The Wasatch Frontier Emerging Small Countries Fund returned just 1.93% in the first quarter, underperforming both its primary benchmark, the MSCI Frontier Emerging Markets Index, and the MSCI Frontier Markets Index, which were up 7.28% and 7.41%, respectively. Frontier markets finished the quarter well ahead of both their emerging and developed market peers with some of the best performance coming from the Middle East in the United Arab Emirates (U.A.E.), Qatar, and Kuwait—countries where the Fund is underweight relative to the benchmark. It appears these markets are being driven by two different but intertwined catalysts. The first is the upgrade of the U.A.E. and Qatar from frontier to emerging market status with their placement in the MSCI Emerging Markets Index, which represents a much larger pool of passive money than is available in frontier. The second catalyst is Kuwait being left behind in the frontier index but with a much larger position in the Frontier Emerging Markets Index. The upgrade announcement was made in June of 2013 with the index changes becoming effective in May of this year. It was at the approximate time of this announcement that the Fund started to underperform relative to the Index.
We recognized that some of these markets in the Middle East had low valuations.†† We sought to invest in quality companies when we discovered them on fundamental research trips, but we saw a risk to the Fund’s short-term performance relative to the Index if valuation bounced up. We also were unable to find enough names that we thought were high enough quality to have the Fund’s weight match that of the benchmark in the Middle East. As long-term investors, this was a risk we were willing to take. We do not believe we can time short-term moves in the market. Looking ahead, we feel much better about relative performance. A number of inexpensive, cyclical companies in the Middle East have risen significantly. When reviewing these cyclical companies, they no longer seem inexpensive, and we do not believe market rallies driven by low-quality, cyclical companies are sustainable. Hence, while we cannot call the timing of the end of this low-quality bounce up (the actual date of the Index rebalancing might be a catalyst though), we know it will end, and we feel we have a broadly positioned portfolio of high-quality stocks that should do well when things change. On a trailing 12-month basis, the Fund tended to do well on days the market pulled back.
Details of the Quarter
On my recent research journey through Southeast Asia and Africa, I had a chance to read James Rickards’ book, Currency Wars. The tome starts in the Pentagon with a simulated game of global currency war, and then seamlessly carries its readers through a simple and often frightening history of global monetary policy to the present day currency wars being waged by the United States, China, Europe, and Japan. The book postulates on a potential coming crisis and dismisses the notion that competitive devaluations will end with benign consequences. The book instantly catapulted me back to the 1980s cult classic film WarGames, where Joshua, the computer programmed by Professor Falken, asks, “Shall we play a game?” Joshua was created to practice nuclear war without allowing the world to destroy itself. Much like the simulated games in Currency Wars, the point of Joshua was to teach computers to learn from the mistakes human beings could not afford to make. However, Joshua never learned the most important lesson—futility—when the game should end. The equivalent is tic-tac-toe, where the outcome is no winners. The warriors playing global nuclear war believed in winners, but also believed in “acceptable losses.” I can’t help but think that this is what our current monetary policy makers believe—that some losses are acceptable in order to win. We’ve seen a number of countries, particularly in the emerging world, that have been damaged by inflation in this monetary policy game, including Egypt, Turkey, Brazil, Thailand, Indonesia and Morocco, to name a few. However, as a world traveler, as a person who sees human beings and economies as more than just collateral damage, there are times I would like to simply unplug the global monetary machine. At best, this is not responsible leadership, and at worst, it creates vast misallocations of capital. I believe the games have not reached their climax, and hence, I’m investing shareholder money cautiously. Perhaps, too cautiously, in a market that just seems to want to go up.
Looking at the Fund’s results for the quarter, we had strong performance due to our stock-picking and overweight positions in Pakistan and Bangladesh. A number of our best contributing stocks came from Bangladesh, including Square Pharmaceuticals Ltd., British American Tobacco Bangladesh Co. Ltd., and Olympic Industries Ltd. Saudi Arabia, a country we consider to be a frontier market, also added a number of top contributors, including Abdullah Al Othaim Markets, Jarir Marketing Co., and Herfy Food Services Co. Our team was on the ground in Saudi Arabia during the quarter. While valuations do not appear stretched and the outlook for growth is still good, we are watching valuations carefully—the Saudi market has had a big move.
Our worst contributing market was Nigeria. While the performance of our stocks was roughly in line with the Index, our overweight hurt. The sell-off was broad across stocks in the country, with names like Zenith Bank plc, Nestlé Foods Nigeria plc, Guinness Nigeria plc and Cadbury Nigeria plc all contracting during the quarter. The good news is that valuations in Nigeria look attractive, and since quarter-end, we have been seeing a strong recovery in a number of our names. As mentioned in the Overview, the Fund was hurt this quarter by our underweight position in the Middle East. In addition, lower-quality companies, including a handful of cyclical property companies, led the rally in markets like the U.A.E. and our names, which we consider to be higher-quality, just didn’t keep up. This is illustrated quantitatively by looking at returns in the quarter by return on equity (ROE)‡‡ deciles. Higher ROE stocks, which tend to exemplify higher-quality companies, did not keep up. When looking at these cyclical companies a year ago, I was worried that we might see exactly what is happening right now—the Fund would underperform against a rally by low-quality, cyclical companies. However, when I look at the valuations of our higher-quality names compared to these cyclical companies today (e.g., property companies in the Middle East), I feel much better about what lies ahead. While there is no guarantee of an immediate reversal in this low-quality rally, when I look at valuations, I believe it will come eventually.
I’m often asked the question, “Have frontier markets come too far too fast?” Frontier markets have enjoyed a sustained period of outperformance...their salad days. Investors have been attracted to the asset class on the hopes of better growth than what they are seeing in both the emerging and developed world and on prospects of better diversification benefits. What’s curious to me is that the markets that have had higher correlation‡‡‡ to the developed world (e.g., the Middle East, which went along for the global financial crisis with a property bubble that was synchronized with that of the western world’s, and is now going through a similar cyclical recovery) are driving recent performance. It makes me wonder if our competitors are using liquidity as a prime barometer for investing, while we are investing in a broad portfolio of long-term growth companies based on fundamental investing. There are signs of a momentum trade gone too far—of valuations in some parts of the world that are rising too quickly. We are not chasing these investments. For anyone thinking about real diversified investing, I would consider the markets that truly lack correlation—portfolios with broader country exposure than the indices.
Paul Theroux described an idyllic spot in the book Dark Star Safari on the Osama Road to Nubia in the Sudan. Relaxing in the village, he listened to the radio, which blasted the daily news that “Japan is in its most severe recession ever, with high unemployment. The world economy is expected to be in its deepest recession since World War II—I thought, ‘None of this news will affect a village like this in the slightest, for such a place is both so marginalized and so self-sufficient that nothing will change it.’” I had these same thoughts as I sat on the island of Zanzibar at the idyllic Zanzi Resort. White, burning skin under blue sky watching dark skin on turquoise waters pulling fish from the sea in a rickety dhow, a vacation of watercolor images in the frontier. A majority of islanders were unaware of the events erupting between Russia and Ukraine. They simply went about their days in this peaceful place. Driving down the rutted, dirt roads to the hotel, I couldn’t help but think about the myriad of questions I get about socially responsible investing in the frontier world, as I stared enviously at seven women ranging in age from young to old sprawled casually on their wooden veranda in the brightly patterned khangas (traditional cotton dresses commonly worn on the island of Zanzibar). Whether relaxing away from the hot sun with the knowledge that gathering wood and food in a country where even stones will grow was a simple task, or from sheer lack of employment, I can only hypothesize. I meandered to my hotel, feeling guilty for metaphorically dropping the Coke bottle from the sky, as in the movie The Gods Must Be Crazy. Then, I recalled the history of the island. The Arabs, or perhaps others before them, dropped trade onto the island. Frontier investors were not the first nor will we be the last group of people to attempt to drive investment returns by pulling the frontier world into the modern trading economy. By the very definition of correlation, dropping dollars and euros into these idyllic spots will lead to higher relationships between markets over time.
However, for now I would argue that we are in the early innings for many of these countries on the road to development. Our trip during the quarter to explore mobile money in the markets of Tanzania, Uganda and Kenya highlighted their early stage of development. Mobile money moves phantom currency from one phone to another, but it rarely acts as an agent of credit—yet. However, as systems like Tigo Pesa, the Millicom International Cellular S.A. platform for money transfers in the Tanzanian market, start to be used by even the bean seller at the local market of Kariakoo, East Africa’s largest open air market, higher correlation will come, and global bankers will help push that development with continued policies of easy money in a far too extended game of quantitative easing.§ For now, the village is the village, unaware of global monetary war and emerging market malaise—less permeated by global events. However, we should be aware of our impact on these people and places, and we should be asking our companies questions about their impact on lives through growth. We were very fortunate to get a broad opportunity to do this by traveling with a bright, young, local Tanzanian woman from Millicom who oversees corporate social responsibility for the company in Tanzania. Millicom is advocating improvement in the lives of women and children in the country. Things that are seemingly simple to us, such as the issuance of a birth certificate, are rare events in the developing world. These are changes companies like Millicom can help push in their local markets. These people should not be viewed as acceptable losses. (Current and future holdings are subject to risk.)
As I rode comfortably in the backseat of a small SUV to the airport in Zanzibar, I peered out at a junior high school-aged boy with a pile of fruit for sale, balanced precariously on a heavy plate, glaring hatefully at our driver, with his cell phone visibly displayed. The boy’s feet were bare, blistered and painfully swollen. Once the Coke bottle falls from the sky, the cycle of development, materialism and credit cycles begins, and it eventually pops too. Every country is a product of its credit cycle, and fortunately, many frontier markets are in the infancy of their cycles. I do not believe they will avoid the pitfalls of the U.S., Europe, Japan, or even China now, but they have simply not reached the point of credit growth, where they have messed things up vis-à-vis overzealous expansion and bad policy. However, the Coke bottle has dropped, inaugurating the cycle of capitalism in most parts of the world.
“Shall we play a game?” The answer is no, we are not and will not. We are running broadly diversified portfolios on a country basis. These are portfolios focused on high-quality companies. We are less concentrated and will continue to be less concentrated than our indices, which we believe are poorly diversified. The Fund is not positioned to keep up with the movements in the current markets. Shareholder money should be treated dearly. When markets get too hot, we are willing to step back, stay diversified, and focus on quality. In short, we are willing to lose a short-term battle in order to retain the potential to deliver good consistent returns. We recognize futility. Even Joshua recognizes (after playing out all possible outcomes for Global Thermonuclear War) the game for what it is… “A strange game. The only winning move is not to play.” Hopefully, the world’s central banks will recognize the futility of its games at some point. Human beings should not be collateral damage in a game that will have no long run winners. Yes, the U.S. economy is seeing some benefit in the short run, and this is helping other regions of the world, the Middle East and Frontier Europe, to cyclical recoveries. As long-term investors though, we want to focus on sustainable long-term returns, and I’m worried that equity markets have gotten too hot in some regions of the world. It might simply be the shifting of the sands—the graduation of the U.A.E. and Qatar from frontier to emerging and the increasing weight of Kuwait in the frontier index. When these regions of the world are stripped away, frontier valuations look reasonable. The beauty and problem of investing on the frontier is that there is no static frontier story. Frontier is a myriad of stories. It is a patchwork quilt composed of countries with economic growth, currency and economic diversification, demographic dividends, improving politics and governance, opening markets, increasing liquidity, and great companies. It is a bottom up, quality and deep due diligence investor’s paradise. New pieces of the quilt in the form of the entry of new markets and countries (e.g., Panama, Iraq, Nepal and Tanzania to name a few) will give us new markets to explore, add, diversify and improve the quilt over time. While I’m cognizant of a run up in the Middle East, I’m optimistic about the portfolio we’ve constructed. I believe it is positioned to hold up well if the market pulls back, which we believe is possible given this stage of the rally. The Fund is composed of a unique and differentiated set of frontier market countries and stocks. We believe those companies have outstanding potential for long-term growth and valuations look reasonable. However, we are always cautious of the credit cycle, and where our countries sit in the midst of the continuing global game. Thank you 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.
††Valuation is the process of determining the current worth of an asset or company.
‡Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
‡‡Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
‡‡‡Correlation, in the financial world, is a statistical measure of how asset classes, securities, markets, or countries move in relation to each other.
§Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.