The Wasatch Frontier Emerging Small Countries Fund fell -4.52% in a disappointing first quarter of 2015. The Fund also underperformed the MSCI Frontier Emerging Markets Index, which lost -2.42%.
The first quarter was a difficult time for frontier markets. Lower oil prices continued to weigh on net exporters of oil and hurt performance in Nigeria, Colombia and Kuwait. In particular, Nigeria was a source of weakness for the quarter as it confronted Boko Haram. But the country also underwent a presidential election that saw the first truly democratic transition in the government since the country’s independence in 1960—one of the many positive macro developments we witnessed in frontier markets during the quarter. Many frontier markets remain bright spots of both positive change and growth in a growth-challenged world.
I think the pullback in frontier markets has been overdone and has been driven by sharply lower oil prices, which have had collateral effects on more domestically oriented companies in various countries. We don’t have much exposure to oil-exporting companies. And with the retrenchment in the equity markets, stocks look attractively valued. In our opinion, the pullback has awarded us with one of the best long-term investment opportunities we’ve witnessed in a quite some time.
Details of the Quarter
In his latest quarterly message, Wasatch Funds’ President, Sam Stewart, speaks of dragons as metaphors for uncertainty in today’s investment environment. And there’s no better fund than the Frontier Emerging Small Countries Fund to discuss venturing into places relatively unexplored on the map, where dragons illustrate a boundary not yet crossed by most investors.
It’s 10 a.m. I’m sitting on a boulder atop a cliff of a small Asian island, reading and occasionally glimpsing out at the ebb and flow of the tide. The book in hand is one on Vietnamese history, written from the Vietnamese perspective. The book’s lyrical writing teaches so much about the culture, which is important for investors to understand.
An occasional dragonfly flits through the air, meandering aimlessly around the rocks. Suddenly, hundreds of colorful dragonflies gather overhead and then for hours are on a course to circle the island. Now, as an analyst, it’s impossible for me to avoid thinking about why they’re doing this—instead of just viewing it as a simple, natural, magical happenstance.
The sea catches my eye again. Having recently watched the movie Unbroken, I ponder, are these dragonflies the unlucky sky soldiers chosen to sacrifice their lives for other dragonflies? Or maybe, just maybe, they’re simply out having fun, enjoying a gloriously sunny day.
The dragonflies would not repeat this pattern the next day. Was this purely a random event? Was I overthinking the actions of these real modern-world dragons that float over Asia’s beautiful emerald rice paddies?
Given a number of weak quarters in a row for frontier markets and all the headlines in the media suggesting that something might be wrong with the economies where we invest, my team and I rolled up our sleeves this past quarter and we went out in an attempt to slay the dragons—to find out if the negative movements in the markets had much justification based on the fundamentals. We ventured into Vietnam, Cambodia, Laos, Turkey, Sri Lanka, the United Arab Emirates (UAE), Qatar, Egypt, Tunisia and South Korea (which has a number of listings that capture growth in frontier economies).
We met scores of management teams and spent hours with central bankers, the International Finance Corporation, the International Monetary Fund, journalists, economists and other experts in each country. This was one of the most-grueling explorations of frontier markets since the launch of the Fund, and that says a lot coming from someone who spends the majority of her days away from home. When stocks go down, I always fear I’m missing something. However, I walked away from this trip—this deep dive—with even stronger convictions. The frontier story remains as good as, if not better than, ever.
While my time on the island watching the dragonflies might seem idyllic, it was literally my first weekend and day off in four weeks, as dragon-slaying entails hours of weekends on planes, in customs, in cabs and in meetings. The island gave me the seclusion and time to summarize and ponder the dragons.
Norman Lewis wrote a great travel book, A Dragon Apparent, about Vietnam, Cambodia and Laos. Dragons and other mythical beasts comprise a vast array of symbols in Asia. The travels of Lewis took him to an untouched world of temples, statues, ancient rituals and customs. Places where ghosts easily intermingled with the living, where one could still see dragons—the unknown, the scary, the things not witnessed by many, and often the imaginary—the stuff of fantasy.
It had been roughly a year since I last touched down in Vietnam and about three years since I had been to Cambodia and Laos, and the changes underway are stunning. These countries appear perfectly positioned to benefit from the movement of jobs from China. Dynamic, young, educated labor pools set off a pulse—a vibrancy—that’s lacking even in parts of the emerging world.
It doesn’t stop at low-end jobs. High-tech jobs are moving here as well, and the rapid adoption of technology will push one of the fastest commerce transitions in the world. The area is buzzing. In Vietnam, the cyclo drivers, those who once peddled travelers through meandering alleys, have given way to motorcycle riders, and motorcycles are slowly losing out to cars. Even the mom-and-pop shops are ceding ground to the likes of Louis Vuitton and Popeyes Chicken.
Vietnam is targeting hundreds of initial public offerings (IPOs).†† Cambodia is introducing companies as well, though custody is still a bottleneck. Laos is behind the curve, but has plenty of funding from regional governments that see placing money here as having the potential for great returns on investment. We can gain access to this market through regional players with a strong footprint in Laos. So why isn’t the Vietnamese stock market raging? From our deep due diligence, it’s nothing fundamental. Perhaps some frontier investors believe the best is in the past and are taking profits. However, our analysis concludes that for most constituents of the frontier asset class, the best is yet to come. Vietnam, Cambodia and Laos exemplify our conclusion, and valuations††† are enticing.
These three countries aren’t the only great examples, though. Sri Lanka is largely misunderstood and, in our view, is on a very positive course. Yes, the newly elected government made a few tactical mistakes. But the main point, and I can't emphasize this enough, is that the government was freely elected. The people voted to reject the status quo, which had been evolving into a one-man, one-party system. This new level of democracy is also supported by the business community. The country is sitting pretty in the middle of the Indian Ocean. With a deep-water port, a young and educated workforce, and an enviable landscape for tourism, other countries such as China, India and Japan are pounding on Sri Lanka’s door wanting to get in on the ground floor of this amazing opportunity for economic growth and business prosperity.
In Egypt, the abayas (cloaks for women) were off. Egyptians, both men and women, were walking the streets. The tourists were returning to the ancient sites. Now, with pragmatic military governance in place, the country is once again establishing law and order. Egypt has a young, vibrant population as well. There is huge potential for growth here. My only fear with Egypt in the very long run is that the desert simply can’t support the huge swell of humanity. The country is overpopulated. With that long-term risk in mind, the next few years look good. Due to the resurgence in the economy, we’re seeing ample high-quality investments and new listings.
As for Tunisia, it was my first visit. This is the country where the Arab Spring‡ was ignited. Surely, this would be a terrifying place—filled with dragons. As we flew out of Egypt and around Libya’s airspace, my windows projected a view of verdant hills covered in olives and grapes, a sparkling sea, and modern roads and buildings. This was not chaotic Egypt. It was like Europe—Croatia, Italy or Greece to be specific. And with its French colonial legacy, the Tunisian mind seemed existential and free—inspired more by the words of Camus than the dogma of many Middle Eastern cultures. After a day of meetings and a lunch at the last remaining caravan hotel in the city, it was crystal clear to me that the reason the Arab Spring started in this nation was that it could. Tunisia is an open, peace-loving nation that allows free speech (or a close-enough proximity).
The country does have the misfortune of neighboring two dysfunctional nations that push their radical ideologies over the border (and with the backing of oil money). However, the radicals in Tunisia hold a minority position. The majority voted for democracy. The majority is pushing the country ahead. The country will continue to see radical behavior inspired by well-funded groups outside its borders, as happened again recently at the National Bardo Museum. But I think this is the sad cost of trying to uphold freedom, and Tunisia is an inspiring story in this region. While Tunisia is a small market, its companies have a long history of regional success and significant growth rates. In addition, attractive IPOs are springing up in the country.
I’ve already mentioned the peaceful elections in Nigeria. Another positive development is that Myanmar is pushing to open up markets this year. And Iran is at least paying lip service to peace. These are all pivotal events in the fledgling frontier space.
During the first quarter, the sector that detracted the most from the Fund’s absolute performance was consumer staples. We believe consumer-staples companies continue to offer the most attractive exposure to frontier markets with the best risk-to-return profile, which explains why over 40% of the Fund is in this sector. During the first quarter, our consumer-staples holdings declined, but not as much as those in the benchmark.
Several of the Fund’s biggest detractors for the quarter came from the consumer-staples sector, including food-products manufacturer and distributor Nestlé Nigeria plc, Nigerian Breweries and food processors Grupo Nutresa S.A. (Colombia) and Juhayna Food Industries (Egypt). However, six of the Fund’s top 10 contributors to performance were consumer-staples companies including British American Tobacco Bangladesh Co. Ltd., Universal Robina Corp., the largest food and beverage company in the Philippines, and Agthia Group PJSC, a UAE agribusiness and consumer-foods company.
The materials sector also weighed on the Fund’s performance and detracted from results versus the Index. Our performance in the sector was hurt by our holdings in Lucky Cement Ltd., a Pakistan-based cement manufacturer, and Hoa Phat Group JSC, a Vietnamese steel company.
Health care was also an underperforming sector within the Fund. Our health-care holdings, though down, held up a little better than those in the Index. The underperformance was the result of being overweight in this sector. The Fund had a health-care weight of over 7% compared to a weight of just over 1% for the benchmark. Abbott Laboratories Pakistan Ltd. was one of the Fund’s largest detractors in the quarter with its stock price down over 30%. One of the Fund’s top 10 contributors was NMC Health plc, a UAE-based hospital company.
Our holdings in Nigeria and Pakistan, traditionally strong markets for the Fund, were the sources of weakness for the quarter. Bangladesh and the Philippines were the two largest contributors to positive performance.
Followings its dismal performance last quarter, Nigeria continued to be the biggest source of weakness for the Fund. Although we trimmed our holdings in Nigeria during the quarter, our performance in particular was hurt by our holdings in Nestlé Nigeria and Nigerian Breweries (mentioned earlier). Kenya was the rare outperformer for the Fund in sub-Saharan Africa, helped by our investment in telecommunications company Safaricom Ltd., the Fund’s top contributor for the quarter.
The Fund’s holdings in Pakistan were down over -17% for the quarter and underperformed their benchmark counterparts. The effect on the Fund’s performance relative to the Index was compounded by our overweight position in the country. Although Pakistan started off strong in the first quarter, the Pakistan component of the Index fell by 17% from February 3 to March 30, driven largely by selling from foreign shareholders, before rebounding. In the previous quarter, however, our overweight position in Pakistan and the outperformance of our holdings made the country the Fund’s top contributor. Two holdings—Lucky Cement and Abbott Laboratories (mentioned earlier)—hurt the Fund’s results in Pakistan.
Not all was gloomy in South Asia, however. Our position in Bangladesh contributed positively. Our holdings were up about 5.5%, while those in the benchmark were down approximately 1.7%. With a weight of around 9%, the Fund was overweight in Bangladesh, which helped performance versus the Index, which had a weight of about 1.2%. (Current and future holdings are subject to risk.)
One of my favorite pastimes while living in Asia was visiting the myriad of shrines, temples and pagodas. Twisting banyan trees rooted in front of enormous pillars often framed huge doors to the temples. Dragons swirled and twisted up the pillars in a dance. I never feared entering under the dragons and discovering the magical interior of the temple. But development is progressing rapidly, and with this the dragons are opening and changing and for me this is bittersweet. Our investments have magnificent growth potential, but the spots on the map with mysterious, fantasy dragons will continue to disappear.
There are many appealing conditions within the frontier asset class. Moreover, the majority of frontier markets are growing, accelerating and inexpensive. Most of the countries aren’t oil exporters. In fact, they are importers benefiting from the fall in commodity prices. Frontier is not an oil story. It is the story of youth, vibrancy, change, ambitious labor, and often enviable geography. It is a story of political progress, and not of political perfection. Nigeria should be a catalyst. Let’s hope it is.
While I’m comfortable with our investments, I’ve had the privilege of personally venturing to these places to see the opportunities firsthand. My hope is that investors trust me as a dragonslayer. I take my fiduciary duty with the utmost seriousness and invest alongside all of the Fund’s shareholders. My fear is that without confronting the dragons firsthand, investors will confuse falling stock prices with weak fundamentals. I hope I’ve convinced you otherwise, but I certainly understand the confusion and disappointment in the short run. I remain confident and excited about the long-term prospects of frontier markets in general, and the Fund in particular. I believe in active investing over passive investing. I believe in investing where we see the best potential for returns on capital‡‡—and not chasing momentum-driven stocks, which is what often happens in index funds.
I’m using the current dislocation in frontier markets to upgrade quality even more. I continue to seek the best long-run returns with a constant eye on risk and diversification.‡‡‡ I still believe the opportunities are apparent—they are in frontier markets—and they continue to have the highest growth prospects with relatively low correlations§ to developed and emerging markets.
Thank you very much 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.
††An initial public offering (IPO) is a company’s first sale of stock to the public.
†††Valuation is the process of determining the current worth of an asset or company.
‡The Arab Spring was a series of antigovernment protests and demonstrations across the Middle East and North Africa that commenced in 2010.
‡‡Return on capital is a measure of how effectively a company uses the money, owned or borrowed, that has been invested in its operations.
‡‡‡Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. Diversification does not eliminate the risk of experiencing investment losses.
§Correlation, in the financial world, is a statistical measure of how asset classes, securities, markets, or countries move in relation to each other.