Global Equity Archives

A young kitten rubbing up on her adopted mama dog,

The profound and enduring love people feel for their pets is a testament to the unique and cherished bond between humans and animals. Across cultures, generations and geographies, this affection runs deep and is driving unprecedented demand for high-quality pet care, products and services. There is no doubt that pets occupy a special place in our hearts. But should they also occupy a special place in your investment portfolio?

When it comes to investment strategy, recognizing the remarkable growth within the pet industry is paramount. At Global Alpha, our preference is to invest in large and growing markets, and the pet industry perfectly aligns with this approach. As part of our meticulous investment process, it is essential to delve into the underlying factors propelling this industry’s expansion, as these drivers often vary by theme – such as demographics, innovation and environment.

How big is the pet market in North America?

As of 2023, data from the American Pet Products Association reveals that pet ownership in the United States has reached a remarkable milestone, with 66% of households, equivalent to 86.9 million homes, proudly welcoming pets into their lives. This figure marks a substantial increase from the 56% recorded in 1988, underscoring the enduring trend of pet ownership. So, how important are these pets to their owners? An astounding 85% of dog owners and 76% of cat owners affirm that their pets hold a special place as bona fide members of their families.

In 2022, Americans alone spent $136.8 billion on their pets. Back in 1996, that number was just $21 billion. Even more fascinating is that millennials comprise the highest percentage (33%) of pet owners in the US, followed by Gen X at 25% and baby boomers at 24%.

In Canada, pet industry spending reached $12.9 billion in 2022, up a whopping 486% from $2.2 billion in 1994 according to Statistics Canada.

How is the pet market different internationally?

While the US is the clear leader when it comes to spending on pets, other countries are also seeing the market grow. In the UK, the vet market is worth more than £2 billion ($2.5 billion USD) with almost two thirds of households owning a pet.

China has become the second-largest market, even though only 23% of Chinese households have pets. China’s pet industry is expected to reach $66.1 billion by the end of this year, which is 10 times the size it was a decade ago.

At the same time, there are more than 31 million pets in India and this number is growing at an annual rate of over 12%. According to a Bonafide Research report, India’s pet care industry is expected to reach close to a billion dollars by 2025, with a CAGR of more than 19%.

How have our pet industry holdings performed?

Since inception in 2008, we have continuously maintained exposure to the animal health industry. Below are a few highlights.

VCA Antech: Profiled in our February 28, 2012 weekly

Founded in 1986, VCA Antech is a leading animal healthcare services company
The company provides lab testing for over 17,000 animal hospitals with over 30,000 veterinarians
Provided exposure to animal hospitals and pet diagnostics
Exited in Q2, 2016 as the market cap crossed the upper limit of the benchmark – the company was acquired by Mars in September 2017

Heska:

HSKA is a veterinary diagnostic company
It has 162 US patents and 139 foreign-issued patents
Provided exposure to veterinary diagnostics
Exited in Q1, 2017 as it had reached our fair value

Greencross: Highlighted in our June 3, 2016 weekly

Australian pet health company, founded in 1994
Number one pet care specialist in Australia, providing both retail and veterinary services
Provided exposure to animal clinics and pet retail stores
Exited in Q1, 2019 as it was acquired by private equity group, TPG Capital

Our current exposure to the pet industry

We are currently invested in UK pet health company, CVS Group. Founded in 1999, the company went public in October 2007.

Business overview

Headquartered in Norfolk, CVS is one of the leading veterinary services providers in the UK with about 10% market share. As of 2022, CVS has about 500 practices across its three markets, including eight specialist referral hospitals and 37 dedicated out-of-hours sites. The company also runs three laboratories, seven crematoria and an online retail business called Animed.

CVS recently entered the Australian market with a small number of acquisitions, bringing the total number of practices outside the UK to 35.

Target market

The total addressable market in the UK for veterinary products and services is over £2 billion. The market consists of six large chains and a number of independent/small chains representing 45% of the market.

On the other hand, according to IbisWorld, Australia has a $5.3 billion addressable market which is growing at 6% per annum. The level of consolidation in the Australian market is just 20% when compared to the UK, adding for future potential growth via M&A.

Competitive advantages

Largest and most comprehensive provider of vet services in the UK, meeting all customer needs
Scale – has developed shared facilities and opportunities to cross sell its products, like lab testing, generic medicines, loyalty schemes, specialist surgeries and pet cremation

Growth strategy

Consolidate large-animal vet practices (delivering equine & livestock care), which is more fragmented
Their laboratory diagnostic business could enter the farm animal diagnostics market
International expansion continues like their latest entry in Australia

Where we’re looking next?

We have our eyes on a few interesting companies operating in the animal health space, ranging from pet insurance and fresh pet food to a diagnostics company. Our ability to be highly selective and nimble in our portfolio holdings leaves us well-positioned to add some exposure to the animal health industry at attractive valuations.

So just one question remains: How much are you spending on your pet?

The Godil family cat

NASA image of a huge hurricane between Florida & Cuba.

This week, Global Alpha is looking at the increased frequency of natural disasters and how climate change is affecting the insurance industry.

The recent wildfires in Hawaii, the deadliest in over 100 years, is the latest in a long line of severe natural disasters. The town of Lahaina was hardest hit as damage assessment maps indicate over 2,200 buildings were destroyed or suffered some harm. Rebuilding Lahaina has been estimated to cost $5.5 billion.

Just this past Friday, a significant earthquake registering 6.8 on the Richter scale shook Morocco, leading to early estimates of over 2,800 casualties and causing severe damage to historic sites in Marrakesh. This comes after an event in February this year when Turkey and Syria were hit by an earthquake measuring 7.8 on the Richter, followed by aftershocks reaching up to 7.5. In that catastrophe, thousands of buildings collapsed, resulting in thousands of injuries and tens of thousands of deaths. It became the deadliest global disaster since 2010 and ranks as the 11th deadliest event in recorded history. Beyond the loss of life, financial assessments from the government of Turkey, the World Bank, the UN and the EU estimate the economic loss at around $91 billion, making it the 11th most costly disaster globally, after adjusting for inflation. Both events have underscored the need for stricter enforcement of modern building codes. In Syria and Turkey, a number of the buildings that fell, including newer multi-story residential structures, should have had sufficient structural integrity to mitigate significant fatalities.

Closer to home, there has been an extended period of wildfire activity across many Canadian provinces. While many of the wildfires occurred in remote regions far from major population centres, total insured losses are expected to reach several hundred million dollars and thick smoke caused hazardous air conditions in the Northeast. In June, New York and Montreal both recorded the worst air quality in the world.

Overall, the first half of 2023 experienced the highest economic impact from catastrophes since 2011, and the fifth highest on record, with the highest ever number of at least $1 billion insured loss events (18 versus the historical average of 7).

The end result is that insurers are choosing to limit exposure in some markets. Reinsurance companies are raising their rates to insurers to help cover losses above certain levels. These higher rates get passed on to consumers and other insurance buyers. Recently, State Farm and Allstate announced they are no longer providing insurance in California, the most populated US state. Reasons for their withdrawal include increased catastrophe exposure, construction costs and the reinsurance market. A similar situation is unfolding in hurricane-prone Florida, where property insurance costs are skyrocketing and Farmers Insurance pulled out of the state altogether, citing increased risk exposure.

Global Alpha holds two insurers: RLI Corp. (RLI.US) and Vienna Insurance Group (VIG.AV).

RLI is a specialty insurance company with more than 50 years of experience serving the property, casualty and surety markets. RLI focuses on niche markets that need deep and unique underwriting expertise. The company operates on both an admitted and non-admitted basis with exposures predominately in the US. RLI had some exposure to the Hawaiian wildfires primarily due to homeowner insurance in the state and recently announced its loss estimates. Although preliminary in nature, RLI estimates pretax net catastrophe losses of $65 million to $75 million related to 200 structures. These losses will be reflected in Q3-2023 results. RLI regularly monitors and attempts to manage exposure to catastrophes by limiting concentrations of locations insured to acceptable levels and by purchasing reinsurance. Catastrophe exposure models can help assess risk, but are inherently uncertain due to the sporadic observations of actual events.

Vienna Insurance Group offers insurance solutions in the property and casualty, life and health business across approximately 30 countries in Central and Eastern Europe. Vienna has a climate change strategy that provides general principles for dealing with climate change and guidelines for investments and insurance operating business. One of the first initiatives was to eliminate investments in the coal sector and significantly limit insurance coverage for new coal mining and coal-fired power plant projects. The company’s scenario analysis highlights the main natural risks as flooding, winter storms and summer (hail) storms. Science is expecting the risk of flooding and hailstorms to increase. The 2021 flooding in Bernd, Germany led to unexpectedly large losses while the same year also saw severe hailstorms in Austria and a tornado in the Czech Republic. As for winter storms, the risk is expected to increase in some countries and decrease in others. Vienna offers insurance coverage in Turkey, albeit in the less affected western part of the country. Nonetheless the company announced an expected gross impact (including active reinsurance) of €170 million.

The world is currently observing a warmer El Nino phase that often leads to shifting rainfall patterns in different parts of the world. For example, more flood-related losses have been reported in Europe, the Middle East and Africa during El Nino phases. Insurance companies have always been concerned with potential losses due to natural risks. Global warming is highlighting the critical nature of this problem. As we confront a world where the frequency and severity of natural events are exacerbated by climate shifts, the question becomes: are insurance models robust enough to adapt, or will we find ourselves financially unprepared for the evolving landscape of risk?

Female tying her running shoes preparing for a run.

In the wake of the unprecedented COVID-19 pandemic, global lifestyles underwent a significant transformation. As travel restrictions and lockdowns became the norm, people found themselves with limited options for entertainment and recreation. Unable to travel, many redirected their discretionary spending towards athleisure wear and comfortable shoes, fueling a boom in the sneaker and sports shoes market.

As we come out of the pandemic, the surge in leisure goods spending is proving to be unsustainable, especially in the face of a global recession. The footwear industry, like many other sectors, is feeling the pain of this economic downturn.

Recent earnings reports from major footwear retailers and manufacturers offer insights into this situation. Foot Locker reported its second quarter earnings last week. Revenue was down 10%, gross margins declined by 460 basis points (bps) and the company revised down guidance and paused its dividend. Reasons include weak consumer sentiment, increasing theft and shoplifting of its products and a reset strategy as Nike prioritizes its DTC channel.

Industry giants like Nike and Adidas have their challenges too. In the quarter ending May 2023, Nike reported revenue growth of 5%. However, gross margins were down by 140 bps due to higher input and freight costs and higher markdowns. Adidas saw its revenue decline by 1% and gross margins deteriorate by 510 bps on higher supply chain costs, deeper discounting and inventory allowances for Yeezy.

The destocking trend has been observed by one of our holdings, Coats Group PLC (COA LN), which is a world leader in thread manufacturing and structural components for apparel and footwear. It has a 24% global market share in structural components and a 28% market share in threads for the footwear category. With an extensive customer base that includes Nike, Adidas, Puma, VF Corporation and others, Coats offers invaluable insights into the worldwide footwear sector. The destocking trend emerged in the second quarter of 2022 and is expected to take another five months or so to clear the existing inventory. Coats has been in the business for over 200 years and has navigated through various market cycles to be able to anticipate upcoming shifts. This foresight has led it to implement cost-cutting measures during periods of high demand and focus on enhancing profit margins. Coats has been gaining market share consistently over the years while its competitors suffer from high leverage.

According to Coats, the initial six months of 2023 witnessed a 30% reduction in global shoe production. However, this adjustment was not uniformly distributed across all categories. Coats observed that the performance and athletic products demonstrated a higher degree of resilience than the rest.

Asics (7936 JP) is a Japan-based company in our portfolios that operates in this performance category. While the brand is also noticing weakness in North America and Europe, it is doing better than its peers and strong sales momentum in Asia helped the company to grow revenue by 15% in the latest quarter and improve margins by 150 bps, as price optimization was more than enough to offset the higher costs. Asics faces limited inventory risks compared to peers and does not offer deep discounts. It even revised up full year guidance and hiked its dividend forecast. The reasons behind the outperformance include:

Focus on performance categories. Performance running shoes and core performance sports shoes (for athletics, tennis, volleyball and other competitive sports) account for around two thirds of Asics’s revenue. The total numbers of shoes to be sold by Asics this year is expected to be down 10%, as the company is trying to produce less entry-level products and focus on the premium models. Revenue is expected to be up 13.5% as a result of higher average sales prices.
Expand the profitable channels. Asics has been shifting its distribution channel from general sports goods retailers to specialty stores, with a very small portion of revenue coming from Foot Locker. In addition, the brand has been expanding its e-commerce and DTC channels, which have the highest margins. Currently, e-commerce accounts for 17% of group revenue and Asics aims to achieve 25% by 2025. The company is building a running ecosystem with its OneASICS membership program, which currently has a member base of 8.3 million. Data shows members tend to spend 50% more than non-member customers.
Asia reopening and inbound tourism in Japan. In the June quarter, Asics’s sales from Japan increased by 42% and sales from Greater China and Southeast/South Asia increased by 35% and 56%, respectively. In Japan, sales from inbound tourists have recovered to about 90% of 2019 levels. The anticipated recovery of Chinese tourists is expected to boost sales further. Out of the sales associated with inbound tourism, over 80% was Onitsuka Tiger (OT), Asics’s high end, stylish sneaker brand. This brand enjoys much higher margins than the company average, also contributing to its margin expansion.

The company’s further growth will be fueled by additional market share gains, new market expansion and new product launches. Asics has been gaining market share from peers globally, now has 13% to 14% share in North America and Japan, 29% in Europe, and expects to continue this trend by offering competitive products. As a next leg of growth, Asics will look to expand its presence in emerging markets especially in Asia, as there is rising demand for sports goods and services in the region. Asics is also launching new products in other sports and has been gaining market share. It already claims the top market share in tennis shoes in Europe and the US.

Sustainability is also a big focus for Asics. Over 90% of Asics’s running shoes contain recycled polyester. In 2022, the company unveiled the lightest ever CO2e emissions sneaker, emitting just 1.95 kg per pair, over 80% less than a regular pair of sports shoes on the market.

With its competitive and eco-conscious product offerings, coupled with well-defined growth strategies, Asics is poised to sustain its expansion in the years to come.

In June this year, 3M was ordered to pay $10.3 billion for its contamination of US drinking water supplies with per- and polyfluoroalkyl substances (PFAS), also known as forever chemicals. In the US alone, there are currently over 15,000 open claims against PFAS manufacturers and users, with some experts estimating that payouts could exceed the $200 billion payout levels of tobacco companies in the 1990s.

PFAS were invented in the 1930s and started to be widely adopted in the 1940s. These chemicals have been used in many industries for various applications since. In response to growing concerns about their side effects in humans, such as liver damage, obesity, fertility issues and cancer, many authorities around the world are considering strict regulations to limit their use.

Per- and polyfluoroalkyl substances are synthetic, manufactured chemicals that are mostly used in products for their nonstick and repelling properties. They have a special type of bond called carbon-fluorine, one of the strongest bonds in chemistry. This explains why PFAS do not degrade easily in the environment and human body and instead tend to accumulate. Within usage and production, they migrate into soil, water and air. Long-term PFAS use has resulted in at least 45% of US drinking water supplies containing traces of these forever chemicals.

Illustration/map showing Per- and Polyfluoroalkyl Substances (PFAS) in Select U.S. Tapwater Locations

The widespread contamination of US drinking water led the Environmental Protection Agency (EPA) to propose new limits of four parts per million, a drastic reduction compared to the limits set back in 2016 of 70 parts per million.

For visualization purposes, four parts per million would be equivalent to a grain of sand in a football field!

Though these limits have not yet been approved, many municipalities around the US have started testing their drinking water supplies. If the limits do become the standard, all municipalities will need to begin regularly testing their water supplies within three years from the adoption of the law.

The clean up of PFAS is an expensive overhang for water utilities, especially because of the age of the infrastructure. Some US water treatment facilities are over 100 years old. The American Water Works Association, an international nonprofit founded in 1881 and dedicated to providing total water solutions assuring effective water management, estimates that PFAS clean up will cost between $2.5 and $3.2 billion annually for the next decade.

Many companies currently have treatment technologies to facilitate the cleaning up of chemicals in water supplies. The three most widely adopted ones are activated carbon, ion exchange treatment and high-pressure membranes.

Activated carbon is a porous element derived from organic materials that have high carbon content, such as wood, lignite and coal. It can trap various compounds including certain types of PFAS. The activated carbon is used as a filter through which water flows and the chemicals are captured. The activated carbon within the filters needs to be replaced every 6 to12 months depending on the frequency of use, volumes of water filtered and PFAS concentration.

Ion exchange treatment involves resins. These resins are made of porous materials with positively charged ions. The negatively charged ions of the PFAS are attracted to the positively charged ions acting as magnets. This resin is then discarded typically through incineration, thus ensuring no further contamination occurs.

High-pressure membranes such as nanofiltration use nanometer-sized holes or pores to trap particles. This technique is highly effective but also requires that the membranes be changed every few years.

One of our companies, Kurita Water (6370 JP), is a leading water treatment company that manufactures and sells speciality equipment. The company operates throughout the world, but is focusing growth plans in the US market. Since 2015, the company has been acquiring in the US, EU, Korea, Canada and the Middle East to increase its global footprint.

Due to the increasing regulations among public water supplies authorities and emerging concerns about contaminants, many clients are turning to Kurita for its expertise and speciality treatment facilities to address these concerns and adhere to regulations.

Kurita is able to provide a large breadth of solutions to its clients. It offers both on-site and remote planning and support as most water systems are customized to customer specifications. For PFAS treatment, Kurita provides all three technologies mentioned.

As PFAS regulations become more stringent, Kurita is poised to benefit from the vast adoption of advanced water treatment facilities.

Much of the initial spike in inflation that the Federal Reserve (the Fed) is now working so hard to curb came from strong energy prices. After WTI crude crossed $120 a barrel, energy prices are back in the $70 range. Today’s bear case for oil is widely discussed – from an impending recession to China’s tepid economic rebound and the eventual transition to EV vehicles. These are sensible arguments, but the oil and gas industry has undergone some structural changes. The seeds of these changes can be traced back to the last big run up in oil prices in 2008 when oil peaked at close to $140 a barrel.

After the demand-driven boom that peaked in 2008, encouraged by the recent high prices oil, drillers in the US began exploring ways to reach previously untouchable deposits using fracking and horizontal drilling. While fracking and horizontal drilling had been around since 1998, the spike in oil prices incentivized US producers to leverage this technology. The result was a shale boom with US production that had been in terminal decline since the 1960s, doubling from about five million barrels per day in 2008 to 10 million per day over the next 10 years.

Line graph illustrating growth in US field production of crude oil, 1920 to today.

With OPEC unwilling to cede market share to a new generation of American drillers, elevated rates of supply eventually led to a fall in prices in 2014-15. In retrospect, this marked the beginning of the end of the US shale boom. Then came the one-two punch of slowing demand from China (the largest driver of incremental demand for oil) and COVID-related lockdowns that caused oil prices to hit lows of $20 per barrel in 2020 after a brief reprieve in 2018-19.

The two price shocks that occurred over a short period led to two changes in behaviour that we think has structurally changed the industry.

First, a new base of conservative investors replaced the more growth-oriented cohort from the shale boom. The new investor base now pushed for an end to risky new projects, instead focusing on debt reduction and returning excess cash in the form of buybacks and dividends.
Second, taking a cue from their investor base, management of companies that survived this boom-bust cycle vowed to be conservative with their capital expenditure programs and promised to divert their future capex to more renewable projects.

In the past, for every dollar of dividends and buybacks, oil companies would reinvest $3 to $4 back in the business. Now as we can see in the following chart, every $1 of reinvestment is matched by $1 of buybacks and dividends.

Bar graph illustrating decline in level of share buybacks by oil companies since 2008.

The result of this structural change in the market is that big oil producers will continue to be conservative with projects that take a decade or more to earn returns on investment. We are now in a situation where supply is tight due to both long-term factors, such as limited new exploration projects, and short-term factors like replenishment of the Strategic Petroleum Reserve (SPR) by the US, increasing from current levels of 350 million barrels to 650 million barrels. Adding to this, OPEC has committed to restricting supply until the end of 2023 by cutting 1.16 million barrels per day.

On the demand side, we are seeing record demand in 2023 at 101.9 million barrels per day, an increase of two million barrels from last year. While we anticipate an eventual transition away from oil, the combination of tight supply and persistent rising demand could lead to a messy transition with price spikes near-term volatility.

We think this new normal allows small and nimble players to quickly respond to a stronger pricing environment with ramped up spending. A good example of such a player is Parex Resources (PXT CN), which is part of our emerging markets portfolio.

Parex is the largest independent oil and gas exploration company in Colombia sitting on over 200 million barrels of reserves and exploration opportunities. In 2023, it added 18 new blocks and expanded its exploration land by four million acres over the last five years. Currently, it produces 60,000 barrels of oil equivalent (BOE) per day and its production has grown at an 8% CAGR over the last five years, as seen in the following chart. Absolute proved developed producing (PDP) reserves have registered a 10% CAGR over the same period.

Consistent growth in oil production (barrels per day)

Bar graph illustrating growth in CAGR of Parex Resources, 2013 to 2022.

If we were to sum up our thesis on Parex, it would be capital efficiency with best-in-class execution. All of this in a country that has faced its fair share of curveballs with natural disasters, political uncertainty and infrastructure bottlenecks. To elaborate further:

We like Parex’s transition from a single-asset operator to a countrywide operation, with new asset acquisitions and an MOU with state giant EcoPetrol.
This had led to product diversity, moving from heavy oil to adding light oil, gas and condensates.
Parex has a track record of using of proven exploration technologies from the West to tap into easy-to-produce reservoirs with low risk.
We appreciate the management team’s commitment to adding shareholder value while maintaining strict cost control.
Finally, Parex has shown consistent growth that has been self-funded, with zero debt on the balance sheet.

Parex has maintained a simple and consistent capital allocation framework. A full two-thirds of its funds from operations are reinvested into the business, while the remaining one-third is returned to shareholders. As seen in the chart below, Parex has reduced its free float of shares by 33% over last five years and returned $1.3 billion back to shareholders. In 2021, it announced a dividend policy to further reward shareholders, with the company offering a 5% dividend yield at current prices.

33% reduction in shares outstanding

Bar graph illustrating 33% reduction in free float of Parex Resources shares since 2017.

Parex also scores well on our ESG framework. It has reduced GHG intensity by 43% since 2019, linked executive compensation to ESG metrics and has a diverse and independent board. With a low cash cost, Parex has performed well even at today’s subdued oil prices. If a sustained period of high oil prices does materialize as we anticipate, we expect Parex to continue delivering shareholder value from a position of strength.

Beautiful view of a Puerto Vallarta beach on the Pacific coast of Mexico.

Latin America has outperformed other emerging markets over the past two years and this positive performance can be attributed to several key factors. However, the challenge lies in sustaining this momentum and ensuring it is not merely temporary.

MSCI World Small Cap Index vs MSCI Emerging Markets Latin America Index, 2021 to 2023

Graph showing the outperformance of the Latin America small cap index relative to its global peers between June 2021 and June 2023.

Source: Bloomberg

Notably, the combination of currency rallies among some Latin American countries and an emerging markets rally is uncommon. Reasons for this mismatch include:

Latin America leads the way in interest rate hikes worldwide. Starting in the first half of 2021, Chile and Brazil raised rates, helping control inflation levels, although they are still high but manageable. Chile will likely start its easing process next week, followed by Brazil within the year. This has boosted their respective stock markets, which were already undervalued in our view.

Additionally, Mexico has benefitted from the “nearshoring” theme. Nearshoring is nothing new to local investors, having been present in the region for decades. What is new is the level of intensity and amount of investment expected over the next three to five years. This has resulted in increased earnings per share (EPS) of 15% to 20% CAGR in the near term for some Mexican companies, outperforming the MSCI Emerging Markets Small Cap Index and contributing to higher valuations in Mexico’s market compared to its Latin American peers. However, there are questions about whether Mexico’s growth is comparable to its peers or to countries like Indonesia or Vietnam that are also heavily dependent on US imports.

Commodities also play a significant role in the region’s performance. Despite a global slowdown, certain commodities, like copper, have maintained high prices due to supply constraints. We believe the anticipated electric vehicle (EV) boom will further drive copper demand, ensuring a deficit in the market from 2026 onwards. For example, every EV, which weigh approximately two tons each, consumes around 60 additional kilos of copper.

Furthermore, the region has demonstrated better fiscal discipline, with countries like Chile and Mexico ending 2022 with fiscal surpluses or manageable deficits, respectively. This responsible fiscal approach has also supported their currencies. There is always the potential for Brazil to surprise on the downside due to its high fiscal spending and debt levels; however, the country has seen no “disruptive” events lately.

US rates hikes have favoured value over growth factors in emerging markets, benefitting markets like Latin America’s over countries perceived as growth-driven, such as Korea or India.

Innovation has not been a main driver for Latin America, but that is starting to slowly change. Moreover, the market has begun recognizing and crediting good companies with sustained growth expectations, which has historically been uncommon in the region. This trend in recognizing innovation and good companies is crucial for bottom-up investors like us who prioritize companies with solid balance sheets, strong cash flow generation and sustained competitive advantages. More Latin American companies have started to share these characteristics.

Latin America is still a small region relative to the rest of the world and it is dominated by, and benefits from, global trends, even though its politics are not always market friendly. However, sustained positive factors like the commodities momentum and nearshoring may make global investors more indifferent to the region’s internal dynamics.

What needs to happen for long-term compounder growth stories to emerge, like Nestle in India or TSMC in Taiwan? To maintain sustainable growth, we believe the region needs to align with external factors and foster strong domestic sectors and companies that promote growth. Improving innovation and adapting to rapidly changing environments are also key. For example, the financial sector in Mexico and Chile remains solid, while the transport-logistics sector in Mexico offers interesting opportunities. Brazil’s large population presents significant potential for emerging middle-class growth, creating opportunities in various sectors.

Latin America has growth engines and the key is to identify the best companies capable of maintaining a sustained differentiation over time. By focusing on these opportunities, our portfolio is well-positioning to capture their potential growth.

Company example

JSL (JSLG3 BZ) has the largest portfolio of logistics in Brazil, with long expertise operating in a variety of sectors and a nationwide scale of services. The company has long-lasting business relationships with clients that operate in several economic sectors, including pulp and paper, steel, mining, agribusiness, automotive, food, chemical and consumer goods, among others. JSL also has a unique position in the Brazilian highway logistics market, as leader for 19 years and much larger than its nearest competitor.

The logistics industry in Brazil is highly fragmented, with a high level of informality and low capitalization among players. This creates opportunities for further consolidation, especially for companies with structured businesses. According to Citibank, the top 10 companies have close to a 2% market share. JSL has roughly 1% market share (almost 5x the second-largest player) and is well placed to continue consolidating the industry. JSL also has a favourable M&A track record, which has been a growth driver in recent years. JSL has acquired seven companies since its re-IPO in October 2020 implying c20% annual organic growth and c60% EBITDA growth considering the acquisitions, maintaining strong returns.

We also expect JSL to continue expanding its ROIC going forward, driven by the ongoing consolidation of new acquisitions into JSL’s financials, the company’s strategy to becoming a less capital intensive, asset light business, and strong revenue growth to maintain gaining scale and operating leverage. The logistics industry offers a lot of opportunities to implement tech-driven innovation, and we see JSL well-positioned to use its sector platform and status as a leading tech player. The stock has performed very well this year, partially driven by rate cut expectations and also strong earnings. We expect the company to continue delivering good results in upcoming quarters amid a highly fragmented sector, creating both organic and inorganic growth engines.

Business woman looking at data on a computer at night. The coding is reflecting off of her glasses.

It seems like it happened overnight. Artificial Intelligence (AI) went from something distant that would not typically come up in small talk between colleagues (unless you work in the field, maybe), to the next great game changer that promises to transform the way everything is done. ChatGPT is now already a household name that can write homework for students, find bugs in programmers’ code or even draft a basic contract according to your specification. Just two months after the release of ChatGPT by OpenAI in November 2022, it had already become the fastest-growing software application in history with well over 100 million users. Subsequently this led to massive investments by Google, Baidu, Meta and many others to develop competing technologies to maintain their market shares.

Every time a new technology or concept is the subject of such interest, the media spends an incredible amount of resources theorizing all the different ways in which the world will be made different by this new shiny thing. Yet very few of these promised changes end up making a lasting impact. Blockchain was supposed to revolutionize the world of finance and decentralize the entire system, yet it remains a niche technology with a damaged reputation from the crypto craze.

The metaverse was sold as something that would be part of our everyday life with most households having their own VR headset, much like everyone had their own PC. We’re not quite there yet, although Apple now seems to believe this is the next big thing.

Finally, 5G was meant to unlock so many opportunities with promised better connectivity, low latency and no pocket loss. Every company was mentioning some opportunities from the internet of things to cloud gaming. All these frenzies had something in common: actors that overpromise and underdeliver in spectacular fashion, at least in the short term.

Then comes the new buzzword: generative AI. Between the Q4 2022 and Q1 2023 earnings season, the mention of AI in earning calls more than doubled among S&P500 companies. Nvidia rallied almost 200% in 2023 as one of the most obvious potential beneficiaries and is now worth over $1 trillion while trading at 40x revenues. For reference, these are dotcom bubble multiples.

Artificial intelligence as a field of research goes back to the late 1950s, 15 years after the famous Turing test was first put forward. So how did it become all the rage overnight over 60 years later? Long story short, significant advances in Large Language Models (LLM) in the last decade paved the way to commercial use of generative AI. In a context where the global economy has needed new productivity catalysts to prevent GDP deceleration and to help reduce inflationary pressure in the post-COVID era, ChatGPT seems to be filling the void almost too perfectly. As a new productivity tool that could potentially impact almost every aspect of the service economy, it’s no wonder everyone is jumping on the hype train. Nonetheless, if the commercialization of the internet is any reference, and assuming the impact of AI is of a similar size, we are still at the beginning of the dotcom/AI bubble where euphoria is high, and every company is set to either benefit from AI or disappear into irrelevance. Seasoned investors who lived through the internet bubble may offer one or more of the following pieces of advice:

Your internet/AI stock pick will likely prove wrong in the long term, as it will take years to fully realize the impact of the technology, while regulations can hinder companies’ plans.
Your stock pick could be the right one, yet the current valuation may still not make sense.
There are solid companies outside the tech/AI bubble that are being unfairly penalized as investors sell them to buy into the new hype stock.

Within this speculative environment, we identified an opportunity to initiate a position in a company that had been on our radar for a long time: Keywords Studios (KWS LN). Based in Ireland, Keywords is the dominant player in the fragmented market of video game outsourcing. With studios in over 26 countries, across eight different lines of business and three development divisions, Keywords operates at an unmatched scale three times larger than its closest competitor, yet with a market share of only 6%. The company offers services covering a wide range of developer requirements, including audio services, customer support for live games, marketing and social media management and bug testing.

Keywords had long been a darling in the video game small-cap space, commanding a valuation that made it challenging for us to justify an investment, despite its strong niche positioning and business model. However, near the end of April, the company appeared on an AI loser basket built by Bank of America, based on the belief that most of Keywords’ services would eventually be brought back in-house by game developers due the reduced need for labour caused by new AI technologies. This triggered a downward spiral in the share price. From that point on, negative momentum continued to feed on itself driven by index weight adjustments, loss cutting, quant signals and so on.

On closer examination, it became clear to us that the story was being misunderstood and that investors were selling services companies like Keywords indiscriminately. In fact, Keywords had already been making acquisitions and investments in AI technologies for at least a year before ChatGPT became a household name. It was already using this technology to enhance its localization services (Kantan AI), customer support business line (Helpshift), and to improve on its quality testing expertise (Mighty Games), among other things. Furthermore, Keywords is uniquely positioned to benefit from exposing its machine learning systems to a variety of games, languages and codes. It has a scale advantage that individual video game developers cannot match.

So why did we choose to invest in Keywords and not a game developer that owns its own intellectual property (IP)? The global video game market is highly hit-driven, which introduces risks and revenue lumpiness for developers, especially in the small-cap space where the number of IPs a company holds is usually limited and few games are released each year. Additionally, there is a significant ramp-up time when a new project is undertaken, as the game developer’s workload is not consistently aligned with that of the audio or functional testing teams, meaning employees may not always have the necessary workload to keep them on payroll.

In this environment, it is easy to understand why video game companies of all sizes are increasingly turning to outsourcing various stages of development. This is where Keywords excels. By working with virtually all the top gaming companies in the world, the company can leverage its scale to provide a consistent workload to its studios. Furthermore, by working across an unparalleled variety of games, Keywords builds a unique breadth of expertise without the need to manage its own IP or take on the risks associated with the release of a single title. Keywords is a great way of betting on the growth of the video game industry without making a call on specific titles or the medium on which it is consumed. The company represents most of what we would look for in a core portfolio holding: a leader in a niche market with pricing power, strong secular tailwinds and a good track record. And we got to buy it at a discount to its average valuation, thanks to investors that fell for this new AI mania.

Monetary and cycle aspects of the forecasting approach used here are currently in tension. Global real narrow money trends suggest a renewed weakening of economic momentum into late 2023. Cyclical forces, however, are scheduled to become more supportive from early 2024 as the stockbuilding cycle bottoms out and moves into a recovery phase.

The two messages can be reconciled if real money momentum recovers over the remainder of 2023, confirming an improving outlook for 2024. Momentum is expected to be lifted by a further slowdown in inflation but a sufficient recovery is unlikely without a policy reversal by major central banks. Current signals are that such a reversal will require a dramatic deterioration in economic data and / or major market weakness.

Economic news has been confusing, allowing optimists and pessimists to claim support for their assessments. Weakness appears the correct interpretation based on national accounts data. An average of the expenditure and income measures of US GDP rose at an annualised rate of only 0.3% in the five quarters to Q1 2023. The monthly measure of UK gross value added has flatlined since last summer while Eurozone GDP slipped into contraction in Q4 / Q1.

Claims of economic resilience or even strength focus on solid employment growth and tight labour markets. Weak GDP expansion has been unusually jobs-rich because of a rebound in the share of lower-productivity services activities. With the goods / services split normalising, this composition boost is probably ending.

GDP / employment divergence has been echoed in PMIs, with manufacturing weakness balanced by services strength. Again, the assumption here is that services exceptionalism is temporary, reflecting a later release of pent-up demand, suggesting focusing on manufacturing as a better guide to trend.

The global manufacturing PMI new orders index reached a 31-month low in December 2022, recovering modestly into the spring before falling back sharply in June. A revival and relapse had been signalled by six-month real narrow money momentum, which recovered during H2 2022 but eased again in early 2023. The recent slide extended into May, suggesting further PMI weakness into late 2023 – see chart 1.

Chart 1

Monetary alarm bells are ringing loudest in Europe. Six-month rates of contraction of Eurozone and UK nominal narrow money quickened further in May, contrasting with less negative and stabilising US momentum – chart 2. Six-month changes in broad money have also now crossed below zero and the corresponding US change – chart 3. Trends in Sweden and Switzerland are even weaker.

Chart 2

Chart 3

China and India remain positive monetary outliers but narrow money momentum is modest by historical standards and has subsided recently. Relative to monetary trends, the consensus view on China looked overoptimistic at the start of 2023 and appears excessively gloomy now, although further policy easing is warranted to cushion the economy against likely export weakness despite a super-competitive exchange rate.

To the extent that the global economy has proved more resilient than expected, one explanation is that the impact of monetary weakness has been delayed by an overhang of “excess” money balances / savings resulting from 2020-21 stimulus. The ratio of G7 broad money to nominal GDP crossed back below its pre-pandemic trend in Q1 2023, suggesting that stock and flow arguments for pessimism are becoming aligned – chart 4.

Chart 4

Cycle analysis is used here to provide longer-term context and a cross-check of monetary signals. Economic fluctuations reflect the interaction of three investment cycles: a shorter stockbuilding cycle typically of about 3 1/3 years in duration; an intermediate business investment cycle of 7-11 years; and a longer housing cycle averaging about 18 years.

The business investment and housing cycles last reached lows in 2020 and 2009 respectively. If current cycles are of normal length, the next lows could occur in the late 2020s. Downswings into lows typically play out over 1-3 years so are unlikely to begin before 2025. This suggests that recent softness in housing and business investment represents a temporary correction within ongoing upswings. Current cyclical weakness, on this interpretation, reflects a downswing in the shorter-term stockbuilding cycle, which last bottomed in Q2 2020 and recently entered the time band for another low.

Stockbuilding cycle downswings in isolation are usually associated with global economic slowdowns or at worst recessions that are modest and / or geographically contained. Examples of the latter include the 1970 US recession and the 2011-12 Eurozone downturn. Against a backdrop of monetary weakness and unusually rapid policy tightening, the expectation here has been the current downswing would be more severe and global than the norm.

The cycle analysis suggests, however, that the window for severe economic weakness will begin to close from late 2023. Recent stockbuilding data indicate that the cycle downswing is already well-advanced, consistent with a low being reached before year-end – chart 5. A stockbuilding recovery could combine with continuing upswings in business and housing investment to drive global economic reacceleration in 2024-25. As noted, however, such a scenario requires confirmation from an early recovery in real money momentum, in turn probably dependent on H2 policy reversals.

Chart 5

The “monetarist” forecast was that G7 headline CPI inflation would fall rapidly from early 2023, mirroring a large and sustained decline in annual broad money growth from a February 2021 peak. This scenario is playing out: a GDP-weighted average of G7 national headline rates dropped from 6.8% in January to 4.8% in May, with a further decline to 4.2% projected for June – chart 6.

Chart 6

Broad money growth returned to its pre-pandemic average in mid-2022 so – allowing for a standard two-year lead – inflation rates may be back at pre-pandemic (i.e. target-consistent) levels in mid-2024. Recent further monetary deceleration suggests significant risk of an undershoot in late 2024 / 25. The cyclical counterargument is that stockbuilding cycle upswings are usually associated with rising commodity prices, which may support headline rates moving through 2024.

A tendency of policy-makers and commentators to downplay headline progress and focus on stickier core readings is the mirror-image of 2021 claims that a headline surge was “transitory”. Disinflation is following the usual sequence from commodities to goods to lagging services / wages. Recent US / Eurozone data confirm a downshift in short-term core momentum, e.g. US “super-core” consumption prices – ex. food, energy, housing and used cars – rose by an annualised 3.1% between February and May, the smallest three-month gain since December 2020.

The two global “excess” money indicators calculated here – the gap between six-month real narrow money and industrial output momentum, and the deviation of 12-month real narrow money momentum from a slow moving average – have been negative in most months since the start of 2022, suggesting an unfavourable backdrop for equity markets. Despite a strong H1 rally, the MSCI World index was 8.2% below its closing 2021 level at end-June. Cyclical sectors (including tech) lagged defensive sectors (including energy) over this period.

An earlier hope that the first measure – the real money / output momentum gap – would turn positive during H1 was dashed by a combination of renewed monetary weakness and a production boost from an easing of supply constraints. With June global manufacturing PMI results signalling output contraction, a cross-over remains possible soon. The second measure – the deviation of real money momentum from a moving average – is further from a switch.

Historically, equity markets outperformed cash on average only when both measures were positive – still a distant prospect. Both the current negative / negative and possible positive / negative configurations were associated with non-energy defensive sectors outperforming non-tech cyclical sectors.

Aerial photograph of a coastal car parking lot as waves break nearby.

The transportation industry has undergone significant change in recent years due to the impact of COVID-19 and technological advancements. Last mile deliveries and car sharing have emerged as important ways of reducing transportation costs. However, it’s worth noting that Uber is now more expensive than taxis in many cases. The industry is continuously transforming, with autonomous driving being a prominent example.

COVID-19 disrupted personal transportation as people avoided public transit and stayed home. But now, as we move forward, consumers are faced with hard choices to balance their budgets, and corporations are demanding increased presence in the workplace.

According to the American Public Transportation Association (APTA), the average household spends 16 cents of every dollar on transportation and 93% of this amount is allocated to buying, maintaining and operating cars. This makes transportation the second-largest expenditure after housing. By opting for public transportation and reducing car ownership, households can save nearly $10,000. This saving becomes substantial when considering the average household income of $67,521 in the United States, especially if housing costs are considered fixed.

There are several secular trends driving the growth of the public transportation market regardless of economic downturns. One such trend is the cost disparity between operating a new bus route and expanding road lanes, which continues to widen as land availability diminishes. Recent studies have also shown that road expansion leads to lower real estate prices compared to improvements in bus transit. Hence, municipalities become important stakeholders for bus transit as real estate prices directly correlate with property taxes.

To support public transportation, governments typically provide subsidies for its operations and passenger ticketing often represents the service rather than a revenue source. In the US alone, the government has subsidized public transport with up to $108 billion, including $91 billion in guaranteed funding until 2026 under the 2021 Bipartisan Infrastructure Law. This represents the most significant federal investment in transit in the country’s history.

Demographically, millennials initiated a shift away from youth car ownership a decade ago. Accelerating immigration and rising housing costs further indicate an increased reliance on public transportation.

The global public transportation market was valued at USD214.54 billion in 2022 and is expected to grow at a compound annual growth rate (CAGR) of 3.7% from 2023 to 2030.

During our recent travels to Australia, we observed the noticeable effects of accelerating immigration. Sydney and Melbourne suburbs are well-positioned for population growth thanks to their organized infrastructure and pleasant weather. The country is now attracting immigrants from beyond Southeast Asia and Melbourne in particular is a vibrant cultural hub poised for multi-year urban expansion.

We visited several real estate developments that are unaffected by slowdowns due to high immigration levels and lack of housing.

When it comes to sustainability, public transit is surpassed only by bicycles. According to the Environmental Protection Agency, transportation is responsible for 28% of greenhouse gas emissions. Whether using electric, biogas or hydrogen-powered vehicles, implementing green public transportation is crucial for controlling greenhouse gas emissions, especially as emerging markets catch up with urbanization levels.

In the realm of public transportation, Global Alpha holds the Kelsian Group (KLS:AU).

Headquartered in Adelaide since 1989, the Kelsian Group has emerged as a leader in public bus, marine transport and tourism operations. It consists of Australia’s most experienced providers of multi-modal public transport services and tourism experiences, operating ferry, bus and light rail services domestically and internationally.

In 2022, the Kelsian Group transported more than 257 million customers, employing around 9,000 people and operating approximately 4,000 buses, 113 vessels and 24 light rail vehicles.

Earlier this year, the company acquired the US-based All Aboard America to establish a presence in the US sunbelt region, which has favourable demographics. The founder of Kelsian personally relocated to Denver to ensure successful acquisition integration.

The US bus transportation industry remains fragmented and as the market becomes more complex with the need for new technologies and multi-engine platform expertise (such as biogas, electric and hydrogen), smaller operators will struggle to compete.

The public transportation industry qualifies as defensive growth. Bus operators typically work under multi-year agreements, often lasting seven years, with inflation adjustment clauses to protect them from cost accelerations. Their compensation is typically based on the quality of their route execution rather than the number of passengers, making low-volume routes still profitable.

Kelsian operates a best-in-class technology platform to optimize its routes and its comprehensive bus driver acquisition and training programs result in low turnover rates. Additionally, it leads the way in offering electrified biogas and hydrogen-powered transportation solutions. As we redesign transit for a greener and more connected society, the future holds tremendous opportunities.

Downtown business skyscrapers in Warsaw, Poland.

Our Emerging Markets team recently returned from an insightful trip to Poland, where we explored its dynamic investment landscape. Since emerging from its communist past and establishing itself as a democratic state in 1989, Poland has achieved remarkable progress. It has not only become one of the major economies in the European Union (EU), ranking after Germany, France, Italy, Spain and the Netherlands, but is also one of the region’s fastest growing.

With a population of over 38 million, Poland boasts one of the largest consumer markets in Central and Eastern Europe. The country is known for its highly educated and skilled workforce. Polish universities tend to produce graduates in the fields of science, technology, engineering and mathematics. It’s no wonder Poland has attracted major players in the EV battery and semiconductor industries, such as LG Energy Solution, SK Inc. and Intel, further cementing its reputation as an attractive investment destination. Cities like Warsaw, Krakow and Wroclaw offer a vibrant startup environment, presenting excellent investment opportunities in technology, gaming and entrepreneurship. Notably, Poland is home to nearly 500 gaming companies employing over 14,000 people.

The country has also benefited from the recent settlement of 1.5 million Ukrainians fleeing Russia’s invasion who are expected to make Poland their permanent home, providing a significant boost to the local economy. Ukrainian can be heard on almost every major Polish street.

Poland’s accession to the EU in 2004 played a pivotal role in its development, granting Polish businesses unprecedented access to a vast market and creating abundant opportunities for growth. The EU membership also facilitated access to funds for infrastructure development, research and other strategic projects, contributing to Poland’s progress.

During our visit, we engaged with our holding companies, explored potential ideas and attended a consumer and technology conference. Key takeaways from our meetings include Polish companies rapidly expanding across Europe, intense competition in the grocery sector (especially from discounters), Polish consumers dealing with high inflation and negative wage growth (but that situation has likely bottomed), concerns surrounding the upcoming Fall parliamentary elections and the hope that the resolution of the war in Ukraine will open up vast opportunities for Polish companies.

Although the current level of inflation remains high, it meaningfully declined to 13% in May from 18.4% in February, mainly driven by moderating food and energy prices. Poland’s central bank has kept its key policy rate unchanged at 6.75% since September 2022, with the governor mentioning the possibility of rate cuts later this year under certain conditions. Meanwhile, the Polish labour market remains robust, with a record low unemployment rate of 5.2% as of April 2023.

A historic mass protest in Warsaw on June 4 that saw as many as 500,000 demonstrators gathering was primarily driven by a controversial law proposed by the ruling party, raising concerns about potential misuse against opposition leaders. The demonstrations also highlighted such issues as inflation and women’s rights.

We anticipate that inflation in Poland will likely persist at a high single-digit level through to 2024. The outcome of the parliamentary elections could either maintain the current political status quo or unlock the flow of EU funds to the country. Additionally, there is potential for a gradual decline in the country risk premium as geopolitical factors become less disruptive.

Considering the current situation, Poland’s equity market looks attractively valued. The WIG20 Index, consisting of the 20 largest Polish companies, trades at a forward P/E ratio of 8.3x, below its 10-year average of 10.9x and the broader MSCI Emerging Markets Index of 11.3x. Foreign investors and operators have shown increased interest in both Polish public and private companies, with notable examples including UK Entain’s acquisition of STS Holdings, German Mutares’ acquisition of Arriva Poland and Czech PPF’s acquisition of a 15% stake in InPost (INPST), an e-commerce logistics company with a strong ESG profile.

Taking advantage of what we believe to be a temporary dislocation in Poland-based equities, we initiated positions in InPost and Grupa Kety SA (KTY), a manufacturer of aluminum products and flexible packaging.

InPost specializes in out-of-home parcel delivery services primarily in Poland, as well as France, the UK, Spain, Portugal and Italy. Through a network of approximately 30,000 automated parcel machines (APM) and 27,000 pick-up and drop-off points, InPost offers a cost-efficient alternative with a significantly reduced carbon footprint compared to traditional door-to-door delivery. The company’s logistics infrastructure in Poland, supported by an efficient technology platform, covers first, middle and last-mile capabilities. We are impressed by InPost’s dominant market position in the rapidly growing Polish market, aided by attractive business economics. Its first-mover advantage in Poland provides a solid foundation for international expansion, further amplified by the acquisition of Mondial Relay in 2021, which unlocked substantial opportunities in Western Europe. Notably, InPost is still guided by its visionary founder, who retains a significant ownership stake in the company.

Grupa Kety is the leading Polish producer of aluminum products used in construction, automotive industries and flexible packaging for household products, confectioneries, pharmaceuticals and cosmetics. With a consistent track record of revenue growth and profitability, Grupa Kety holds a strong market-leading position. The company is led by a stable and professional management team with an impressive track record. We believe Grupa Kety is well-positioned to increase its market share within the EU and expand into higher-margin hard alloys.

Despite visible challenges, Poland presents compelling investment opportunities in various sectors. The country’s economic potential, combined with its strategic advantages and ongoing developments, make it an attractive prospect for investors looking to capitalize on its growth trajectory.

CC&L Financial Group Ltd.

Identifier: Global Equity