By Varshan Maharaj, fund manager of the Allan Gray Frontier Markets Equity Fund
It has been said that a perfect world is scary for stocks, and a scary world is perfect for stocks – alluding to the observation that cheap prices are usually accompanied by negative news flow. By many measures, frontier markets are currently a scary choice for more conservative investors, considering the higher levels of uncertainty. However, the negative sentiment and uncertainty can lead to mispricing in the market, which presents opportunities for long-term investors.
2022 began with unrest in Kazakhstan followed by the Russian invasion of Ukraine. Inflation was high in many markets within the frontier universe and many currencies came under significant pressure, notably the Ghanaian cedi which depreciated by 39% versus the US dollar in 2022.
This backdrop, contributed to a large degree of volatility in share prices in the frontier universe and many companies that started the year on what we considered to be low multiples of price-to-earnings, continued to derate further irrespective of the quality of their business or their earnings prospects. Furthermore, while many companies grew their earnings in local currency, US dollar strength led to declining earnings when measured in US dollars.
The net effect of these factors was that there was a large range in returns amongst the various markets in 2022. For example, Vietnam which was an investor darling in recent years, derated significantly on concerns relating to its property sector whereas the Georgian economy grew significantly in 2022, benefiting from a large inflow of people into the nation and higher tourism and transportation-related revenues, among other factors. The Georgian lari also strengthened by 14% relative to the US dollar in 2022.
Few would have predicted these outcomes at the beginning of 2022, especially given the bright prospects for Vietnam and the geopolitical challenges that Georgia faces. This highlights the importance of focusing on valuations and fundamentals at a company level. Our large overweight position in Georgian banks was a strong contributor to the Allan Gray Frontier Markets Equity Fund’s performance in 2022. Some of the larger trades that we made during 2022 included adding to Georgian and Kazakh banks, and to Filipino stocks. At a country level, our material overweight markets include Nigeria, Argentina, Georgia and Kazakhstan, while our material underweights include the Philippines, Vietnam, Peru and Columbia.
Prevailing market conditions suit assets that produce things that are needed, such as food and industrial raw materials. We are seeing potential in consumer staples, sin stocks and commodities. High inflation usually leads to higher interest rates, which erode the value of long-duration assets, because they make future cashflows less valuable. Businesses can offset inflation by raising prices but only partially. Banks stand to profit from a larger spread between their lending and deposit rates. Stocks that trade on low price-to-earnings ratios should see their multiples relatively less affected by rising rates. Furthermore, the flipside of the prevailing low earnings multiples is that lower starting prices are positive for returns going forward.
There are many profitable businesses with good competitive positions in frontier markets that are currently trading on low valuations. For example, Halyk Bank, which is our largest holding in Kazakhstan. Halyk Bank is targeting loan growth of over 30% per annum. About 35% of its loan book is US dollar denominated, enabled by cheap funding from US dollar deposits. Russian exposure is manageable, provisioning seems to be adequate, and it is well capitalised.
Consumer goods companies represent 23% of the Allan Gray Frontier Markets Equity Fund, including several consumer staples stocks. This is an industry that has been undergoing global consolidation over a number of decades. Several of our retail holdings could be attractive acquisition targets, providing upside optionality. Frontier staples are currently trading on low multiples relative to their history, their developed market peers and their earnings growth prospects. The ability to pass on rising input costs (many of which are denominated in US dollars), the strong US dollar and concerns over consumers’ disposable income are weighing on sentiment. We consider these factors to be cyclical rather than structural and we do not expect them to permanently reduce the earnings power and intrinsic value of these businesses.
Some 14% of the fund is invested in resource stocks, with the main exposures to uranium, platinum group metals, oil and gas, and base metals. These businesses trade on low multiples of our normal free cashflow estimates and our assessment of the medium-term demand-supply dynamic is that they are likely to be supportive to the underlying commodity prices. Valuations of mining stocks are depressed relative to other sectors, and the likelihood and observed occurrence of supply disruptions is rising. Furthermore, the prolonged lack of capital expenditure in many commodities and the rising costs of production are seen as factors that could limit the downside if there is a prolonged recession.
What about Nigerian stocks? The Nigerian All Share Index is trading at 2003 levels when measured in US dollars. While these stocks are attractively priced, repatriating funds from Nigeria remains challenging.