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

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

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

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

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

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

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

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

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

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

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

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

Vergent Asset Management LLP

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

Economics 

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

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

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

Politics

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

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

Earnings vs. Valuations

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

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

Outlook

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

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

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

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

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

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

Vergent Asset Management LLP