March 26, 2020
Addressing the Coronavirus Impact: Frontier Markets Portfolio
March 26, 2020
Addressing the Coronavirus Impact: Frontier Markets Portfolio
March 26, 2020
In light of recent events surrounding the COVID-19 virus, and the subsequent oil shock, we wanted to update investors on the Frontier strategy. Our portfolio remains one focused on investing in quality growth companies. That means companies with high relative growth, high returns on capital, and low levels of debt, overseen by a strong management team. We believe this period of relative turbulence will allow our investments to emerge stronger relative to their competitors. Below we provide some insight into how we are thinking about the oil price shock and the COVID-19 virus.
First, the price of oil has collapsed by over 40% during the last month, driven by a decline in demand due to COVID-19 and an increase in supply as the OPEC+ oil producing countries were unable to come to an agreement, ultimately leading to Saudi Arabia’s decision to increase oil production to a record 13 million barrels per day.
The MSCI Frontier Index has fairly large exposure to this oil price risk, as over half of the index (51.5%) is made up of heavy oil exporting countries, consisting of Kuwait (index weight of 37%), Bahrain (6%), Nigeria (5.4%), Kazakhstan (1.7%), and Oman (1.4%)1.
In our Frontier portfolios we have a significant underweight to oil producing countries, with an aggregate weight of 24.2%, or nearly half that of the index, consisting of Kuwait (12%), Bahrain (0%), Nigeria (2.4%) Oman (0%), Saudi Arabia (1%), UAE (2.75%) and Kazakhstan (6%)1. Secondly, with respect to COVID-19, it is difficult to measure the current and future impact on our portfolio given the dynamic situation, but a few comments we would make are:
Some of our portfolio companies in Asia—Vietnam, Indonesia—have sold sharply, as many of them are concentrated in the consumer/retail sector. Following calls with their respective management teams over the past two weeks, we have gained confidence that this is but a temporary shock, as footfall traffic has already begun to return. Thus while a few of the stocks with discretionary consumer exposure have sold off, we are confident in their longer-term growth profile, market position, and profitability, and in some cases have used this temporary weakness to add to certain positions.
The current COVID-19 related downturn will also sow the seeds for an acceleration in a number of our investment themes, which we believe can experience accelerated adoption in a “post COVID-19 world” due to changing outlooks in consumer, corporate and regulatory behaviour. Yet as is typically the case in equity risk-off contagion episodes, the market does not properly distinguish between business models that will be impacted, either positively or negatively, from a specific shock.
For example, one theme that has driven some of our investments is “fragmented to formality.” Currently, many consumers in frontier markets still purchase groceries, retail goods, and healthcare from small, informal “mom & pop” businesses. We believe formal penetration will steadily increase towards companies with professional, formal businesses, with stricter health and safety standards. This penetration trend is likely to accelerate in the coming years and we have invested in companies that stand to benefit from this in Vietnam, Morocco and Egypt, to name a few.
Another theme that has driven investment decisions is digital payments (companies in Argentina, Indonesia, Vietnam, UAE and Kenya) which we believe will continue to be a secular trend, but which may be boosted incrementally by fears of virus spread from hard cash. Similarly, our investments in themes surrounding e-commerce, video-gaming and software solutions companies, for similar reasons, could see their steadily increasing penetration accelerate in a post-COVID-19 world. Downturns often accelerate trends already in place. For example, landline phone penetration held up fairly well in the US until the dot-com bust and it then collapsed as consumers prioritized expenditures. We believe our thematic overlay in the above mentioned industries will add valuable alpha in the coming 2-3 years.
The biggest active overweight and underweight in our portfolios continues to be a large 25% underweight in Kuwait, and a large 9% overweight in Egypt.
Our structural underweight in Kuwait is driven by a lack of investable opportunities in quality growth companies in the country. We do have two positions in the banking sector playing different themes, but we are not willing to allocate anywhere near 40% of our capital (MSCI Frontier Index weight) to a country with only 4 million people where income levels are already quite high at ~$30,000 USD per capita2. In the near term, Kuwait has begun to outperform as it is graduating into the MSCI Emerging Markets Index, and it typically behaves as a defensive market (currency peg, low oil breakeven price for fiscal accounts vs oil exporting peers), however we are seeking better opportunities in markets where valuations are more compelling given the recent stock sell-off.
In Egypt, the country had begun to reap the rewards of recent reforms in the form of an interest rate cutting cycle leading to a capex cycle after nearly a decade with no investment. However, Egypt does rely on tourism (4% of GDP) as a source for US dollar inflows and thus we could see some impact on the currency3. We nonetheless believe some of the recent sell-off in the market has been overdone as valuations are nearing the levels last seen in 2015 prior to the 50% devaluation of the currency and reform program. As such we believe Egypt is one of the most compelling markets in the Frontier landscape, but we will be closely monitoring the currency and how the country reacts to COVID-19.
We remain very positive on the Frontier market equity asset class. In a world increasingly characterized by de-globalization, we continue to invest in the winners of the next decade, including countries benefitting from a shift out of China (Vietnam), and countries with large shares of domestic demand which are less reliant on exports (Egypt, Indonesia). Frontier economies are growing faster than developed and most emerging markets, and we believe strongly in the ability of our highly concentrated portfolio of companies to capitalize on this strong growth. The Frontier market equity asset class continues to offer strong diversification benefits, and this diversification can be bought at historic lows in terms of valuations relative to global equities. After a period of underperformance, we believe Frontier equities are set up well to be a clear winner in the coming decade.
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