Emerging Markets – Page 3 – CC&L Financial Group Ltd.

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

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

Retail Portfolio

The strategy saw healthy returns during the period from the ASEAN retail portfolio, led by Philippines Seven Corp. (the master franchisee of 7-11 stores in the Philippines) and Mr. DIY Group (the multi-price point value retailer in Malaysia).

Our investment in Philippines Seven Corp. (SEVN) is premised on its first-mover advantage in convenience store (CVS) retailing in the country. As of the end of March 2024, SEVN has a network of 3,829 stores, ~9x that of its closest competitor. The magnitude of SEVN’s scale advantage is perhaps best captured by the fact that its annual store openings nearly match the entire store network of its closest competitor. Scale and location are key success factors in convenience retail, especially in an archipelago where an efficient and agile supply chain requires significant capital and operating investment.

From a top-down perspective, the Philippines’ large and young population (+100 million people with a median age of 25), expanding cities, and growing tourism sector should provide a long growth runway for CVS retail, resulting in a narrowing of the penetration gap (measured in CVS stores per capita) with neighboring countries like Malaysia and Thailand.

In addition to scale, location, and market opportunity, SEVN’s management team has proven over the years to be formidable operators and good stewards of shareholder capital.

Our team turned more bullish on SEVN at the end of last year, encouraged by evidence of an inflection point in store productivity, resilient operating margins, and an acceleration in store openings. Unusually, the stock was trading at all-time low multiples despite the company reporting three consecutive quarters of strong results. The team also identified a catalyst for the shares in the form of an expectation that SEVN will resume paying dividends after a three-year hiatus due to an SEC (the Philippines Capital Markets Regulatory Agency) mandated technicality. This technicality resulted from the implementation of IFRS 16 accounting standards in the Philippines in 2019. For SEVN, the capitalization of leases mandated by IFRS 16 standards created a large, deferred tax asset which, according to SEC rules, is deducted from the retained earnings base from which the company can pay dividends. On a recent earnings call, management estimated that the company is sitting on twice the amount of cash it needs to run and grow the business due to its inability to pay out excess cash. As SEVN’s operations accumulated cash (reaching ~20% of its market capitalization), retained earnings finally exceeded the regulatory hurdle above which dividends can be paid, and management was able to recommend a dividend to its board. Furthermore, management announced it is in the process of crafting a dividend policy that will entail distributing excess cash on an annual basis, a positive step.

Mr. DIY Group’s (MDIY) 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). This optimism stemmed from the restructuring of the Employee Provident Fund (EPF), which created a new “flexible” sleeve that allows for early withdrawals from beneficiaries below the age of 55 (previously, early withdrawals were only possible for critical needs like healthcare, housing, and education). The expectation is that this new feature (effective from May 11, 2024) will support disposable incomes and lead to a boost in spending among the B40 group.

MDIY is well-positioned to benefit from this given it is over-indexed to shoppers from the B40 group. For context, the company operates 1,283 stores in Malaysia (as of the end of March 2024) and has been expanding stores at a net rate of ~150 per year since 2017. This rapid expansion in stores has been internally funded by a highly cash-generative business model characterized by fast breakeven periods on new stores (2-3 years), reflected in industry-leading returns.

This profitability is supported by a virtuous cycle of supply chain optimization and store-level operating efficiency that enables the company to invest in price and offer shoppers value-for-money across the +10k SKUs it carries on its shelves. Low prices and new store expansion drive demand and larger volumes, which the company uses to negotiate with suppliers and unlock further discounts. Overlaying that cycle is a highly scientific approach to SKU management, which ensures optimized inventory turnover and minimizes drags on operations and the shopping experience. MDIY has also become more progressive with dividends in the last twelve months, with a quarterly payout policy of 50-65% of earnings, an appropriate level that balances the company’s strong cash position and growth requirements.

Internet and Technology Portfolio

Investments that the team made and wrote about in previous letters, including Vietnam’s FPT Corporation (FPT) and Turkey’s Logo Yazilim Sanayi (LOGO), performed well in the quarter.

We are especially pleased to see that FPT’s early foray into the AI space through global partnerships and acquisitions is helping it sustain a robust growth profile in global IT services. This was evident in the first half 2024 results, wherein global IT services revenue grew at ~30% in the first half of 2024 and is showing no signs of slowing down. FPT’s global IT services business exceeded $1bn in revenue in 2023, and recent underlying trends are positive with a larger proportion of higher-value digital transformation projects in the mix (47%), a diversified and growing geographical revenue stream across APAC, US, and Europe, and an increase in the number of contract wins in excess of $5m. FPT is also reinforcing its human resource advantage by adding AI and other technology modules to its university curriculum, which will help its own workforce and supply future skilled workers for other technology companies in Asia and around the world. For example, FPT University is expected to admit 1,000 students for the first batch of its semiconductor major, specializing in integrated circuit design.

LOGO shares performed well in the period as investor confidence in Turkey’s outlook strengthens. The government seems intent on pursuing macroeconomic policy orthodoxy that started a year ago. This policy goodwill is reflecting itself in Turkish assets, with the BIST 30 index up ~30% in the first half of 2024, and Moody’s upgrading its credit rating of the country by two notches from B3 to B1 in July. While it is early days and inflation remains stubbornly high (a staggering 75% in May 2024), Moody’s forecasts that inflation will begin to moderate from elevated levels and exit the year with a print of 45%.

If the economy does indeed turn a corner and business confidence grows, this will reflect positively on LOGO, which has so far underperformed the broader market (on a twelve-month basis) due to margin pressure from wage inflation and headcount investments, softness in its core SME segment in Turkey, and drag from its EUR-denominated low-margin business in Romania. Nevertheless, we remain confident in LOGO’s position as the leading enterprise resource planning (ERP) provider for Turkey’s large SME corporate market and are constructive on management’s initiatives to improve product flexibility through Software-as-a-Service (SaaS), and expand the product suite to new segments of the market (large retail customers, micro SMEs, e-government services, and HR). This should drive the penetration of ERP software in the country and position the company for strong earnings growth as business confidence returns.

Outlook

We continue to be constructive on the opportunity set for the strategy for the second half 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 promise to investors.

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

MENA equity markets had a weak second quarter of 2024 with returns of -4.2% (for the S&P Pan Arabian Index Total Return), trailing the MSCI Emerging Markets Index which was up 5% in the same period. For the first half of 2024, MENA equity markets are up 3.0% compared to 7.5% for the MSCI EM index.

The performance drag in the quarter can be partly attributed to a surge in equity capital market activity that led investors to sell existing positions to fund a long list of initial public offerings and secondary sales. Top of the list was the $12bn secondary share sale of Saudi Aramco, which drew strong demand from foreign and local investors and was reportedly multiple times oversubscribed. For context, the Saudi Aramco equity raise is equivalent to 5.5x the average daily traded value for the entire Saudi market in the second quarter of 2024 and resulted in an increase of ~3% in the market’s aggregate free float market capitalisation. (Note: much more money was actually drained out of the market given oversubscription levels).

In November 2019, when Saudi Aramco first listed, foreign investors were demonstrably absent from the deal, as many viewed both the company and the country as non-core and even un-investable. Less than five years later, foreign investors are reported to have accounted for over 60% of the $12bn Aramco share placement. This is a strong vote of confidence in the Saudi market, and an indication of the credibility that it has deservedly earned with foreign investors in a short period of time. Excluding Aramco, seven other transactions concluded in Saudi and the UAE in the second quarter, with an aggregate amount raised of $3.4bn. While this pace of capital raising is typically associated with a rich valuation environment (i.e., a low cost of equity and high multiples), we believe it serves the strategy well as it strengthens our long-term thesis on capital market development in the region.

As discussed in previous letters, we believe the region’s share of global market capitalisation will steadily increase over time and we have expressed that theme through an investment in Saudi Tadawul Group, the country’s stock exchange holding company. Moreover, the combination of new listings and higher free floats is deepening the strategy’s investable universe and opening opportunities for the strategy to invest in strong businesses in healthcare, technology, and infrastructure, sectors that have not been well represented in MENA public markets historically.

Two key, related events in the quarter were the dissolution of the Kuwaiti National Assembly and the suspension of certain articles in the Constitution related to legislative powers in the country. This surprise announcement was made in a televised speech on Friday May 10th by Kuwait’s Emir Sheikh Meshal Al Ahmad Al Sabbah. The Emir came to power in December 2023 after the passing of his predecessor. His televised speech demonstrated clear intentions to break the cycle of policy paralysis and deadlock that has plagued the country due to the hostile and volatile relationship between parliament and government.

Kuwait has had four elections in the last five years and its economy has suffered from very low economic growth, a bloated public sector, rising levels of corruption, and crumbling infrastructure (most recently on display in late June when the country announced power cuts due to peak seasonal demand in the summer). The decision by the Emir to strip parliament of nearly all its powers and transfer control to the government will likely mean that stalled and much-needed economic policy legislations like the debt and mortgage laws, approval of national development plans, and fiscal reforms will now see the light of day.

This is a significant development for Kuwait that we expect will unlock a capex cycle that will have to catch up on nearly twenty years of significant under-investment. To position for this, the strategy invested in National Bank of Kuwait (NBK), the country’s largest corporate bank with over 30% share of system loans. We believe NBK’s strong deposit franchise and market leadership puts it in a strong position to benefit from a multi-year loan growth cycle that we expect will commence in the second half of 2025.

Our team spent some time in Morocco this quarter meeting with portfolio and prospective companies. The primary objective of this trip was to validate the strategy’s investment in Aktidal Group (AKT), a leading healthcare provider in the country with ~15% of the private bed capacity in the country. (Note: the private sector accounts for ~30% of total bed capacity). AKT operates 2,532 beds in 23 sites spread across 11 cities. The clinics managed by AKT are reputed for their quality of care and are known for the strength of their oncology department (~30% of consolidated revenue). The Moroccan healthcare market is severely under-served, with bed and physician 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). To address this shortage, the Moroccan government embarked on a series of reforms including the rolling out of a universal healthcare scheme and the removal of a restriction that allowed only doctors to invest in the sector. AKT is at the forefront of the growth in the sector, as has been validated in its 2023 results which showed revenue and operating profit growth of 84% and 86% respectively. Site visits and meetings with Moroccan doctors and competitors of AKT during our trip validated the company’s brand and reputation in the market, and highlighted the growth opportunity that lies ahead for the company.

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

The underperformance of emerging markets equities relative to the US has tested the patience of even its most diehard advocates of the asset class over the past few years. While EM equities posted a respectable 9.9% return in USD terms in 2023, this looks anaemic next to a roaring 26.3% for the S&P 500.

The disparity between the US and EM over the past decade tempts investors into the behavioural trap of building conviction for future returns based on what has performed well in the recent past. It is easy to forget that the annualised returns from 2000 to end-2023 for EM were 7.6% versus 7.8% for the US, both outpacing 6.2% for MSCI World. The risk here is that a pro-cyclical mindset can lead to perverse thinking where conviction strengthens for a popular asset class as the likelihood of a good result decreases, and vice versa.

US equities outperformed on a decade of stronger economic growth out of the GFC, fed by a new credit cycle and strong fiscal deficits fuelling stronger corporate earnings and a dollar bull market, along with multiple expansion. On the flipside, EM moved through a painful deleveraging compounded by foreign reserve managers chasing US exceptionalism and buying dollars which choked EM further.

Several contrarian market commentators have recently pointed out that the fundamental picture in EM in many ways looks more compelling than in the US – lower valuations, trough earnings, cheap currencies, lower inflation, as well as greater fiscal and monetary discipline.

So what explains the continued underperformance, and is there anything that can break this cycle?

Vicious and virtuous circles in EM equities

George Soros’s theory of Reflexivity provides an explanation for how biases and preconceptions interacting with economic reality can distort market pricing and create extended periods of disequilibrium. For EM, the combination of weaker fundamentals coupled with a perception of US exceptionalism has led to the formation of a self-reinforcing feedback loop which has been a major headwind for the asset class. Below is a rough schematic for how this loop has played out.

Source: NS Partners.

Our view is that this cycle is coming to an end. Indeed, we believe that there is potential for a shift into a “virtuous circle” for EM, outlined below.

Source: NS Partners.

This outlook is based on a set of signals which we have used to advise clients invested in our DM and EM strategies looking to tweak the balance of exposure between the two. For context, our checklist is based on the idea that EM equities are a cyclical asset class and so tend to outperform when the global economy is strengthening (industrial cycle, commodity prices) and there is liquidity to chase the EM story (excess money, falling USD). They should also do better when economic prospects and earnings momentum are stronger than in DM (real money growth gap, revisions gap) and valuations are attractive.

Our latest update to the checklist (as of June 30, 2024) is below.

EM versus DM checklist
Source: NS Partners.

The balance of factors we monitor now favours emerging market equities for the first time in years.

Our two cents – don’t wait around until everything goes green, as you will have missed the sharpest part of the rally.

Two checklist factors deserve special attention, given their historical usefulness in signalling an improving environment for EM equities.

Liquidity

The E7 / G7 real money growth gap has been in favour of EM for some time, underpinned by better monetary policy making since 2020. This was reflected in better relative inflation performance for EM over DM, which has meant less need to tighten aggressively through the inflationary upswing, and potentially plenty of room to cut as the Fed eases.

Positive E7-G7 real money growth gap
Source: NS Partners and LSEG Datastream.

Additionally, the global excess money backdrop – proxied by the gap between real money and industrial output growth – may now be entering positive territory because of inflation peaking and industrial momentum weakening. The surplus liquidity can find its way into unloved financial assets, including EM equities. Prospective central bank pauses / reversals will sustain the trend.

Global “excess” money turning positive?
Source: NS Partners and LSEG Datastream.

This is what we call a “double positive” liquidity environment, and could signal improving prospects for EM equities. In periods where these two monetary indicators have lined up this way, EM equities have outperformed MSCI World by an average of 10.5% per annum. Periods of EM outperformance are indicated in the shaded areas of the chart below. They line up nicely with the double positive.

EM relative performance & monetary indicators
Source: NS Partners and LSEG Datastream.

King Dollar

The vicious and virtuous cycle diagrams above hint at just how important the dollar is as a driver of price and fundamental momentum in emerging markets.

The chart below illustrates just how large a tailwind or headwind the dollar can be for the asset class.

EM outperformance during secular USD declines
Source: NS Partners and LSEG Datastream.

The relative performance drawdown for EM versus global equities during the last dollar bull market is in line with previous dollar bull markets, but the period over which this has occurred is roughly twice as long. The risk for investors fatigued from such an extended period of relative underperformance is capitulation right as the asset class is primed to outperform.

The real trade-weighted dollar is far above its long-run average and may have reached another secular peak in October 2022 – recent strength has failed to take out this high.

October 2022 USD peak?
Source: NS Partners and LSEG Datastream.

The combination of monetary easing as inflation falls coupled with a weaker US dollar would provide a favourable backdrop for the outperformance of EM equities. Likely easing by the US Federal Reserve later this year will provide further scope for emerging market central banks to cut rates, allowing the credit cycle to move from stabilisation/recovery into expansion, providing support to economic and corporate earnings growth.

Such a pick up would encourage allocators oversaturated with US exposure to send marginal flows to emerging markets. With positioning at such extreme relative lows, even a small shift would be significant and another potential catalyst for entry into a virtuous cycle.

The futility of pollsters was on full display in India, Mexico and South Africa this month. Prime Minister Narendra Modi’s BJP fell short of expectations for a landslide in India. In Mexico left-wing party Morena took the presidency as expected, but came surprisingly close to a supermajority in Congress. In South Africa, the dismal performance of ruling party ANC opens up a new era of coalition politics.

Political risk spiking in these countries has fuelled some wild swings in their stock markets.

All three markets took a hit on election uncertainty through May-June

Source: NS Partners and LSEG Datastream.

Political risk is a factor that we consider as part of our macro analysis, which we know is crucial in EM investing. Fundamentals alone will not save you when the macro is headed south and the risk premium spikes. Outperforming in EM is about finding the right stock in the right country.

India

India’s Modi is set to become the first Prime Minister to serve three consecutive terms since the first post-colonial leader, Jawaharlal Nehru (Congress Party). Early June exit polls sent expectations (and stocks) soaring for Modi’s BJP to storm home to victory and claim as many as 400 hundred seats out of 543 in India’s lower house. Stocks exposed to infrastructure led the way on the expectation that a strong mandate would allow Modi to pursue a growth/investment-focused manifesto.

Instead, the BJP failed to claim a majority on its own and will have to rely on the support of regional allies to form government.

Seats won in the 2024 and 2019 elections

Source: Financial Times & Indian Electoral Commission, June 2024.

BJP strongholds crumble

The BJP ran on a record of positive reform over the past decade which has fuelled economic growth that has lifted millions out of poverty, cracked down on corruption, and built out electrification and sanitation access across the country. Tax reform also led to a doubling of tax revenue that has been reinvested into developing critical infrastructure, including freight railway lines and ports. Personalised rule and a presidential-style campaign positioned Modi as the figurehead of such rapid progress. At the outset of the campaign, approval ratings for the Indian PM were among the highest for any major democracy in the world.

Yet the damaging swing against the BJP came from the party’s Hindi-speaking northern heartland. The opposition INDIA alliance was able to peel away BJP supporters by targeting poorer rural communities feeling the effects of high inflation and unemployment.

Losses in Uttar Pradesh were pivotal

Source: Financial Times, June 2024.

Positive structural story intact

Modi nevertheless claimed victory in a coalition with regional allies known as the National Democratic Alliance. Despite the surprise verdict, it is unlikely that Modi will be prevented from pursuing his agenda barring a few tweaks likely to increase social spending. This may dilute business sentiment and infrastructure spending in the near term, while consumption should remain robust.

One positive is that the result should alleviate fears Modi would use a supermajority to pursue regressive constitutional changes. On the other hand, there also is a higher risk that a diminished Modi, a pro-growth moderate within the BJP, could cede influence to nationalist elements who will have more sway over a leadership transition.

Overall, our expectation for markets is some profit taking in the short term, while the long term structural story remains very positive.

South Africa

The African National Congress (ANC), South Africa’s dominant political party having governed since 1994, was rebuked by voters for having presided over a polycrisis in the economy, energy and law and order. The scale of the result was the surprise, while uncertainly looms over the make-up of a governing coalition.

The ANC fell a long way short of a majority, commanding only 159 seats of the 400 in the National Assembly. The graphics below illustrate just how sharply ANC support has fallen from a once commanding position.

2009 ANC National Assembly share

2024 ANC National Assembly share

Source: Daily Maverick, May 2024.

The result could mark the beginning of a new era of politics in South Africa. Much like with the decades-long decline of the Congress party in India, the ANC as a post-colonial liberation movement finds itself out of step with the challenges that confront the country today.

Uncertainty and opportunity

The horse trading to form a coalition government within the next two weeks is now underway. The worst outcome, a deal with a radical breakaway party such as disgraced former president Zuma’s MK, who wants to ditch South Africa’s constitution, is off the table, while a direct deal with Julius Malema’s socialist EFF won’t command a majority.

A coalition between ANC and the second largest party Democratic Alliance (DA) is clearly the outcome markets are cheering for, the most likely outcome is for the ANC to kick the can down the road through a multiparty alliance that should disintegrate within 12 months. The result of this may well be a broader re-alignment of South African politics. No doubt this will be a time of high uncertainty, but there is also a chance that some political creative destruction will act as a catalyst for positive change.

Mexico

While the election of Claudia Sheinbaum to Mexico’s presidency was widely expected, the surprise was her left-wing Morena party running close to a parliamentary supermajority. Mexican stocks tumbled 12% and the peso fell on the result as investors fret that a stronger mandate for Morena will allow Sheinbaum to carry on with the agenda of outgoing president Andrés Manuel López Obrador (AMLO).

AMLO’s chequered legacy

AMLO leaves office with high approval ratings owing in part to large cash transfers from the state and minimum wage hikes that lifted over five million Mexicans out of poverty during his term (The Economist (November 2023): Andrés Manuel López Obrador has reduced poverty in Mexico, but he could have done better). In contrast to India’s Modi alleviating poverty through reform-driven economic growth, critics argue AMLO achieved this by diverting funds away from education and healthcare.

Is Morena a threat to Mexico’s democratic institutions?

Crucially for investors, AMLO and Morena are pursuing policies that could threaten Mexico’s institutions. Institutional quality is a key factor in determining whether a country moves up the economic development ladder. Throughout his term, AMLO threatened to attack institutions on the notion that they have been corrupted by neoliberal partisans. His term also saw the military play a growing role in domestic affairs, becoming involved in major infrastructure projects, tourism and customs oversight, and the militarisation of domestic security as a response to rising cartel violence (which proved ineffective).

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.

Hopes for fiscal discipline

Finance Minister Ramírez de la O has been credited with steering AMLO away from the fiscal profligacy characteristic of so many socialist leaders in Latin America. Markets have welcomed his return in Sheinbaum’s cabinet, with the leader tweeting a series of pledges concerning the economy following a recent meeting with the Minister:

A fiscal consolidation in 2025 of 3% of GDP to stabilize public finances and the overall debt/GDP ratio;
Maintain an open dialogue with the investor community and rating agencies to reiterate the new government’s priorities: economic stability, fiscal prudence and feasible fiscal targets.
Work closely with Pemex [state-owned oil company] and take advantage of the government’s support in Congress to “optimize the use of public resources.”
Reiterate to international organizations and private investors that the government’s project is based on fiscal discipline, preserving and protecting Banco de México’s independence, a commitment to the rule of law, and incentivising domestic and international private investment.

We are encouraged that the incoming administration is clearly looking to soothe frayed market nerves.

Mexico has been a favourite for most GEM managers

We have been in the minority of GEM investors to remain underweight the market on concerns over political risk, an overvalued currency and exposure to a US slowdown.

GEMs active vs. passive country allocations

Source: EPFR, June 2024.

That’s not to say there isn’t real potential – the trend of global supply chain reshoring and Mexico’s geographic proximity to the powerhouse economy of the US leaves it well-positioned to harness a major structural tailwind in the years ahead.

However, making the most of this opportunity hinges on the dynamism of Mexico’s private entrepreneurs, supported by strong institutions. The question is whether Morena under Sheinbaum can resist their worst instincts.

Profiting as an investor occurs in the delta between expectations and reality. One example is the boom in enthusiasm for AI stocks being fuelled by blockbuster earnings of industry monopolies such as Nvidia consistently outpacing consensus forecasts.

In emerging markets, India’s bull market stands out as the obvious example of this. India has long appeared perpetually expensive to investors relying on mean reversion tables. The problem with this approach is that expectations may be out of kilter with reality when there is structural change occurring – much like in the new AI frontier – and the domain of the economy is expanding. The chart from Jefferies below illustrates this structural shift.

India is climbing the development ladder – on track to be the 3rd-largest economy globally

Source: Jefferies, Q1 2024.

A succession of reforms in Modi’s India is unlocking a virtuous circle of development, including:

Sanitation in every village empowering women in rural areas to become economic agents.
Establishing a nationwide digital payments network accessed through biometric identification, allowing even the illiterate to transact and access welfare payments.
That network allows the government to accurately calculate what taxes citizens owe, which has seen the state tax take double in around five years.
Higher government revenues alongside private investment are helping to fuel a new capex cycle, targeting electrification, ports, freight and telecommunications infrastructure.

The self-reinforcing nature of these reforms fuels the growth of what will become an enormous Indian middle class, whose consumption habits will evolve as they become wealthier. This surge in new wealth is also fuelling the rise of domestic pension funds, which are biased to equities given India’s young population and long investment horizon.

Careful relying on mean reversion when there is structural change

Source: Jefferies, Q1 2024.

Local allocators are more incentivised than foreigners to drive Indian corporates to improve corporate governance and returns for minority shareholders. This feeds into improving domestic liquidity, where it is increasingly local allocators that set the price in Indian equities, not fund managers in London or New York.

As investment strategist Keith Woolcock pointed out a few months ago commenting on the AI boom, there are times when valuation is the “alpha and omega of investing but most often it is not.” The same applies to India, where simple mean reversion can mean that investors miss the potential for upside surprise when positive structural change is occurring.

Is the bear market over in China?

China presents us with the flipside of the above – 1) longer-run structural risks as institutional quality deteriorates under Xi Jinping, which risks the country getting stuck in the middle-income trap; 2) this deterioration depressing the animal spirits of consumers and entrepreneurs who are less confident about the future; and 3) the rigid commitment of authorities to fiscal and monetary orthodoxy even at the risk of a deflationary bust.

This gloomy backdrop has seen foreign investors abandon the market, with Chinese equities halving since 2021. At 10x CAPE, China now trades at a record discount to the rest of EM, pricing in a dire economic outlook.

China now trades at a record discount to the rest of EM

Source: NS Partners, LSEG Datastream.

However, prices being driven to such depressed levels eventually exhausts the sellers to the point that a market can rebound even before a recovery in the economy or corporate earnings gain real steam.

Are we starting to see this in China?

Chinese equities have outpaced even the S&P500 this year

Source: NS Partners, LSEG Datastream.

Chinese equities have so far outpaced even the US, including an S&P500 Index dominated by the Magnificent-7 tech giants.

We have been writing to our investors for some time about the gradual economic recovery taking place in China, the steady improvement in earnings growth among corporates, and ratcheting up of fiscal and monetary support (but without the stimulus bazooka). Animal spirits remain broadly depressed, and risks lurk within property and the banks. However, with much of this pain priced in and with positioning in China at such depressed levels, all it takes is for a slight pick up ahead of expectations to ignite a rally.

Short positioning in Chinese equities has begun to unwind (falling by a third in China A-shares over the period), while GEM managers tentatively reduce underweight positioning. Indeed, April was a record month for foreign flows into Chinese equities.

Foreign buying of China stocks tops record

Source: Bloomberg.

There are a number of reasons to think that the rally can be sustained:

Positioning across GEM and global equity portfolios remains light, leaving plenty of headroom for allocators to add exposure and chase the positive momentum (forming a virtuous circle).
Policymakers, and most importantly Xi Jinping, have acknowledged the severity of the economic malaise and have pledged more aggressive measures to avoid a bust.
Company earnings are strengthening across several industries including travel, exporters and names aligned with key policy aims such as energy security, automation and import substitution.
The market is (finally) beginning to reward earnings beats.

This rally could carry on for some time. However, in contrast to India where we are more willing to run winners given the positive structural tailwinds driving the market, our bias is to be more conservative in China as the longer-term structural story remains negative.

China risks getting stuck in the middle-income trap so long as Xi continues to favour greater state control over rekindling the animal spirits and creative dynamism of entrepreneurs. However, much like in Japan’s lost decades, there were opportunities to take advantage of that delta between reality and depressed expectations, which precipitated sharp trading rallies. Also much like Japan, China’s deep universe of companies will offer up a rich opportunity set for active managers to generate alpha, even when running structurally lower exposure to the market.

In March, our team embarked on a two-week trip to two of the most dynamic economies within Emerging Markets: Poland and Turkey. During our visit, we engaged with companies spanning a variety of industries – from construction and renewable energy to waste management, IT, commercial services, airlines and airport operators. Also, we gained insights into the consumer sector, meeting with leaders in production and distribution for a wide range of consumer products, including confectionery, fast food, denim, automotive, electronics, soft drinks and beer. The trip’s objective was not only to check up on existing holdings but also to identify nascent opportunities and understand the challenges these businesses face.

Poland’s optimistic outlook

It has been a year since our previous visit to Poland. During that visit, we observed consumers struggling with high inflation, wage growth continuing to decline, public concerns around the upcoming parliamentary elections and hopes for a swift resolution to the war in Ukraine, which would bring peace and vast opportunities for Polish companies.

We were happy to see a rise in optimism regarding these concerns during our latest visit. Most of our interviewees were more bullish this time around. Post the parliamentary elections, we sensed a renewed optimism as a pro-European Union (EU) coalition regained power. The new Polish government seems committed to mending relations with the EU, having successfully unblocked the first tranche of €76 billion frozen by the European Commission due to legal concerns after judicial reforms by the former government. Since joining the union, Poland has been a significant beneficiary of EU funds, receiving approximately €164 billion from 2004 to 2020. For context, Poland’s GDP was €750 billion last year. These substantial financial inflows have contributed to various crucial projects across the country, enhancing infrastructure and improving structural economic growth and overall wellbeing. No wonder these EU funds are expected to drive economic growth for several years to come. Coming in the form of grants and low-interest loans, this financing is mainly for funding infrastructure and renewable energy projects.

Contrary to last year, this time we saw consumers in Poland enjoying strong real wage growth of around 10%, with no labour market slowdown. With inflation easing to low single digits in the first quarter of 2024, these factors create a conducive backdrop for the robust recovery of Polish consumers. Growing disposable income is likely to not only rebuild their savings but also drive rebound in consumption.

However, the road ahead may be bumpy due to potential inflation spikes in the second half of 2024 on the back of higher energy prices, a VAT hike on groceries, fulfillment of costly pre-election commitments, domestic political tensions and the potential escalation of the ongoing war in Ukraine. The war remains one of the major risks to the region and was a frequent topic in our conversations, not only with corporate executives but also with ordinary citizens. Centuries of conflict between Poland and Russia have left deep scars in the psyche of the average Polish citizen.

Turkish economic reforms and investor confidence

In Turkey, a surprising pivot to orthodox monetary policy last year reignited hopes for economic normalization, buoyed the local stock market and turned foreigners in net buyers for the first time since 2019. Committed to controlling escalating inflation, the central bank raised its key policy rate from 8.5% in June 2023 to a staggering 50% in March 2024. Moreover, the monetary authority signaled its readiness for further rate hikes if necessary. Investors welcomed the government’s adoption of market-friendly measures, which drove the Turkish stock market higher by over 30% in US-dollar terms since the first hike last summer. Simultaneously, foreign reserves have started to recover, sovereign credit spreads have tightened to multi-year lows and the current account balance is expected to get meaningful support from the tourism season starting in May.

Although the recent municipal elections marked a significant defeat for the current leadership, President Erdogan reiterated policy continuity and his commitment to an economic turnaround program in the second half of the year. With no elections for the next four years, the government has time to tackle inflation and achieve long-awaited results. However, this requires the implementation of further austerity measures, including fiscal ones. Current market expectations see inflation peaking in May above 70% before declining to 30%-40% by year-end. However, potential new rounds of minimum wage hikes, premature rate cuts and higher energy prices continue to threaten the turnaround policy and could derail efforts to reduce inflation and improve the trade balance.

Nearshoring opportunities

Despite being influenced by very different forces, Poland and Turkey share some commonalities. In the last few years, the term “nearshoring” has become strongly associated with Mexico and Vietnam. We explored the impact on the Mexican economy in a previous commentary. However, Poland and Turkey have turned out to be underappreciated beneficiaries of supply chain shifts toward near- or friendshoring as a way to reduce reliance on China. Nearshoring opportunities repeatedly came up in our discussions with corporates in both countries. We see Poland as a launching pad for opportunities into Western Europe and hard-to-access markets in the east like Hungary, Romania and Bulgaria. Similarly, Turkey offers a gateway to explore opportunities in CIS countries and less liquid frontier markets. We highlight one such opportunity below.

As bottom-up investors, we focus our macroeconomic analysis primarily on enhancing the risk management aspect of our portfolio management. When investing in highly turbulent economies, we prefer to stick to companies that we believe can succeed even when their domestic economies face challenges. Additionally, we look to benefit from a possible decline in country risk premiums in the event of macro normalization.

Investment spotlight: Coca-Cola Icecek and Mo-BRUK

Our largest position in Turkey is Coca-Cola Icecek (CCOLA TI), a coke bottler. In the last 20 years, the company has evolved from a single-country operator to the third-largest coke bottler globally, with a footprint spanning 12 countries and 600 million people. Icecek generates less than 30% of its EBITDA in Turkey, with Pakistan, Kazakhstan, Uzbekistan and another eight countries in the Middle East and Central Asia accounting for the major part of the business. Robust strategic alignment with The Coca-Cola Company, combined with Icecek’s proven record of successful integration, positions it as the preferred partner for further consolidation of Coca-Cola’s bottling operations in the region.

Bangladesh is the recent addition to Icecek’s portfolio. It is a country with over 170 million people and a heavily underpenetrated non-alcoholic beverage industry poised for double-digit volume growth over the next decade. This positions Icecek well to replicate its successful strategy of distribution network enhancement to ensure product availability, build infrastructure and enrich merchandise offerings. Leveraging its leading brand portfolio and a highly experienced management team, Icecek is set to continue capitalizing on the vast potential of its markets.

Mo-BRUK (MBR PW) is a waste management company in Poland specialized in processing hazardous waste. The founding family established the business more than 30 years ago and has built a strong franchise in an industry characterized by high entry barriers. The company does not operate landfills and focuses solely on processing waste. EU regulations on waste management create significant tailwinds for the industry in Poland, as the country must undertake considerable efforts to meet EU objectives. Due to its specialization in hazardous waste and limited competition due to entry barriers, Mo-BRUK enjoys superior business economics. High margins are driven by volume growth and technology improvements, as well as price hikes due to limited capacities in the country. In terms of growth strategy, the company is conducting several expansion projects within available permits. At the same time, it is filing for new permits. Remediation of the illegal landfills or so-called ecological bombs represents an attractive business for Mo-BRUK, but it is highly dependent on the budget allocation by municipalities. The cadence of such projects is erratic, but the company intends to participate in all tenders as they are announced. Additionally, the management team sees multiple consolidation opportunities in the country. In late-2023, Mo-BRUK acquired two independent operators that not only provided the company with scarce permits but also expanded its footprint in northern Poland.

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

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

Financial Services Portfolio

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

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

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

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

Consumer Portfolio

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

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

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

Outlook

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

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

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

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

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

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

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

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

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

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

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

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

Source: NS Partners & Refinitiv Datastream

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

Source: NS Partners & Refinitiv Datastream

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

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

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

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

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

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

Valuations are compelling

Source: NS Partners & Refinitiv Datastream

EM currencies look cheap (Brazil and Mexico are outliers)

Source: NS Partners & Refinitiv Datastream

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

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

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

Excess money measures mixed, double positive soon?

Source: NS Partners & Refinitiv Datastream

Hypothetical performance of excess money switching rule

Source: NS Partners & Refinitiv Datastream

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

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

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

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

1. Company visit in Jeddah

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

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

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

SADAFCO factory, Jeddah.

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

Total water withdrawl/production volume

Source: Sustainability Report.

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

Gross margins vs. average SMP price vs. product prices

Source: Company, CIAL.

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

2. Saudi Capital Markets Forum in Riyadh

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

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

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

GDP per capita (purchasing power parity)

Source: World Bank.

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

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

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

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

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

3. Company visit in Dubai

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

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

Greenfields International School (GIS).

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

Private education market in KSA is still the lowest in GCC

Source: NCLE Presentation 1Q24.

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

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

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

Source: KHDA.

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

GIS utilisation (%)

Source: Company/KHDA.

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

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

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