Bab Bou Jeloud gate (The Blue Gate) located at Fez, Morocco at sunset.

MENA equity markets finished the fourth quarter with returns of 0.7% (S&P Pan Arabian Index Total Return), significantly outperforming the MSCI Emerging Markets Index, which was down 8.0% in the same period. For the full year of 2024, MENA equity markets ended up 6.3%, a slight underperformance relative to the MSCI EM Index which was up 7.5%. Through to the end of 2024, MENA markets outperformed the MSCI EM Index by 43.4% and 17.3% over the last five and three years respectively.

Annual return dispersion among the major MENA markets (at the index level) continued to be high this year. The performance differential between the best (Dubai) and the worst (Qatar) market was 29% in 2024. Interestingly, this has also been the quantum range of returns between best and worst in 2023 and 2022. This high level of dispersion is a particularly desirable feature of investing in the region and one we believe is likely to remain given the composition of listed securities in each market (providing different earnings-factor sensitivities), the presence of domestic capital pools dedicated to each market and, more generally, the relatively low levels of foreign ownership in the region.

MENA equities were put to the test this year as they grappled with an escalation in political risk, lower oil price, high interest rates and incremental supply of shares from initial public and secondary offerings. Our view on this was articulated in our fourth quarter letter of 2023 wherein we described our approach to the Saudi market in particular:

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…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.

In the same letter, we cited a preference for owning the UAE:

“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.”

Fortunately, that view has largely played out in 2024 (with some exceptions of course), and we now find ourselves in a situation where our relative preference has reversed in favour of Saudi as valuations appear more reasonable. We spoke about this more constructive stance on Saudi in our third quarter letter last year following our trip there in October 2024:

There are three factors working for the strategy at the moment. Firstly, there are growing profit pools resulting from reforms and demographics which is critical to our investing style – growth. Secondly, in the last two months, the market has begun the long-awaited process of recalibrating its expectations of earnings to levels that we deem realistic and interesting – reasonable valuations. Lastly, the strategy has already begun shifting the portfolio to areas where there is a healthy combination of growth, risk-reward and low investor positioning.”

In other markets, we continue to favour Morocco in the portfolio as it represents one of the best structural economic development and equity stories in emerging markets and certainly the region. While the portfolio in Morocco has experienced some turnover in 2024 (primarily due to an exit of a long-held position in the retail sector), we remain committed to our long-term holding in technology and have expanded the portfolio to include companies in healthcare and financial services.

In Qatar and Kuwait, our statement from last year’s letter remains largely relevant today:

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.

While our optimism on Kuwait may have proven pre-mature, we believe the direction of travel is positive and have continued to build selective exposure over the year, primarily in banks and financial services.

As for Egypt, we expressed an openness to increasing our small ownership last year, subject to the devaluation of currency and a correction of the imbalances in the country’s trade and capital positions.

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.

The Central Bank and the government of Egypt did eventually capitulate and devalued the currency from just above 30/USD to 50/USD. The devaluation came two weeks after the government sealed a mega property deal with one of Abu Dhabi’s sovereign wealth funds. As a result, we felt more comfortable with the medium-term outlook for US dollar returns on Egyptian assets and stepped up our exposure to our technology company by way of a discounted block transaction in June last year that so far has proven rewarding for the portfolio.

In conclusion, the region passed a particularly testing year in 2024. The structural story for the region remains sound and we are confident it will underpin a powerful combination of a multi-year growth in earnings and a low equity risk premium relative to emerging markets. While it is too early to determine what happens in 2025, a strong US dollar, stable oil price and a Trump presidency all bode well for MENA equities.

We wish you a prosperous 2025 and look forward to sharing updates on our strategy with you.

High angle view of illuminated buildings during sunset in Makati City, Philippines.

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 several key factors that influenced returns in 2024 and share observations on the portfolio and the markets.

Internet and technology portfolio

The portfolio’s investments in the internet and technology sector propelled returns in 2024. This was driven by FPT Corporation (FPT), the Vietnamese IT services company, which established a relatively early mover advantage in the AI consultancy space. This placed the company firmly in the AI winner camp in 2024 and led to a re-rating of its shares. FPT also benefited from continued IT capex recovery from its traditional markets in the APAC region as well as strong execution in the US and Europe, which drove a ~30% growth in the company’s global IT services revenue in the nine-month period ending September.

The sector also saw strong contribution from Kenya due to improvement in the macroeconomic environment there. This was reflected in a strong appreciation of the Kenyan Shilling and a lower cost of equity that transmitted favourably into the valuation of Safaricom PLC (SCOM) (which we own primarily for its fintech asset, M-Pesa). We took advantage of the macro-induced rally and reduced our exposure to Safaricom in the first half of 2024.

We were also fortunate to have the opportunity to participate in discounted share sales by the private equity owners of Baltic Classifieds Group PLC (BCG), the leading online classifieds group in the Baltics. This helped the strategy increase its investment in the company at attractive prices. BCG continued to flex its market leadership in auto and real estate classifieds through calculated price increases and the introduction of value-added services which translated to an 18% growth in operating profits in the six-month period ending October.

We experienced a drag in returns from our investment in Allegro.eu S.A. (ALE), the leading Polish online marketplace. Allegro’s management provided relatively downbeat commentary in their guidance with their nine-month report which it attributed primarily to competition from Chinese players (mainly Temu). The stock had already come under pressure from the unexpected resignation of Roy Perticucci from his CEO role, and so the incremental negative news on competition put extra pressure on the stock. Fortunately, we decided to reduce exposure to Allegro following the news of the departure of the CEO but the strategy still experienced a drawdown from the stock’s reaction post the nine-month results. We still have a small position in Allegro as we believe it will weather the current competitive pressures given its dominant position in the Polish online marketplace.

While we made changes to our internet and technology portfolio during the year to reflect relative valuation preferences and make room for new ideas, the sector remains the largest bet in the portfolio entering 2025 (the end-of-year exposure to the sector is equal to the average exposure in the year). The combination of improving macro, evolving consumer habits, benign regulatory environment and strong management execution is likely to drive another year of strong earnings growth in 2025.

Retail portfolio

Retail was the second major contributor to returns in 2024, but contribution was top heavy, with the shares of Philippine Seven Corp (SEVN) and Mr D.I.Y. Group (M) Berhad (MRDIY) in Malaysia generating nearly all the returns. With Seven, the resumption of dividend payments (via a special dividend) after a three-year hiatus proved to be a powerful catalyst that woke the market up to the company’s strong fundamentals and growth prospects (14% growth in EPS in the nine-month period ending September 2024 and one of the fastest growing 7-11 convenience store networks in the region).

Mr D.I.Y. Group’s shares benefited from the anticipation of a recovery in demand from the B40 group of Malaysian households (B40 refers to the bottom 40% income group) and the entry of the company in a 49% joint venture with Chinese retailer KKV, as well as a supportive equity market environment in Malaysia last year.

We took decisive action to reduce exposure to this sector in the second half of last year, emboldened by what we deemed to be full valuations following the rally in our core holdings above, and better opportunities emerging inside and outside the sector.

We also saw some pressure on consumer wallets and increased competitive intensity in some areas of the retail portfolio including in the home improvement and grocery categories which we deemed to be persistent and as such triggered selling of underperformers in the portfolio. One such example is Wilcon Depot Inc. (WLCON), the Philippine’s largest home improvement retailer, which is experiencing significant pressure on sales densities as demand for home renovations appear to have stalled after the post-Covid demand pull.

We also exited our long-held investment in Moroccan grocery retailer Label Vie S.A. (LBV) on a combination of slowing growth and concerns on capital allocation decisions that we deemed would be dilutive to minority shareholders.

While we end the year with exposure that is well below the average exposure in the year for the sector, we are bullish on some of the additions we made to the portfolio in the year in UAE grocery retailing and Indonesian variety retail which we hope we can share more information on in 2025.

Fast moving consumer goods portfolio

Consumer goods were the third largest contributor to returns this year, driven by long-term holdings Philippines’ Century Pacific Food Inc. (CNPF) and Indonesia’s Industri Jamu dan Farmasi Sido Muncul Tbk PT (SIDO), or Sido Muncul. Century Pacific’s consistency in delivering on their guidance of low- to mid-teens yearly growth proved to be extremely valuable this year as most other Philippine consumer companies experienced significant headwinds from lower disposable incomes and commodity price pressures. The consistency in delivering is the result of a diversified portfolio of consumer products (mainly canned seafood and meat, and dairy), an exposure to institutional demand from developed markets (mainly canned marine and coconut water) and the large consumer market in the Philippines. This creates natural hedges in the company’s cost structure and foreign currency exposure.

Sido, the herbal medicine company that we have discussed extensively in the past, emerged from a difficult 2023 with operating income growth of ~29% in the nine months ending September. Sentiment on the shares also benefited from a transaction in which the controlling shareholder Irwan family bought out the full 17% stake of Affinity Equity Partners, a private equity investor that had come to the end of its investment cycle in the company. The transaction was done at a 30% premium to the three-month average price, signalling confidence from the family in the prospects of the business, and removing the overhang on the shares that typically arises with late-stage private equity ownership of public companies in our markets.

We remain highly selective in this sector and continue to see pressure on profit pools due to increasing competitive pressures, changing consumer behaviour, and the rise of new distribution channels that are disrupting the competitive advantage that many leading companies have historically enjoyed.

Healthcare portfolio

Healthcare was the fourth largest contributor to returns in the year driven mainly by Morocco’s Aktidal S.A. (AKT) and Turkey’s Medical Parks – MLP Care (MPARK).

Aktidal listed its shares on the Casablanca stock exchange at the end of 2022 and came back to the market for a follow-on offering (USD100 million) last year as growth exceeded the company’s initial expectations. Management at Aktidal expects its bed capacity to increase 2.5x between 2023 and 2026 as it capitalises on the structural undercapacity in the market and a supportive regulatory environment for private healthcare investments that is leading to quick utilisation ramp-ups and strong unit economics.

We invested in MLP early in 2024 as we started seeing encouraging signals from the Turkish government on its intent to reverse course and pursue market-friendly economic policies. MLP benefited from improving sentiment toward Turkish assets as the country received its first credit rating upgrade in over a decade from Moody’s in July. Fundamentally, MLP has established itself as the market leader with a 40% share in the lucrative top-up insurance segment which is the fastest growing payor group in the Turkish healthcare market. MLP has also been making sensible single-site acquisitions which it is successfully integrating into the network.

We experienced some drag in returns from the sector from investments in Indonesia and Thailand where weak equity market sentiment and pressure on payors (insurers and medical tourists in the case of Thailand) led to a de-rating of our stocks at the end of the year. That being said, our position size in that region is relatively small and we are oriented to be buyers of this weakness as growth drivers around demographics and regulations remain intact.

Outlook

We are constructive on the strategy’s positioning in 2025. While the global market environment is uncertain, we believe earnings visibility from our portfolio companies is relatively high in the next two years. As in every year, we reduced valuation risk when appropriate (reducing exposure to areas where share prices ran ahead of fundamentals), and exited underperforming positions where fundamentals are likely to worsen. Positively, we found many areas to invest in and, as a result, find ourselves with low levels of cash relative to the history of the strategy.

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

Gambling hand holding two playing cards.

This month, NS Partners fund manager Luis Alves de Lima writes on navigating a volatile backdrop in Brazilian equities, and the huge potential this market offers if political risks ease.

Imagine a game of blackjack. Not your typical duel in the bowels of a dark casino, but a game of chance steeped in the vibrant hues of Brazil’s economic landscape. This is a game where the potential rewards are tantalizingly high, but the risks, like the Amazon rainforest, are dense and unpredictable. Like a card counter, we watch carefully as each card is dealt – investigating companies and assessing the macro backdrop – to formulate a running count of the deck and calculate our odds of hitting 21.

The ace in this deck represents the transformative power of political change. A conservative victory in the 2026 federal elections could usher in an era of fiscal responsibility, market-friendly policies and renewed investor confidence. Drawing this ace could yield a multi-bagger return as Brazil sheds its “risk premium” and the investment narrative flips from basket case to market darling. That doesn’t mean you won’t be wiped out before the ace arrives.

As we count, the deck is stacked with low number cards (2-6) – embodiments of lurking macro uncertainties – with the ability to wipe out your hand. Brazil’s fiscal deficit, stubbornly high cost of capital and the ever-present spectre of political volatility loom large. Playing aggressively to a deck loaded with low number cards favours the dealer’s odds, much like the potential downside risks that could erode investment value when macro is deteriorating, but valuations are yet to catch down.

The high cards (10, Jack, Queen and King), represent the underlying strengths of the Brazilian economy (all high cards are worth 10 points, with the ace either 11 or 1 depending on what’s best for the player’s hand). These cards increase your chances of winning if low number cards are dealt out of the deck and the proportion of high cards increases. The low cards in Brazil are coming out as the clock ticks on socialist president Lula’s term, with elections in 2026. While an increasing proportion of high cards does not offer an immediate payout in our game, it does suggest an investment environment where the player/investor can soon lift their bets in line with improved conditions and chances of upside surprise increasing.

Investing in Brazil today is a calculated gamble with ever-shifting odds. While the macro and political backdrop seems daunting, low cards are exiting the deck as pessimism runs to an extreme and fails to reflect the true potential of the market. While future outcomes remain uncertain, we see a disconnect between strong company fundamentals and depressed valuations. The “true count,” the extent to which a deck favours the dealer or player (investor), will swing in the latter’s favour as political risks ease. The probability of making it to that elusive ace rises.

My recent virtual roadshow with 20 Brazilian companies painted a picture of resilience and growth. Companies like Grupo GPS, Rede D’Or and Lojas Quero-Quero are demonstrating robust financials, exceeding growth expectations and trading at inexplicably low valuations. I have also planned a trip to Brazil next month to continue the mission of finding when the ace might appear in this high-stakes game. It’s an opportunity to delve deeper into the dynamics of the Brazilian market, gather firsthand information and assess the true probabilities beyond the abstract numbers.

Investing in Brazil today requires a contrarian mindset; an ability to understand the macro risks and direction of travel and weigh this against what we are seeing on the ground as we engage with companies. It’s a game for those who understand risk and can calibrate their bets as the odds shift for or against them. As any seasoned player knows, ignoring the headlines and acting with conviction when the true count tilts in your favour is when the most lucrative bets can be made.

Korean national assembly hall at night in Seoul, South Korea.

Deeply unpopular South Korean president Yoon Suk Yeol committed a monumental act of executive overreach with his declaration of martial law on the 3rd of December. The decree was a wild strike against the opposition Democratic Party, which had effectively paralysed his presidency since taking power in parliament earlier this year.

The move set off a chaotic few hours of street protests with deployment of the military in the streets of Seoul and politicians of all stripes, including the head of the president’s own People Power Party, denouncing the declaration. The drama culminated in a unanimous vote by the country’s legislature (including members of the president’s party) to reverse the failed coup attempt.

Big moves in the Won and Korean equities

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Source: Bloomberg Opinion, December 4, 2024

Yoon now faces the threat of impeachment, but that is probably the least of his worries. Around half of South Korea’s living former presidents are sitting in prison, and Yoon may be set to join their ranks.

Is it too rose-tinted a view to argue that the legislature’s swift move to strike down the declaration is a positive demonstration of institutional checks shifting into gear? Almost certainly, as the People Power Party has said that it will seek to block any impeachment motion in the legislature (the motion requires a two-thirds majority of the 300-seat parliament). It is safe to say that this political crisis is set to grind on for some time yet.

Sitting tight

We have been underweight South Korea, with low exposure to the domestic economy  through bank KB Financial, Kia and Hyundai, partly reflecting weak monetary trends. DRAM export giants SK Hynix and Samsung Electronics make up two-thirds of our holding.

Earlier this year we wrote to investors on the prospects for the Value-Up corporate reform program promoted by the Yoon government to boost perennially cheap Korean equities (Super-cheap Korean equities rally on market reform talks). At the time we had shifted to a significant overweight, favouring likely domestic reform beneficiaries.

However, a landslide win for the opposition DPP in the legislature in April made it less likely the program would be implemented in full. The political shift occurred against a weakening economic backdrop globally, and also in South Korea’s highly cyclical domestic economy.

Following a downgrade to our country rating, we reduced exposure to Kia and Hyundai. We also took some profits from our position in SK Hynix after strong performance on its monopoly as a high-bandwidth memory supplier to Nvidia.

Given the above, we are not tempted to try and catch a falling knife by doubling down in South Korea.

Samsung Electronics is cheap, but is that enough?

Following a strong start to the year, Samsung Electronics fell sharply since July and now ranks as one of the worst performers year-to-date in our portfolio. What happened?

Sell-off for Samsung Electronics since July

A line graph illustrating the value of Samsung Electronics Co. Ltd over the past 12 months.
Source: Bloomberg

Investors fear that management missteps have cost the company its technological edge in chipmaking. Indeed, we have been surprised by how badly Samsung has lagged SK Hynix in high-bandwidth memory. It ranks as a distant second to Hynix as a supplier of HBM3E memory to Nvidia and it is uncertain whether the company can close the gap in the next generation of HBM products.

In addition, the long hoped-for demand recovery in commoditised DRAM products is yet to arrive. More bearish analysts fret over the rise of Chinese memory and what this could mean for the Samsung-Hynix-Micron oligopoly, which has kept supply in check over the past decade.

Samsung Electronics, SK Hynix and Micron have maintained an iron grip on DRAM supply
A bar chart illustrating the share of DRAM revenue between the leading manufacturers.Source: Statista 2024

Major Chinese DRAM players like CMXT are yet to register in global market share, but risks to the oligopoly may emerge down the road.

All of the above paints a pretty sorry picture for Samsung, reflected in valuations that are at the bottom of historic ranges.

Buying at these levels has historically been a good bet – Samsung Electronics Price/Book

A line graph illustrating the price to book ratio of Samsung Electronics Co. Ltd over the years.
Source: Bloomberg

Management is desperate to turn this around through deep restructuring, boosting R&D spend and buying back shares. Samsung has a history of pivoting out of trouble, and the valuation is incredibly cheap for one Asia’s most successful tech behemoths.

We are not tempted to double down at these levels, but plan to maintain the current weighting. Moving forward, we will look to see whether Samsung can reassure investors by gaining qualification as a HBM supplier for Nvidia’s leading-edge products. Not only would this boost earnings, it would also signal that it can close the tech gap with SK Hynix.

Mindful of “success bias” in US equities

Investors in emerging markets are going against the grain. Today the herd is stampeding into US stocks. The drivers for the dominance of US equities are compelling, propelled by better economic performance, higher productivity growth and innovation.

Equity flows by region
A series of bar and line charts illustrating equity flows by region.
Source: EPFR

And yet, making money as an investor is all about the delta between reality and expectations. Investors myopically fixated on market narratives about US exceptionalism as justification for extreme outperformance versus the rest of the world risk overstaying their welcome, along with missing opportunities in unloved markets.

Ruchir Sharma’s Financial Times article The Mother of All Bubbles opines on just how dominant the United States has been as an investment destination:

  • Global investors are committing more capital to a single country than ever before in modern history.
  • And the dollar, by some measures, trades at a higher value than at any time since the developed world abandoned fixed exchange rates 50 years ago.  
  • The US now attracts more than 70 per cent of the flows into the $13tn global market for private investments, which include equity and credit.
  • America’s share of global stock markets is far greater than its 27 per cent share of the global economy.
  • Thoroughly dominating the mind space of global investors, America is over-owned, overvalued and overhyped to a degree never seen before.

UBS just published some excellent charts illustrating just how stark this dominance has been:

Relative sizes of world stock markets, end – 1899 (left) versus start – 2024 (right)
Two circle graphs comparing the relative sizes of world stock markets from the end of 1899 and the beginning of 2024.

Source: Global Investment Returns Yearbook 2024, UBS

Investors adding to US exposure at the expense of the rest are making a bet that such scorching outperformance can continue.

While it seems unlikely, author of liquidity theory and bubble expert Gordon Pepper said that to work out the duration of a bubble, take your best analysis to work out how long it will go, double that, and then subtract a month. In other words, extenuated bull markets (or bubbles) have a habit of going on longer than we could ever imagine before ending abruptly (and often brutally).

We believe it is a fool’s errand to attempt to predict when equities ex-US will be back in vogue. However, what we know for sure is that less competition among buyers in unloved emerging markets tilts the odds of unearthing value-creating businesses at attractive prices in our favour.

Aerial view of Cairo, Egypt showing the 6th October Bridge crossing over the Nile.

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 several key factors influencing returns and share observations on the portfolio and the markets.

Internet and technology portfolio

Investments that we wrote about in previous letters, including Lithuania’s Baltic Classifieds Group (BCG) and Egypt’s Fawry for Banking Technology and E-Payments (Fawry), performed well in the quarter.

BCG is 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. The company’s shares rallied in the quarter as the market reacted positively to the exit of Apax Partners LLP, the private equity firm that brought BCG to market via IPO in July 2021. Private equity ownership of public companies can often lead to an overhang on the share price and liquidity in the market. Typically, incremental buyers are discouraged by the prospect of an eventual wall of shares hitting the market when the private equity owner(s) decides to sell, and liquidity is lower because a relatively large percentage of the outstanding shares is not freely floated. A high-quality business like BCG, whose revenues and operating profits grew approximately14% annually over the last 4 years, generally absorb this type of overhang on their shares as incremental buyers step into liquidity events with more confidence. This was the mindset with which we approached BCG and thus actively participated in Apax Partners’ share sales this year, ramping up our participation as they approached their exit sale in July.

Fawry is the leading payments technology company in Egypt. The business is anchored by a base of over 360k point of sale machines (POS) that enable merchants to accept payments for the sale of their own merchandise (e.g.: a carbonated beverage) or on behalf of other large businesses like telecoms and utilities. Fawry has leveraged its first mover advantage in POS by introducing value-added services to their merchants such as supply chain financing (i.e.: working capital loans), ATM (a consumer can take out cash from a POS using the merchant’s float at the till for a fee), payment acceptance across many services and agency banking where it acts as a distributor of bank products to underbanked merchants and consumers through dedicated branches that are branded FawryPlus.

Fawry’s merchant offering extends beyond brick and mortar; it is also a leading payment gateway enabling online payments between consumers and merchants and, in the process, captures a piece of the fast-growing e-commerce market in Egypt. On the consumer side, Fawry’s app (MyFawry) counts over 5 million downloads and is experiencing strong momentum, driven by the introduction of a wide range of use cases including bill payments, virtual debit card wallets, buy-now-pay-later, insurance and savings products. In an inflationary environment like Egypt’s, Fawry’s transaction-based revenue model means it can grow revenues at a faster rate than costs due to the operating leverage inherent in its business. This was evident in second quarter 2024 results with operating margins expanding by more than 6% compared to the same period last year. Fawry shares reacted positively to the results, and more importantly to management guidance on net income for the full year, which implied a growth of about 67% y-o-y in local currency.

Like BCG, Fawry shares also benefited from the exit of private equity firm Helios Investment Partners (Helios) from the company in the quarter. Helios has been pressuring the shares through open market sales. Like the BCG case, we took advantage of the liquidity event and were involved in a discounted clean-up sale in which Helios sold its remaining 5% stake in Fawry, which helped remove the overhang on the shares.

Healthcare portfolio

The strategy experienced good returns from the healthcare portfolio during the quarter, driven mainly by Morocco’s Aktidal Group (AKT).

AKT is the leading healthcare provider in the country with approximately 15% of the private bed capacity in the country. The Moroccan healthcare market is severely underserved, with the rates of beds and physicians per 1,000 persons below regional averages and well below WHO recommended levels. (A WHO study ranks Morocco 79th of 115 countries in doctors per capita.) This has severely curtailed investment in the sector, with private providers accounting for under 30% of bed capacity in the country of around 40 million people. To address this shortage, the Moroccan government embarked on a series of reforms including rolling out a universal healthcare scheme and removing a restriction that allowed only doctors to invest in the sector. AKT operates 2,532 beds in 23 sites spread across 11 cities.

The clinics managed by AKT are known for their quality of care and the strength of their oncology department (30% of consolidated revenue). AKT is at the forefront of the growth in the sector: its 2023 results which showed revenue and operating profit growth of 84% and 86% respectively. On a recent trip to Morocco, we conducted site visits and meetings with Moroccan doctors and competitors of AKT which validated the company’s brand and reputation in the market and highlighted the growth opportunity that lies ahead for the company.

Outlook

We continue to be constructive on the opportunity set for the strategy as we enter the fourth quarter of the year. We believe we positioned the portfolio to be considerate of changes in the interest rate cycle, political environment and portfolio company valuations. As always, the ultimate objective of our decision-making process is to express our best research opinions through a diversified portfolio of high-quality businesses that we believe will help us deliver on the strategy’s return objective.

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

Sunset over the King Abdullah Financial District in the capital, Riyadh, Saudi Arabia.

MENA equity markets had a strong third quarter of 2024 with returns of 6.7% (for the S&P Pan Arabian Index Total Return) but trailed the MSCI Emerging Markets Index, which was up 7.8% in the same period. For the first nine months of 2024, MENA equity markets are up 5.4% compared to 14.4% for the MSCI EM Index.

Our team spent time in Saudi Arabia recently and came back feeling positive about the Kingdom’s medium-term prospects. The impact of the bold socioeconomic reforms that the country pursued in the last few years is visible not just in economic activity (and bad Riyadh traffic), but also in the sentiment expressed and captured in interactions we had with company executives, government officials, Uber drivers and hotel and restaurant staff. One can make the case that Saudi women have been the group that benefited the most from the country’s reform program. The elimination of the religious police establishment and lifting of the driving ban led to freedoms and mobility that Saudi women had not experienced before in their own country. This resulted in remarkable growth in their labour force participation, with data from the World Bank showing it had increased from 20% in 2018 to 35% in 2023. Much has been written about the changes that have been taking place in the Kingdom in the last few years, and we will not expand further on that here. However, we believe Saudi Arabia is in the early innings of a major societal and economic transformation project that will generate multi-year growth in profit pools in certain sectors like financial services, healthcare, education, entertainment, tourism, real estate and technology. Some of the profit pool growth will come at the expense of sectors that are not prioritized under the government’s Vision 2030 program or are not as geared to the evolution in consumer behaviour and evolving regulatory environment. These include brick and mortar retailers or companies that over-earned on government contracts, and which can be found in several sectors including construction and engineering.

Of course, not all is rosy in the Kingdom. While significant progress was made on diversifying the economy, nearly three quarters of the budget is still funded from oil revenue. If it stays, the current combination of low oil prices, production curtailment and high government spending is likely to weigh on growth or raise the risk of fiscal imbalances in the long term. The economic viability of some of the giga projects is difficult to determine and so poses additional capital allocation and fiscal risk. Positively, the country is preparing for this reality and has been actively diversifying its sources of funding from debt and equity capital markets. According to Fitch Ratings, Saudi Arabia was the largest US dollar debt issuer in emerging markets (ex-China) in 1H 2024. The listing of Saudi Aramco and the dividends that the government will receive from that will also continue to support the budget.

Additionally, inflationary pressures are building up in the system – specifically in Riyadh as demand- and supply-side factors collide in areas of housing and transport. This is resulting in downward pressure on household disposable incomes and is manifesting itself in downtrading and increased household debt. Unsurprisingly, many consumer companies are observing down trading in their revenue mix, and many are reacting through aggressive discounting to preserve market and wallet share. Consumers are embracing buy-now-pay-later financing to maintain or extend their purchasing power and this channel is becoming increasingly more prominent in the revenue of many consumer-facing businesses. Furthermore, consumer pressure in Saudi Arabia has the potential to delay further necessary reforms and regulations that can open new profit pools as the government looks to strike a balance between diversifying the economy and protecting consumer purchasing power.

The strategy has had good success investing in Saudi Arabia from identifying growing profit pools early on and investing in companies that were best positioned to grow their share of them. Those include companies we have previously discussed in our letters such as Saudi Dairy & Foodstuff Co. (SADAFCO) in 2018, National Company for Learning and Education (NCLE) in 2019, and The Company for Cooperative Insurance (TAWUNIYA) in 2023. However, there are several challenges that have impeded our ability to express a fuller position in some of the sectors mentioned above. Firstly, we view the quality of certain companies in sectors like real estate and tourism as relatively poor and place some of those in the over-earners group we describe above. The other dynamic that has been increasingly challenging to navigate is the valuation environment, especially with regards to growth stocks. In the last two years, the market moved well ahead of earnings expectations, creating an unfavourable risk-reward set-up for companies the strategy owned and prospected. Using the MSCI Midcap Saudi Index to proxy growth companies in Saudi Arabia, we find that the price-to-earnings (P/E) ratio in 2023 was 38 times, more than double the 2022 levels and above levels we believe reflect cost of capital and growth dynamics on the majority of stocks in that index. Of course, we have made exceptions where we maintain ownership of a few high P/E ratio companies only when we believe their quality and growth potential justify such valuations. While we strongly believe in momentum as a factor for driving returns and outperformance, valuation is the ultimate determinant of our capital allocation reflexivity.

Fortunately, there are three factors working for the strategy at the moment. Firstly, there are growing profit pools resulting from reforms and demographics which is critical to our investing style – growth. Secondly, in the last two months, the market has begun the long-awaited process of recalibrating its expectations of earnings to levels that we deem realistic and interesting – reasonable valuations. Lastly, the strategy has already begun shifting the portfolio to areas where there is a healthy combination of growth, risk-reward and low investor positioning. One particular area where the strategy has been net buying in is the Saudi conventional banks, where we believe technical overhangs have largely suppressed price discovery year-to-date. The set-up for next year looks particularly attractive as those headwinds become less pronounced and bank earnings continue to compound.

We look forward to continuing to update you on the strategy in the next letter.

Asian lady using a tablet to review stock exchange financial and investment data.

A look at the potential impact of President Trump’s policies on emerging markets, the risks of rising trade tensions with China and the resilience of China’s domestic market

US politics has shifted to the right with an unexpected red sweep of the presidency, Senate and House. Gloomy prognostications for emerging markets abound on expectations for a stronger dollar, stickier inflation and a less dovish Fed. Yet there is very little to go on in terms of hard policy. For example, would President Trump risk a tit-for-tat tariff spiral with China and the EU, or will he pursue deals which incentivise foreign exporters to build manufacturing assets in the US to secure exemptions or reductions? The EU has done something similar with Chinese carmakers.

On inflation, increased deficit spending may be inflationary from 2026 onwards, but our broad money signals suggest the current backdrop is still disinflationary and likely to force a flat-footed US Fed into playing catch-up in its cutting cycle in the short term. This should be weighed against the assumption that Trump means a strong dollar. Further out, with mid-term elections occurring in November 2026, the re-election of the House and a third of the Senate could provide a check on the fiscal agenda.

Should risks of rising trade tensions materialise, this may make EM countries with large domestic markets (i.e., China and India) relatively more attractive versus smaller, open, trading economies in ASEAN.

Overall, our instinct is to avoid knee-jerk repositioning on speculation, at the risk of being whipsawed down the road should events differ from expectations. The reality is that the anti-tyranny checks embedded in the US constitution mean that the president has less power than we commonly think. Our view is that it will pay to remain focused on the cyclical and structural factors at play in shaping return prospects across equities and other asset classes.

Stock picking in a China bull market

Chinese equities took off in the final week of September, rising around 25% in USD terms as announcements of incoming and meaningful monetary and fiscal stimulus blew away traders shorting H-shares and sparked significant domestic inflows. Foreign investors remained on the sidelines.

China equities flows: Domestic vs. foreign investors 
Chart showing China equities flows: Domestic vs foreign investors.
 Source: EPFR

The rally was so big that Chinese stocks are virtually level-pegging US equities as at the end of October.

MSCI Price Indices (USD Terms, 31 December 2023 = 100).
Source: NS Partners; LSEG Datastream

This spurt, led by beaten-down names including property developers and domestic insurers (with high property exposure), is likely the first leg of this rally. We see the pullback in recent weeks as an opportunity to reposition more aggressively at the margins (from a defensive equal weight). While stimulus won’t be a bazooka on the level of 2008-09, the imprimatur for the measures from Xi Jinping himself suggests they will keep coming until we see at least stabilisation in the Chinese economy.

While the threat of tariffs looms for exporters, China has a huge domestic economy with a deep equities market. Direct exports of goods to the US account for only 2.6% of Chinese GDP, less than for Japan and Germany.

With stocks still trading only slightly above their lows of around 10x CAPE, there is an opportunity for deep fundamental analysis to unearth high quality and growing names that have been knocked by investor revulsion for Chinese equities.

MSCI China Style Indices (Relative to MSCI China, 31 December 2023 = 100).
Source: NS Partners; LSEG Datastream

For those interested, a short primer on our stock picking approach below – skip ahead for our coverage of current stock opportunities in China.

Our approach to stock picking – focus on economic value added (EVA)

Made famous by Stern Stewart & Co., the approach homes in on the spread between the rate of return on a company’s invested capital and its cost of capital; economic value added, or EVA for short.

Why? We know that over the medium to long term, EVA is directly tied to the intrinsic value of any company and the fuel that fires up a company’s stock price.

Stock prices reflect how successfully a company has invested capital in the past and how successful it is likely to be at investing new capital in the future. EVA is the best methodology to measure the value that management has added to, or subtracted from, the capital it has employed over time.

How can management create value?

Bennett Stewart in his book The Quest for Value boils it down to three drivers:

  1. The rate of return earned on the existing base of capital improves; that is, more operating profits are generated without tying up more funds in the business.
  2. Additional capital is invested in projects that return more than the cost of obtaining new capital.
  3. Capital is liquidated from, or further investment is curtailed in, substandard operations where inadequate returns are being earned.

We are looking for companies that can be expected to generate high or improving returns on the capital employed in their businesses. These are companies run by management teams laser-focused on making investments that earn more than the cost of capital, and undertaking all positive net present value projects, while rejecting or withdrawing from all negative ones.

Menu of investment opportunities available within a single company.
Source: Bennett Stewart (1991), The Quest for Value

Understand what drives returns

Value creation is not enough for long run success. We need to know whether it can be sustained. Our process is focused on identifying the drivers of these returns and assessing:

  1. whether there are historic changes or potential catalysts for improved value creation that are yet to be reflected in market prices; and
  2. the sustainability of those returns – are there enduring competitive moats that will protect excellent returns on invested capital?

Our approach identifies highly productive and capital-efficient companies pursuing value creation in a variety of ways. It also focuses on whether that value creation is sustained via competitive moats.

Moats can take a number of forms, from differentiation via proprietary tech, brands or prime locations, to high switching costs, network effects, cost leadership, economies of scale or minimum efficient scale.

Investment edge

This strategy got its start just as the Asian Financial crisis of 1997 unleashed havoc across the region before spilling over into Latin America and Eastern Europe. We know firsthand through several cycles that emerging markets expose investors to both great opportunity but also the potential for downside shocks. Investors have endured a torrid decade in EM equities, but the signals we track suggest an improving outlook. We aim to capture that opportunity through a combination of identifying robust and growing companies compounding ROICs coupled with liquidity and macro analysis – the heart of an all-weather approach that has delivered outperformance over the long run.

Eastroc – The domestic energy drink champion

The potential for China’s economy to stabilise on stimulus efforts could feed the next bull market in China. While China looks cheap across the board, our view is that laggard quality growth names look particularly attractive.

 

MSCI China Style Indices (Relative to MSCI China, 31 December 2022 = 100).
Source: NS Partners; LSEG Datastream

Eastroc Beverage fits the bill as a fast growing, highly profitable and yet attractively valued domestic energy drink champion.

Tired? Drowsy? Drink Eastroc.

P/E has drifted lower while earnings have held up
Chart showing P/E has drifted lower while earnings have held up.
Source: Bloomberg

There is plenty of headroom for growth in the segment, with energy drink consumption by volume in China at only 58% of Japan, 32% of the US, and 23% of the UK (Source: Bank of America). Growth drivers include the expansion of the gig economy, along with new consumption channels in music concerts, e-sports and parties. While major cities are posting healthy consumption growth of c.10% CAGR, peripheral markets are growing rapidly at c.35-40%.

Red Bull stumbles

Eastroc is mounting a fierce challenge to incumbent Red Bull, growing market share from 5% in 2012 (with Red Bull at 80%) to nearly 30% in 2023. Not only has Eastroc been effective in building its distribution network out from its Guangdong home base in Southern China, it has also been able to capitalise on strategic missteps from the incumbent. A fallout over a lapsed distribution agreement between Red Bull’s Thai and Chinese operators has spiralled into open warfare over the market. The bickering sister companies are fighting each other in provincial courts, launching rival marketing campaigns and even different pricing strategies. Eastroc offers distributors higher margins and pricing stability, making them more willing to stock the challenger’s inventory. In addition, Eastroc offers value at around half the price per 500 ml of Red Bull, so benefiting from consumers trading down in a weak economy.

No. of sales points.
Source: Eastroc Beverages 2022

Retail price comparison, Red Bull vs Eastroc.
Source: Eastroc Beverages 2022

Optionality through new product lines

What we find particularly interesting is the potential for new growth drivers outside its flagship energy drink. Healthier and plant-based energy drinks targeted at women, electrolyte drinks targeted at sporting activity and sugar-free teas can are all large and fast growing segments.

Eastroc water boost, replenish electrolytes rapidly.
Source: Eastroc Beverages 2024

Eastroc already has a strong distribution network to sell these new lines into, meaning the investment to drive this growth will be relatively small, boosting returns on capital.

Our kind of business – EVA, cash flow and Du Pont tests (charts and data below from Bloomberg)

Growth requires capex to build out the distribution network, and yet Eastroc looks like a cash machine.

Cash Flows - line chart comparing OCF % sale, FCF % sale and Capex % sale.

Overheads look contained as it expands.

SG&A / Sales

This business scales well.

Scalability - Capex % sale vs Sales YoY.

Paid by customers early while pushing out payables.

Working Capital - chart comparing DSO, DIO, DPO and Cash Conversion Cycle from 2019 to 2023.

Margins are resilient.

Margins - GPM vs EBIT Margin.

Unsurprisingly, the EVA (ROIC/WACC spread) is high and set to rise over the next 2-3 years.

Opportunity among the quality names in China

Eastroc is the fast-rising challenger to Red Bull in China and enjoying strong growth tailwinds in the energy drink segment. The company is able to squeeze more value from its established network in Guangdong without tying up significant capital. The capital that it does invest is used to expand carefully into new territories that promise returns that far exceed the cost of capital.

Eastroc is the type of stock we would expect to outperform should this upward move in Chinese equities mature into a wider bull market. CCP stimulus efforts are not yet enough to shift consumer sentiment meaningfully, but valuations are compelling and the growth is there for companies like Eastroc to perform regardless.

Business people walking in front of a building in Beijing, China.

Chinese equities rallied 24% in USD terms through September, much of this in the final week of the month following the announcement of significant monetary and fiscal easing by the PBoC and Politburo respectively. Leading the move were the prime victims of China’s deflationary slump, including online securities broking company East Money (up 90%), property developer Vanke (82%), consumer laggards such as JD.com (57%) and Meituan (46%), along with names in banking, insurance and construction.

Our more cash generative and growing holdings surged, just not as much as the wider market. This included pan-Asian life insurer AIA Group (27%), energy drink beverage maker Eastroc (20%), Spring Airlines (24%), and tech giant Tencent (17%).

The majority of GEM investors, who have been significantly underweight Chinese equities for years, were caught out by the vertiginous rally fuelled by hopes the policy measures signalled a shift from the CCP towards domestic reflation.

GEM investors have maintained underweight positioning in China
A line graph illustrating the declining trend of GEM allocations in Chinese equities, based on October 2024 data from EPFR.
Source: EPFR October 2024

We flagged in our Q2 commentary that despite the risks of institutional quality deteriorating under Xi Jinping, the market was incredibly cheap and positive earnings revisions were beginning to come through:

Instead of allowing a market clearing to resolve supply and demand imbalances in Chinese property, Beijing is attempting a “managed” deleveraging. The issue is that a long and drawn out unwind threatens to entrench deflationary forces that undermine efforts to rebalance the financial system. Further complicating this is that efforts to prevent capital outflows through currency management limit Beijing’s monetary policy flexibility. We wrote in Q1 that a CAPE of 10x for Chinese equities likely signals the build-up of risks that prompts a shift in policy priorities to prevent a bust. While the shift to reflationary policy may indeed be a positive catalyst for unloved Chinese equities, the timing is uncertain.

Hence, we decided to stick with a defensive equal weight exposure in China, on a view that a policy pivot could come at any time and spark a sharp rally.

Our chief economist Simon Ward flagged in Money Moves Markets a few days before the rally that monetary growth was potentially bottoming, and that a falling USD/strengthening yen was opening up space for Chinese policymakers to act:

A key reason for expecting money / credit reacceleration is that the yen rally has relieved pressure on the RMB, easing monetary conditions directly and opening up space for further PBoC policy action. The balance of payments turnaround is confirmed by a swing in the banking system’s net f/x transactions, including forwards, from sales of $58 billion in July to purchases of $10 billion in August. This series captures covert intervention via state banks (h/t Brad Setser) and an August reversal had been suggested by a sharp narrowing of the forward discount on the offshore RMB, which has remained lower so far in September.

A line graph showing China net f/x settlement by banks adjusted for forwards ($ bn) & forward premium/ Discount on offshore RMB (%).
Source: LSEG Datastream

The stage was set for the largest rally in Chinese equities since 2008.

The rally reflects the significance of the monetary and fiscal policy announcements, which signal a shift in the way Xi Jinping views the state of China’s economy and the approach needed to break the malaise. How far is he willing to go?

Structural policy shift the fuel for a rally

Our view is that to break deflation, and for this rally to be anything more than just a liquidity driven trading opportunity, monetary and fiscal measures must be truly forceful. This would represent a structural shift in policy, and even the abandonment of a managed exchange rate in order to free up more room to stimulate. We aren’t so sure how likely this is. Although a falling USD and Fed rate cuts will certainly make a shift easier.

The signals from Beijing are certainly positive and indicate that a new approach is being embraced. Notably, the government is preparing to inject liquidity into the commercial banking system to expand balance sheets and boost money growth. In addition, the Politburo has pledged to deploy the fiscal bazooka to support local governments, small businesses, property and families (and not infrastructure).

Perhaps what is most significant is that Xi himself acknowledged the severity of China’s deflationary spiral and has taken up responsibility for fixing it. Will consumers and entrepreneurs respond, or will the stimulus be more pushing on a string? If the response is weak, Xi may feel compelled to do more lest he look incompetent.

Overall, the relative attraction for Chinese equities has increased. The rally has been short and currently looks overbought. We expect pullbacks to provide opportunities to add to China exposure and become less defensive, while favouring A-shares which should pick up some of the running from here.

Palacio de Bellas Artes building in Mexico City's downtown at twilight.

The recent push by Mexico’s ruling Morena Party to undermine the country’s judiciary is a perfect example of why relying on company fundamentals alone in emerging markets can leave investors exposed to being whipsawed by macro factors.

We covered election risks across EM In July – Political risks in EM spike as Indian, South African and Mexican elections surprise – and flagged that outgoing president AMLO and president-elect Claudia Sheinbaum threaten to undermine Mexico’s institutional quality through a series of regressive reforms. The most damaging of these is the proposal to overhaul the country’s judicial system through having all judges elected by popular vote, along with relaxing the term limits and age/experience hurdles for Supreme Court justices.

As the Financial Times put it in September (FT: Mexico’s retrograde path on the rule of law):

Mexico is barrelling ahead with one of the world’s most radical shake-ups of a legal system, alarming investors and citizens alike. In his final month in office, President Andrés Manuel López Obrador is using his coalition’s congressional supermajority to ram through constitutional changes to change the entire supreme court and several thousand state, federal and appeal court judges with replacements elected by popular vote. Candidates for some posts will need only a law degree, five years of undefined “legal experience” and a letter of recommendation from anyone in order to run.

 Lawmakers have been on strike in recent months protesting the move, but to no avail. In September, Morena wielded supermajorities in both the lower house and Senate to push the reform through, which will see thousands of judicial positions up for election over the next three years. Rather than officials working their way up the legal hierarchy, the judiciary will now be exposed to the corruption, bribery and intimidation of Mexico’s cartels, according to critics.

Snatching defeat from the jaws of victory

Mexico should be in prime position to benefit from supply chain reshoring following the pandemic and ratcheting-up of the Sino-US dispute. Indeed, FDI (much of it from China – Why Chinese Companies Are Investing Billions in Mexico – The New York Times (nytimes.com) was pouring into the country to pursue a bright trade story. We saw this in the sharp appreciation of the Mexican peso and a bull market in Mexican equities through 2023 (MSCI Mexico up 42% in USD terms) with the market a favourite among foreign investors.

US imports from Mexico have outpaced imports from the rest of the world
US imports, index Jan. 2017 = 100

US and world imports from Mexico from 2017 to 2024 based on data from GBM Nearshoring Barometer.

Source: GBM Nearshoring Barometer, August 2024.

 

Mexico a favourite for foreign equity investors through 2023

Global Emerging Markets active versus passive country allocations from 2022 to 2024 based on data from EPFR.

Source: EPFR

 

 Sentiment soured on deterioration in the political outlook as Morena’s dominant performance in Mexican elections in June emboldened the party to pursue a series of regressive policies. As we noted in June:

Investors fear that a strengthened mandate will allow Sheinbaum (or even an outgoing AMLO) to undermine judicial independence and pursue plans to eliminate autonomous government agencies overseeing telecoms, energy and access to information, as well as weaken electoral supervisory bodies.

Currency overvaluation correcting in Mexico and Brazil
Real broad effective exchange rates, % deviation from 5y ma

Real broad effective exchange rates deviation in percentage from 2015 to 2014 based on data from NS Partners and LSEG Datastream.

Source: NS Partners and LSEG Datastream

 

From being one of the consensus overweights among EM investors last year, Mexican equities have been hammered in 2024. MSCI Mexico is down 21% in USD terms to mid-September, while the broader index is up 7%.

MSCI Mexico and MSCI Index based on data from Bloomberg.

Source: Bloomberg

 

Losing the FDI beauty pageant

As one trade official explained to us on a recent research trip in India, competing for FDI is a beauty contest where participants must maximise their appeal relative to their competition to attract those seeking to deploy capital. China’s retrogressive turn to favour state-owned enterprises rather than the entrepreneurs that fuelled its economy’s meteoric rise is a golden opportunity for ambitious leaders in other emerging markets to step up and attract capital and supercharge development. We are seeing this across ASEAN and in India, eastern Europe and the GCC.

But none have Mexico’s advantage of geographic proximity to an economic juggernaut in the US. President-elect Sheinbaum has talked up Mexico’s nearshoring potential and support for private investment in recent months. However, the rhetoric belies an agenda to undermine Mexico’s institutions, which has unnerved key trade partners and investors.

Nothing scares investors and compromises progress up the development ladder more than attacks on key institutions such as the judiciary. In August, the US Chamber of Commerce warned the Mexican government that the reforms would be likely jeopardise trade relations:

 “The U.S. Chamber of Commerce respectfully calls on the sovereign Government of Mexico to continue deliberations with the private sector, academics and legal experts on the package of reforms the new Mexican Congress intends to consider in September. This dialogue is essential to ensure that the proposed reforms contribute to strengthening the rule of law and conditions for economic growth in Mexico.

 Given our longstanding commitment to Mexico’s growth and prosperity, the U.S. business community is an important stakeholder in the reform process. American companies represent by far the largest source of foreign direct investment in Mexico and provide good jobs to millions of Mexicans. Whether operating in the U.S., Mexico or anywhere else in the world, American businesses depend on respect for the rule of law as the foundation of a vibrant investment climate, sustainable development, and job creation.

 While there is a broad consensus about the need to strengthen Mexico’s judicial system, we strongly believe that certain constitutional and legal reforms currently proposed by the Mexican government – in particular, the judicial reform and the proposed elimination of independent regulatory agencies – risk undermining the rule of law and the guarantees of protection for business operations in Mexico, including the minimum standard of treatment under the U.S.-Mexico-Canada Agreement. The reforms also put at risk Mexico’s obligations under other international treaties to provide all with the right to a competent, independent, and impartial judicial system.

 Further deliberation to address these concerns is needed to avoid jeopardizing the incoming Mexican government’s ability to generate shared prosperity and to tap into the potential of nearshoring to strengthen the country’s economic growth and development.”

Macro matters – downgrading Mexico

Our process involves scoring the level of team conviction for every emerging market each month and includes an assessment of the direction of travel for politics in the short run and institutional quality in the long run. The trajectory is negative on both counts, and we think souring sentiment could have some way to run.

We have been underweight and defensively positioned in Mexico for well over a year, on a view that a slowing US economy would be an economic drag for Mexico. The deteriorating political backdrop flows through to a downgrade of our conviction rating for Mexico, and consequently a reduction in exposure. The market is already trading at a significant valuation discount to the 10-year average, but we think it can get cheaper still.

Portfolio activity

We sold our defensive staple Walmex last month, in favour of shale oil producer Vista Energy. While listed in Mexico, Vista is actually an Argentinian company boasting a growing production profile. Its shale assets in the Vaca Muerta (Spanish for Dead Cow) geologic formation are some of the best in the world. In contrast to Mexico, there are also some signs that the political backdrop in Argentina is improving under libertarian president Javier Milei, including efforts to deregulate the oil and gas sector which could provide an additional tailwind for Vista.

The race is on

As Mexico falters, we expect competition to reap the fruits of reshoring to heat up. ASEAN, the GCC and India are all banging on the door for foreign investment flows. Political stability, as well as safeguarding and improving institutional quality, will be the keys to success.

Aerial top view of skyscraper buildings and roads in Mong Kok district, downtown Hong Kong.

Investors have long been attracted to emerging market equities for their growth potential and unique investment opportunities. However, consideration of emerging market opportunities in fixed income has been less common. You may be surprised by the investment case for emerging markets credit and how an allocation can contribute to portfolio diversification and enhanced returns, as explored in this article.

Emerging markets credit refers to the debt securities issued by corporations and sovereign entities domiciled in emerging economies. The debt is denominated in either the ‘local’ currency of the issuer, or in currency of a developed market, such as the US dollar, which is referred to as external or ‘hard’ currency credit. Like their developed market counterparts, a credit rating is assigned to distinguish between investment grade and non-investment grade (high yield) debt.

Some of the key attributes of emerging markets credit include:

  • Large, diversified asset class: combined market value of emerging market local and external currency sovereign and corporate issuers is greater than the US treasury market.
  • Higher yield: can provide a spread premium over comparably rated, developed market
  • Less levered: borrowers are generally less levered than borrowers in developed markets
    at a similar credit rating.
  • Lower default experience: default experience has been at a lower rate than comparably rated, developed markets
  • Diversification merits: low correlation to developed markets credit due to economic cycles and market dynamics being different from those of developed markets provides diversification benefits.

Size of Market

The size of the emerging markets credit issuance may surprise many investors, especially when including both the local and external currency sovereign and corporate market, which when taken together has a market value greater than US treasuries (Figure 1).

Figure 1 – Major Fixed Income Markets

Major Fixed Income Markets Opportunity Set ($B)
US Treasuries $23,900
Other Developed markets Sovereigns $14,700
Emerging markets local currency sovereigns $11,100
Emerging markets local currency corporates $10,700
US Agency Mortgage Backed Securities $8,400
US Investment Grade $7,800
Emerging markets external currency corporates $2,500
Emerging markets external currency sovereigns $1,500
US High Yield $1,400

Source: JP Morgan

 

Emerging markets local currency sovereign and corporate credit have the largest market value. From the perspective of the borrower, the issuance of local currency debt recognizes that if a country has significant debt, say in US dollars, and its currency falls relative to the US dollar, the debt becomes more costly to pay back. However, the issuance of external currency debt can help diversify funding sources by allowing the emerging market countries to tap into international capital markets.

From the perspective of an asset manager, the added benefit from investing in emerging markets external currency credit, both sovereign and corporate, is it can help manage the risks associated with local exchange rate fluctuations. Moreover, emerging markets external currency credit is generally governed by New York or UK law, whereas emerging markets local currency credit is subject to the specific laws of the issuing emerging market country. Emerging markets external currency credit also offers a more diversified universe of investment opportunities. The focus of the balance of this article is therefore on emerging markets external currency credit.

Transformation of the Investment Landscape

There has been a significant transformation in the emerging markets credit landscape. In the early 1990s, the indices consisted of just 10 countries and had a heavy bias to Latin American economies. Today, there is a much healthier universe of countries, and unlike the equity market index whose market capitalization is dominated by a small number of countries, the sovereign and corporate credit indices are much more diversified in terms of country representation (Figure 2).

Figure 2 – Emerging Markets Sovereign and Corporate Credit Index

Figure 2 shows the Top 10% of the JP Morgan EMBI Global Diversified Index and the JP Morgan CEMBI Broad Diversified Index.

*JP Morgan EMBI Global Diversified Index            **JP Morgan CEMBI Broad Diversified Index

Source: JP Morgan, Bloomberg

 

There has also been a healthy annual issuance of emerging markets credit, with corporate issuance tending to be a larger component of the issuance compared to sovereign credit (Figure 3).

Figure 3 – Emerging Markets Credit Issuance

Figure 3 shows the breakdown of corporate and sovereign credit in emerging markets credit issuance from 2008 to 2024 (estimated), based on data from JP Morgan and FortWood Capital.Source: JP Morgan & FortWood Capital

 

Key Merits of Emerging Markets Credit

Higher yield: emerging markets credit market offers a spread premium over comparably rated developed markets peers due to perceived higher risks. Currently emerging markets offer some of the highest yields since the global financial crisis (Figure 4).

Figure 4 – Emerging markets credit yield vs. US 10-year treasuries

Figure 4 shows the emerging markets credit yield vs. US 10-year treasuries based on data from JP Morgan and Bloomberg.Note: EM Sovereign Index – EMBI Global Diversified, EM Corporate Index – CEMBI Broad Diversified
Source: JP Morgan, Bloomberg

 

Emerging markets are often susceptible to political and economic volatility. Changes in government, policy shifts, and geopolitical tensions can impact the creditworthiness of issuers. Sovereign credit also tends to have a longer duration (sensitivity to interest rate changes) and when combining these factors has led to emerging markets sovereign credit generally offering higher yields than emerging markets corporate credit.

Less levered: the perceived risk of emerging markets credit is not always justified despite the higher yield. For example, emerging markets corporate issuers, both investment grade and high yield, carry less debt relative to their ability to generate cashflow to service that debt, and are less levered than developed markets borrowers at the same credit rating (Figure 5). Despite carrying less leverage, emerging markets bonds have generally provided higher yields to investors for the same credit rating.

Figure 5 – Net Leverage Comparison

Figure 5 shows a comparison of net leverage of investment grade and high yield emerging markets corporate issuers according JP Morgan as of 2023.Source: JP Morgan (as of 2023) & FortWood Capital

 

Lower default experience: emerging markets issuers have historically defaulted at a lower rate than comparably rated developed markets peers (Figure 6). Many emerging markets exhibit robust economic growth, which can support the creditworthiness of issuers. For example, higher economic growth can increase corporate revenues, making the repayment of debt easier.

Figure 6 – Emerging markets corporates default less than developed markets peers
Average 10 year cumulative default rate (1981-2020)Figure 6 shows the average 10 year cumulative, default rate of emerging markets corporates to US corporates according to the SP Global Ratings Research.Source: S&P Global Ratings Research & FortWood Capital

 

Diversification merits: the economic cycles and market dynamics of emerging market countries often differ from those of developed markets. The different experience reduces the correlation, thereby providing a source of portfolio diversification. Investing across different countries, sectors, and issuers can reduce the impact of localized issues and enhance overall portfolio resilience.

Portfolio Construction Considerations

Currency management: for Canadian investors to manage any undesirable impact of fluctuations between US dollar denominated emerging markets credit and the Canadian dollar (CAD), the portfolio is typically hedged back to CAD, providing more predictable returns. This can be achieved in a cost-effective manner by the investment manager of the strategy using currency forwards, or other currency instruments.

Liquidity: emerging markets credit is generally a liquid asset class. For example, the liquidity of emerging markets corporate credit bonds is broadly comparable to that of developed market corporate bonds in normal market conditions.

Active management: there are numerous idiosyncratic economic and policy cycles across the different countries, which can contribute to added value opportunities for active managers. Also, like for emerging market equity, there are fewer sell-side research specialist for emerging markets credit compared to developed market credit, which creates opportunities for independent research. Skilled active managers can navigate market nuances, identify attractive opportunities, and adjust exposures in response to changing conditions.

Responsible investing: despite the political and social challenges associated with emerging market countries, governments and companies are increasingly recognizing the importance of environmental, social and governance (ESG) considerations.

Seize the Opportunity

Emerging markets credit presents a compelling investment opportunity with potential for higher yields, diversification benefits, and exposure to high-growth economies. Emerging markets credit can be a valuable addition to a well-rounded investment portfolio.