sold remain static. Moreover, and focusing on Saudi Arabia, the share of oil revenue proceeds going into the banking system has come down considerably as the government allocates an increasing proportion of oil revenue to its sovereign wealth fund where the trickle down to economic activity is seemingly less visible (for now).

2. Higher interest rates – Gulf currencies are effectively pegged to the U.S. dollar and central banks have had to adjust to the Fed’s four rate hikes of 75 basis points in 2022. The relative attraction of owning equities with three months SIBOR rates reported at 5.59% is understandably low. Gulf investors have more alternatives than ever before to invest their money, with the recent Al Rajhi Bank Sukuk proving to be particularly popular among retail investors. Higher rates are also putting pressure on the net interest margins of banks as they compete to attract deposits. This phenomenon is likely to be especially acute in Saudi Arabia, where the liquidity environment has tightened n the fourth quarter of 2022. Saudi banks represent ~23% of most MENA indices and so the aforementioned profit margin compression has a material impact on the market’s aggregate EPS growth expectations for 2023. In other Gulf markets like the UAE and Qatar, state and quasi-state companies have been pre-paying debt at a rapid pace to avoid higher interest rates, leading to anemic corporate loan growth and further pressure on profitability.

3. Weaker USD – Gulf equities are effectively US dollar-denominated assets and are generally more attractive for global investors when the U.S. dollar is appreciating. This relationship has become stronger since Gulf equity markets became a large component of emerging market indices. Active Global Emerging Market (GEM) investors are not incremental buyers of Gulf equities in a weaker USD environment and their current underweight exposure to the region suggests they prefer to own assets denominated in non-pegged currencies.

4. Valuations – Gulf equity markets are coming off excessive valuation levels that reflected over-optimism on the degree and timing of the impact of reform program announcements, and robust foreign inflows following the deletion of Russia from the emerging market universe in March 2022, which we discussed in our second quarter letter.

5. A wall of offerings – 2022 was a record year for capital raised through primary and secondary transactions and the number of deals closed in the region with 47 listings raising a total of $26.5 billion. A large number of deals and the prospect of share sales by government and quasi-government shareholders took the air out of the market. We think it is wise for government funds to reduce or float their stakes in strategically listed companies given the level of ownership is far above what is required to retain control. However, this is likely to weigh on the share prices of many of the large-cap companies in the market where those entities are key shareholders. On a lighter note, overexcited bankers salivating at the prospect of fees from investment banking deals continue to be a reliable indicator of negative future market performance.

 As for the strategy, we managed – to a large extent— to avoid the significant drawdown that the region experienced in the fourth quarter. Three factors helped us achieve this outperformance:

1. Sticking to high conviction portfolio companies like Saudi Dairy and Food Co. (SADAFCO) where management execution and weaker competition are leading to significant earnings growth that the market has been behind on for a few quarters now. 

2. Adding to high conviction portfolio conviction companies that we believe are likely to experience an improvement in an operating environment like the National Company for Learning & Education (NCLE). NCLE’s eleven K-12 schools are experiencing a noticeable increase in utilization as students return to in-person learning in Saudi Arabia and management’s various initiatives (which focus primarily on quality of education in existing schools, M&A and greenfield for new schools) bear fruit.

3. Reducing or exiting portfolio companies we believe have reached valuation levels that are no longer attractive. A good example of this is Saudi Tadawul Group (STG), the country’s stock exchange which we exited at nearly peak average daily traded value. Over 60% of STG’s revenue is linked to traded values on the stock exchange and our exit decision reflected an understanding that traded values cannot just continue to go up, a view that the market is only getting around now as traded values have dropped 50% y-o-y in recent months.

 We continue to see a strong opportunity for the strategy as the market begins to reflect the “bad news” in the price of assets we like, and as investments in companies we’ve made in the last 6-12 months or earlier continue to deliver. 

 While we acknowledge that the environment has been favourable for the strategy, and decisions we made have on the whole been good ones, we are not resting on our laurels and will endeavor to continue delivering differentiated value-added returns for our clients looking to access the growing investable opportunity in the MENA region. 

Vergent Asset Management LLP

As this quarter marks the final letter for the year 2022, we thought it will be helpful to reflect on the key events that shaped the performance of the strategy in the year.

Economics 

The war in Ukraine, and the resulting spillover into higher energy and food prices, exposed structural imbalances that resulted in spiraling inflation and currency depreciation across most markets. Our focus on African and Asian companies and through-the-cycle underwriting process put us at a disadvantage as food and oil prices experienced sharp and sustained inflation.

The consumer basket in our markets is over-indexed to those basic commodities, and the fiscal and balance of payment dynamics of most developing countries (where we exclusively invest) are inversely correlated to commodity prices. In response, we identified the most vulnerable countries in the portfolio and made decisions to exit two companies in Egypt and one in Pakistan, and selectively reduce exposure to Kenya. We highlighted in our third quarter letter that our portfolio companies experience a net positive carry in a higher rate environment, as most hold more cash than debt. Where there is debt, it is mostly in local currency or otherwise matched with foreign currency income. Of the top ten companies in the portfolio, seven enjoy a net cash position.

Despite active portfolio management that reduced exposure to the most vulnerable countries, and defensive portfolio attributes, returns were still dramatically overwhelmed by the impact of currency moves. Around 47% of the strategy’s returns in the year can be explained by foreign currency depreciation against the US dollar, with notable currency devaluation in the Egyptian pound, Pakistani rupee, and the Ghanaian cedi.

Politics

The strategy experienced volatility from the onset as political unrest in Kazakhstan in January led to a meaningful drawdown in the share price of Kaspi.Kz, a fairly sizable position for the strategy. Since then, Kazakhstan’s political outlook has materially improved. On the domestic front, Kassym-Jomart Tokayev secured a second term in a snap election held in November, cementing his position against political rivals from the previous regime. On the foreign policy front, Tokayev seems to have navigated the Russian-Ukraine crisis as well as anyone expected, striking a neutral position that preserved his country’s deep-rooted ties to Russia, while constructively increasing diplomatic and economic engagement with the West and China. Our team visited Kazakhstan in May where we visited with Kaspi.Kz management, their main bank competitor, and other relevant stakeholders. Our visit was instrumental in reinforcing our constructive thesis on Kaspi.Kz, which we then translated into opportunistic buying of the shares at what we deemed to be deeply discounted valuations. Fortunately, this helped turn a 38% drop in the share price of Kaspi.KZ in 2022 to a flat performance contribution to the strategy in the same year. 

Kenya and the Philippines, key markets for the strategy, also held presidential elections this year. In Kenya, a peaceful election held in September saw power seamlessly transition to President-elect William Ruto, a testament to the democratic process, and the strength of institutions, in the East African country. President Ruto’s policy priority to reduce debt and improve Kenya’s fiscal position is negative for near-term growth but essential for sustainable long-term economic growth. His pro-trade stance, and his visit to neighbouring Addis Ababa for the national launch of Safaricom’s operations in Ethiopia, signal a commitment to preserving and expanding Kenya’s role as an economic and diplomatic hub for the region. It is worth noting that this political progress has not had the hoped-for effect on Kenyan equities, where weak macroeconomic conditions and dwindling stock market liquidity are prevailing. In the Philippines, Ferdinand Marcos Jr., the namesake son of the late dictator, was elected President in an election held in May. While many Filipinos are skeptical of Macros Jr.’s abilities and are understandably wary of his family’s history, his appointment of well-regarded technocrats in key economic roles has been a bright spot. While policy under Marcos, just like his predecessor Rodrigo Duterte, is probably going to remain uninspiring, it is fair to conclude that a Marcos presidency is, on the whole, positive for Filipino equities. 

Earnings vs. Valuations

Reassuringly, earnings from key portfolio companies remained resilient in the year, reflecting elements of quality we expected when we underwrote those investments. We calculate that the strategy’s top 10 holdings experienced an average of 17% growth in revenue and earnings per share in the first nine months of 2022, compared to the same period in 2021. Even when there were setbacks in earnings, operating metrics were exceptionally strong for certain portfolio companies. Take Safaricom as an example; while EBITDA and EBIT were down 4% and 11% year-on-year respectively, the company’s M-Pesa ecosystem continued to grow from strength to strength, producing 32% growth in transaction volumes and signalling continued adoption by Kenyan consumers of M-Pesa in their daily lives. More importantly, most portfolio companies are guiding for a better year ahead, which bodes well for earnings visibility in the next six to twelve months. 

With earnings being resilient and share prices coming down, multiples on the portfolio have come down to the level of ~10x Price to Cash Flow (P/CF). This multiple should be put in the context of a Return on Equity (ROE) that is well above 30% for the overall portfolio. This undervaluation has not gone unnoticed by the insiders of some portfolio companies; insider buying in the shares of Integrated Diagnostics Holdings in the third quarter, share buybacks from Kaspi.Kz in the last nine months, and a tender offer from Diageo for the minorities in East African Breweries in October (at a 30% premium) are all evidence of value recognition by the ultimate insiders.

Outlook

We are optimistic on the strategy’s performance in 2023. We highlight four key factors we believe can shape the outlook for performance:

With the U.S. dollar appreciation cycle potentially peaking, the pressure on currencies in most of our markets has abated, and we think it is unlikely we will see any meaningful negative contributions from currencies like the Indonesian rupiah, the Filipino peso, and the Moroccan dirham. In vulnerable countries like Egypt and Pakistan – where the strategy does not have much exposure— central banks are doing away with unhealthy currency management and letting market forces be the primary driver of the FX rate. This is a positive move that will open investment opportunities for the strategy in 2023.

Inflationary pressures have abated on food and certain commodities. While prices remain high by historical standards, we believe consumers, businesses, and governments have taken the brunt of the pain in 2022. The normalization of supply chains from the reopening of China should result in lower supply-side inflation and release the pressure on some of our companies to hold larger than normal inventory levels, which will increase cash conversion.

The domestic political picture is fairly stable after a busy 2022. This bodes well for policy visibility in 2023 and beyond. We expect policy to generally be pro-business and positive for equities. Looking forward, we expect the Indonesian general elections in February 2024 to be a positive catalyst for the strategy’s Indonesian portfolio in the second half of 2023.

The starting point for valuations is considerably low relative to the earnings power and visibility of portfolio companies. In other words, there is a fair amount of downside that is priced in. We are seeing insiders act on those valuation levels and consider that to be a strong bullish signal.

Finally, it is worth reminding readers that our objective is to deliver differentiated returns that can be attributed to the skill of investing (alpha) over the directionality of markets (beta). We believe there is an abundant alpha opportunity in frontier and emerging markets, which we choose to express through a concentrated but geographically diverse portfolio of companies with idiosyncratic earnings drivers and share price catalysts. Naturally, this should result in significant deviations from global and emerging market indices in certain periods, but hopefully provide a superior risk-adjusted return profile to investors in the long term.

Vergent Asset Management LLP