The Wasatch Frontier Emerging Small Countries Fund gained 0.68% in the second quarter of 2015 and outperformed the MSCI Frontier Emerging Markets Index, which retreated -1.18%.
Details of the Quarter
When you think of the Silk Road, you probably think of caravans, wind-swept desserts, camels and Marco Polo trading silk, spices and precious stones across a vast swath of Europe, the Middle East, Africa and Asia. Today, China is forming a New Silk Road with what it calls the Silk Road Economic Belt, also known as One Belt, One Road. This policy would allow for a mountain of manufactured goods and a swath of savings (foreign direct investment heading out of China and into One Belt, One Road countries) to flow out of China. This New Silk Road has captured the imagination of the world. The One Belt, One Road policy represents a vast shift in economic policy from an inward focus on growth through internal investment and exporting manufactured goods through a cheap currency to a focus on external investment and creating a strong currency by expanding economic influence regionally—recreating the enchanting trade routes of the past. One Belt is a land route that follows the course of the historic Silk Road, running through Central Asia, the Middle East and Europe. One Road is a sea route that follows the course of the historical Spice Route and encourages greater trade between Southeast Asia, South Asia and North Africa. The policy arguably helps boost growth in an economy that is maturing and slowing. The reality is that China is simply a huge country now and most of the Silk Road economies are tiny—they can’t move the needle for a slowing China. They might help boost the prosperity for some of China’s firms that expand across the new trade routes. What the New Silk Road will most definitively impact is many of the frontier and emerging small countries in which we invest, and this is just one of the many tailwinds we see as a positive for our investing universe. The New Silk Road has grander investment dimensions than just our frontier universe—it reaches across the developed, developing and frontier market countries.
For the Fund, the second quarter of 2015 saw performance improve from the previous quarter. The modest improvement in oil prices and earnings growth†† had a positive effect on Nigeria and Kuwait, while Colombia continued to struggle with a collapsing currency. In Kenya, markets began to cool off from their record highs as investors took profits. Though most frontier markets began to recover from commodity-price fluctuations this past quarter, they faced regulatory headwinds.
Across our diverse markets, negative performance typically came not as a result of corporate underperformance, but rather through increased regulatory action by governments. In Bangladesh, increased taxes on mobile-phone operators led GrameenPhone Ltd. to be among the Fund’s detractors. In Kenya, regulators similarly sought measures to limit the dominance of Safaricom Ltd., the country’s largest telecommunication-services provider. In Sri Lanka, regulatory pressure continued to weigh on a number of our holdings including Dialog Axiata plc, the country’s largest telecommunication-services provider; Ceylon Tobacco Co. plc, the nation’s dominant cigarette maker; and Lanka IOC plc, the listed gas-station operator.
In the second quarter, the Fund’s best-performing sector was information technology (IT). This is owed to FPT Corp., a Vietnamese technology conglomerate, which gained 10.2% on the back of strong revenue and earnings growth. We continue to explore for other companies within IT, as the sector benefits from a longer-term trend of outsourcing labor to lower-cost markets, and further from the growing pool of highly educated and/or skilled labor within frontier markets.
While health care hurt performance last quarter, it was the top-contributing sector this quarter. The Fund’s performance in health care was led by Abbott Laboratories Pakistan Ltd., which recovered following a sharp downturn in March; NMC Health plc, a hospital group based in the United Arab Emirates; and GlaxoSmithKline Nigeria plc, which re-rated as investors grew more confident of the company’s longer-term growth prospects. Highlighting the relative resilience of the sector, our positive returns were geographically dispersed with little correlation across these markets. Within the frontier universe, health care continues to show strong secular growth trends, a reason why we remain overweight in this sector relative to our benchmark.
The energy sector detracted from performance relative to the Index during the quarter. We continue to be underweight in this sector with 1.8% of the Fund in energy versus a 7.1% weight for the benchmark. While our benchmark has a significant weight in energy, and a greater real weight in the sector indirectly with its exposure to Kuwait and Colombia, it remains difficult for us to find energy companies that meet our rigorous investment standards.
Our underperformance in energy was due to two holdings in Sri Lanka, where the sector has seen increased government regulation and increasing competition. Gas-station operator Lanka IOC was greatly impacted by the government setting a price ceiling on fuel gas. In light of this, we exited our small position during the quarter. Our other holding, Chevron Lubricants Lanka Ltd. was hurt by price competition in its industry.
The Fund had a couple of detractors from the telecommunication-services sector—Safaricom and GrameenPhone mentioned earlier. In the case of both companies, given their dominant market-share positions in their respective countries, local regulators effectively increased the cost of regulation. On the other hand, Globe Telecom, Inc., a telecommunication-services provider based in the Philippines, was a source of strength in the sector with a gain of 26% driven by earnings growth.
Our investments in Kenya and Bangladesh detracted from performance during the second quarter. Pakistan and Vietnam were the two largest positive contributors.
The Kenyan market lost all of the gains made in the previous quarter and is now trading slightly below where it started the year. Kenya is the Fund’s largest country weight and it is overweight compared to the Index (9% versus 3% for the Index). While our Kenyan holdings broadly followed market performance, Safaricom and East African Breweries Ltd. were the key detractors from performance. Increasing scrutiny by local regulators of Safaricom, and of East African Breweries’ acquisition of Serengeti Breweries negatively impacted performance. Regulatory behavior in Kenya, in conjunction with the Nairobi market reaching all-time highs, has led us to judiciously trim our holdings there as appropriate to manage risk. We remain confident in Kenya longer term—it is a One Road economy. Nairobi is emblematic of the opportunities presented by our frontier universe. It is one of the world’s largest open-air markets with mobile money leapfrogging credit cards. For anyone who has never been to a frontier market, the absence of a formal retail industry does not indicate a lack of economic vibrancy. Kenya has a decentralized, de-institutionalized commercial structure. Back home in the U.S., all you have to do is wander down to your neighborhood food truck, farmers market, or downtown to understand that you don’t always need big mass-market stores—a lot can be done in the streets, often in a more unique and vibrant fashion. From this perspective, the U.S. looks a lot more like the Silk Road economies we invest in on the frontier.
Our relative overweight in Bangladesh (9% in the Fund versus 1% for the benchmark) reversed the previous quarter’s trend where Bangladesh was the second-largest positive contributor. The aforementioned GrameenPhone and British American Tobacco Bangladesh Co. Ltd. detracted from the Fund’s performance. Given the Bangladesh market’s strong performance in 2014, some retraction was to be expected. Taking advantage of this opportunity, we added to positions in companies that we consider to be high quality such as Olympic Industries Ltd., a biscuit manufacturer with strong growth and high profitability. Political turmoil remains a source of baseline risk in the country as the opposition BNP party contests the ruling Awami League, plunging Bangladesh into oscillating periods of boycotts and strikes (hartals).
Pakistan, Bangladesh’s erstwhile partner, was the Fund’s top contributor to performance. The majority of our holdings in Pakistan contributed to our success there, led by Abbott Laboratories, discussed earlier, and Lucky Cement Ltd., which saw strong earnings growth.
Vietnam was the Fund’s second-best contributor aided by the Bank for Foreign Trade of Vietnam JSC, which re-rated, and Vietnam Dairy Products JSC, where revenue and earnings continue to show solid growth. (Current and future holdings are subject to risk.)
The vibrancy and robustness of frontier markets continues to evolve in front of our eyes, providing us with new and exciting investment opportunities.
First, our markets are now becoming more accessible with trading becoming less onerous. This past quarter, we saw Vietnam announce that it will lift its restrictive foreign-ownership limits, thereby allowing foreign investors to increase ownership in its equity market. Saudi Arabia also took a leap forward this quarter and opened its massive US$560 billion stock market to direct foreign ownership.
Second, we continue to observe the migration of lower-cost manufacturing from its traditional base in China to cheaper labor markets across South and Southeast Asia. But this is no longer being done on the basis of just cost alone. Our meetings with corporate management teams inform us that talent in frontier markets is rapidly improving and attracting greater foreign direct investment (FDI), with many of our markets now directly competing against their emerging market peers.
Third, we are now witness to the nascent beginnings of China’s drive to become a global power, beyond its traditional manufacturing role. China’s “One Belt, One Road” project—often referred to as the “New Silk Road”—seeks to physically connect the country to markets in Asia, Africa and Europe. In doing so, China is deploying massive amounts of FDI across Asia as it builds physical infrastructure and transportation networks. One of the greatest beneficiaries of this investment has been Pakistan, where China announced US$46 billion worth of investment projects. This colossal influx of FDI into physical infrastructure across frontier markets augurs well for their continued long-term economic growth and, from our perspective, for frontier countries.
Lastly, we would be remiss not to mention risks. As governments in some frontier markets seek to fill their coffers, telecommunication services, energy and tobacco/alcohol prove to be the lowest-hanging fruit upon which taxes can easily be increased. Although, historically, these areas of the market have often provided positive returns to the Fund, regulators are now increasingly scrutinizing them. Consequently, we continue to reduce our weights within sectors and industries that could be targeted for increased regulatory action and to closely manage risk.
It is a privilege to be entrusted with investing your assets, one we take very seriously.
†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.
††Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.