The door slams shut. Cold air rushes through the bug-eyed ventilation system. I take my sleeping pills. Select a movie. Wake up to the sound of the flight attendant announcing our arrival. Step off the plane. Time 1920 - 1970 or thereabouts, depending on where I’ve landed. The setting. Usually Dickensian squalor. A market scene from Romancing the Stone or Cairo in Raiders of the Lost Ark. This is a day in the life of the frontier traveler.
In October 2014, Empirical Research Partners, a provider of in-depth research on a range of topics for institutional investors, issued a report on the two habits of highly effective investors. Their conclusions, in brief, were that to be a successful investment manager, generating meaningful alpha,†† entailed having a high active share and long holding periods. In other words, managers have to sit still and be different—not just from an index but from other investors as well. I’m fortunate to be part of a firm that allows for this type of behavior—that emphasizes long-term performance and risk-mitigation and that doesn’t measure time in days, weeks, months, quarters, or even a year, because if you look at 2014, it wasn’t a great year for the Wasatch Frontier Emerging Small Countries Fund. The quarter was much better, and I believe this is due to the Fund’s long-term positioning. The Fund was and is positioned in a markedly different fashion compared to its indices. The Fund was and is dramatically underweight relative to the indices in commodity-heavy sectors and commodity-exporting countries. That was to the Fund’s detriment in the first half of the year and contributed to a 12-month period in which the Fund was up only 1.69% versus its primary benchmark, the MSCI Frontier Emerging Markets Index, which was up 7.20% for the 12 months, and versus our secondary benchmark the MSCI Frontier Markets Index, which was up 6.84%. In the fourth quarter, the Fund lost -4.74%, while the indices sold off heavily. The MSCI Frontier Emerging Markets Index was down -10.42% and the MSCI Frontier Markets Index fell -12.46%. The Fund’s better performance relative to the indices in the fourth quarter was too little too late for 2014. However, in the New Year the Fund has been seeing a strong continuation of year-end trends. Investors are returning to higher-quality companies. The Fund has been outperforming in all sectors. Weakness in currencies and commodity prices has been taking a toll on some countries in recent months. While I have no idea what the year 2015 has in store for the Fund on an absolute basis—it is hard to predict the market for a year—valuations‡ for companies in frontier markets and the markets of emerging small countries look attractive in spite of a few years of outperformance by the asset class. Frontier companies have been delivering better earnings growth‡‡ than emerging or developed markets.
Details of the Quarter and Year
Cathedral silence in a noisy world. I march down through the ochre and red swirls of the canyon towering above my head. This is my Wall Street—the hushed backcountry of Utah’s Bryce Canyon National Park, where slot canyons twist up into castles in the air. At the onset of my journey, jackhammers had beaten out paths for the less adventuresome to explore the park and a barrage of chattering tourists with cameras—akin to the ceaseless noise of New York City—invade ones thoughts. If you push on, off the beaten paths of the park, like a walk into the periphery of Central Park after dusk, you enter a completely different place—a place where stillness allows for introspection—where the stars burn brightest and footsteps tread fresh paths on unbeaten snow. In quarterly letters for the Fund, I often discuss where the research team has been traveling in the course of the deep due diligence we apply to every investment, but this quarter, I sat still—focusing on home, screening, and portfolio reflection. Sitting still—not chasing momentum and risk—did not work for most of 2014. However, it started to work in the fourth quarter and is continuing to show signs of life in the New Year—the Fund has been outperforming again across sectors. The consumer-related sectors, where the Fund has a large overweight compared to the Index, should see a much-improved year, as low oil prices put extra money into consumers’ pockets.
The year has once again come to a close, and by now, no doubt, you have witnessed the retrenchment of the frontier markets, with an eye to the daily headlines of crashing oil prices, terrorist strikes, wars, and outbreaks of hot viruses throughout our investment universe. In Africa—the frontier—Things Fall Apart. Yes, I’m stealing the title of Chinua Achebe’s great Africa book to describe 2014. That’s mainly what happened last year—Africa, namely Nigeria, slipped as it faced the combined negative forces of an election and falling oil prices. The other reason the Fund struggled is that the first half of 2014 witnessed a large rally in cyclical stocks and countries, namely in the Middle East—the United Arab Emirates (UAE) and Qatar. Earlier in 2014, MSCI reshuffled and the UAE and Qatar graduated from frontier to emerging markets, which helped propel an unsustainable rally in these markets. The positive outcome is that we believe the frontier index now offers better regional diversification, has fewer oil-dependent countries, and offers more countries with the markets we believe are truly frontier (i.e., the sort of markets with good young demographics and the potential for rising productivity). We are excited about the long-term prospects of our asset class.
While Nigeria was a tough place to invest in 2014, we had solid performance in our Asian frontier markets. Bangladesh, Pakistan, Sri Lanka, and the Philippines added to the year. Frontier Asia has a number of tailwinds. The first driver, which I’ve talked about extensively in the past, is relatively cheap labor. Bangladesh, Vietnam, the Philippines, Laos, Cambodia, Myanmar, Indonesia and Sri Lanka should steal market share in manufacturing from China. In addition, most of these countries benefit from falling commodity prices. They are all importers of oil and with oil prices down, the cost of running the countries (the budget) will fall, potentially aiding the currencies. One Asian country that has lagged for us is Vietnam. The reason is that Vietnam had a credit bubble and a banking crisis and is still on the mend. The good news is the market is inexpensive, and fundamentals are turning—the banks are seeing improvement in their loan quality. We believe this means good things for the market in the upcoming years. In the long run, we are extremely optimistic about the entire region. Growth is intact if not improving with falling commodity prices (in spite of slow global growth from the export markets), and valuations look attractive. The Fund has a large allocation to frontier Asia and we are aggressively exploring new ideas.
As I mentioned, Africa was a weak link in 2014. We have opted to own what we believe are the best secular growth regions in the world—so the Fund is overweight in Africa and Asia and underweight in the Middle East, which we view as a more mature market. We want to focus on growth areas. I mentioned Chinua Achebe’s great post-colonial novel Things Fall Apart. It is one of a number of African novels grappling with the process of creating a nation. A Bend in the River by V.S. Naipaul, who won the Nobel Prize for literature, is another work from this genre. Naipaul’s novel is set in an unnamed East African country. Independence has been won. Hope springs for an Africa ruled by Africans, but this East African country is a fractured society on a fractured continent. While surface modernization occurs (new buildings, new schools), there is an entirely new set of dictators—same autocracy, different skin tone. “It isn’t that there’s no right and wrong here. There’s no right.” My point is that Africa has gone through many periods of hope only to have those hopes dashed by setbacks. The short- to medium-term picture for Africa is challenging. A lot of changes are needed including improvement in governance in many spots, advances in education, and also infrastructure development. For now, frontier Asia has a better short-term picture than Africa. In the long run, I’m very optimistic about Africa, and in the short run, I feel good about countries within the greater continent. Egypt, Tunisia, Kenya, Botswana and Morocco all offer improving short-term outlooks. Africa is not a country, it is a continent. However, as a continent it offers great demographics and bold potential for growth through productivity improvement. I believe the setbacks experienced in 2014 are temporary—what happened in Nigeria is merely a bend in a river.
From an early age, I had the urge to be someplace else—a compulsive travel bug. I’ve long since given up hope that old age—maturity—would cure my restlessness. Fortunately, I found a career that has allowed me to scratch this itch in a way that I believe is constructive for investors. Frontier markets are the investment world’s roads less traveled, unbeaten paths where an active manager can make a difference through deep due diligence and exploration. Better yet, I found a firm, Wasatch—off the map in Utah—with an amazingly talented set of people in all departments and the right focus—an emphasis on investing for the long run, being different, and a Fund that allows me to fall off the map, visiting the world’s loneliest untapped markets, trying to find the best long-term growth companies and countries. Like Empirical Research Partners, I believe this is the only way active management will survive and be successful for investors. We can get off New York’s Wall Street—which is trading stocks like a hamster running on a wheel—and practice Pico Iyer’s The Art of Stillness in Bryce Canyon, Utah’s version of Wall Street. It means, as a firm, we have the patience to have bad years relative to the benchmarks in order to pursue the potential for good long-term returns for shareholders. New markets with Back to the Future qualities are opening. Cuba with its antique cars and Ethiopia with its antiqued lands offer what we see as amazing potential. We will be there early, exploring the markets in 2015. We are past the point in the current market cycle where cyclical stocks are raging. The decline in oil and commodity prices is giving the Fund a much-needed respite—at least relative to the Index. Growth can readily be found on the frontier, and we believe valuations are supportive of reasonable long-term returns. We have focused on the long run, and now believe the Fund’s consumer-heavy portfolio is well-positioned to have a better year—for 2014, we hope, was a bend in the river.
Thanks for your investment.
†The MSCI Frontier Emerging Markets and MSCI Frontier Markets indices are free float-adjusted market capitalization indices designed to measure equity market performance in the global frontier and emerging markets. You cannot invest in these or any indices.
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
The Wasatch Frontier Emerging Small Countries Fund’s investment objective is long-term growth of capital.
††Alpha is a risk-adjusted measure of the so-called “excess return” on an investment. It is a common measure of assessing an active manager’s performance as it is the return in excess of a benchmark index or “risk-free” investment. The difference between the fair and actually expected rates of return on a stock is called the stock’s alpha.
‡Valuation is the process of determining the current worth of an asset or company.
‡‡Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.