Asia Frontier Fund USD A-shares lost −1.2% in June 2017. The fund underperformed the MSCI Frontier Markets Asia Net Total Return USD Index (+3.1%), the MSCI Frontier Markets Net Total Return USD Index (+0.6%), and the MSCI World Net Total Return USD Index, which was up +0.4%. The performance of the AFC Asia Frontier Fund A-shares since inception on 31st March 2012 now stands at +77.6% versus the MSCI Frontier Markets Asia Net Total Return USD Index, which is up +48.1%, and the MSCI Frontier Markets Net Total Return USD Index (+40.9%) during the same time period. The fund’s annualized performance since inception is +11.6% p.a., while its YTD performance stands at +4.2%. The broad diversification of the fund’s portfolio has resulted in lower risk with an annualised volatility of 8.91%, a Sharpe ratio of 1.28 and a correlation of the fund versus the MSCI World Net Total Return USD Index of 0.34, all based on monthly observations since inception.
This was a tough month for the fund despite a very good performance of the fund’s Vietnam and Sri Lanka holdings which outperformed their respective markets by a large margin. The fund’s Vietnam holdings were up approximately +7.8% led by positive moves across most holdings as economic fundamentals continue to be positive. The recently announced 2Q17 GDP growth of 6.2% was better than the 5.2% growth reported in 1Q7 and what was more positive was manufacturing growth of 12.3% backed by foreign direct investment inflows and retail sales growing by 8.4%. The economic cycle continues to be on an upswing in Vietnam and it would not be surprising to see similar or higher GDP growth numbers in the second half of the year as has been the case historically.
The fund’s Sri Lanka holdings were up approximately +5.9% led mainly by a consumer conglomerate and a household products company which recently got listed on the local exchange. Low valuations as well as a pick up of construction activities on previously stalled infrastructure projects has led to more interest in the Sri Lankan stock market which has resulted in a good rally in our holdings so far this year.
The largest negative impact this month came from Pakistan which since inception has been the best contributor to returns for the fund. The KSE100 Index corrected by 8.0% this month which is its biggest monthly fall since September 2015 when it fell 7.0%. There are two major reasons for this correction: in anticipation of being upgraded to the MSCI Emerging Markets Index local investors had purchased the large cap names which were expected to be a part of the MSCI Emerging Markets Index in the hope of selling these securities to foreign emerging market funds. However, Pakistan received only a 0.1% weight in the MSCI Emerging Markets Index (0.15% was expected) which is very small for most global emerging market managers which led to lower than anticipated foreign inflows from 1st June 2017 onwards. This enticed the local investors to reduce their positions in these large cap names, more specifically the six names which made it to the MSCI Emerging Market Index. The weight of these six companies is ~29% in the KSE100 Index and they corrected between 14%-26% from the market’s peak on 24th May until 22nd June, just before the Ramadan break.
The other major reason for the weakness was the continuation of the “Panama Papers” drama surrounding the Prime Minister Nawaz Sharif. The Supreme Court in its verdict on 20th April 2017 did not disqualify the Prime Minister from holding office but instead appointed a Joint Investigation Team (JIT) to further investigate the matter. Tensions in the market rose as the Prime Minister was questioned by the JIT in mid-June and this has resulted in a lot of political noise regarding what impact this investigation will have on the Prime Minister. The investigation is expected to be complete by the second week of July 2017 and until this political noise dies down market sentiment could remain weak but we are not surprised by these political issues given that elections are expected to take place in May 2018.
Investors have also become concerned about Pakistan’s current account deficit and weaker foreign exchange reserves. Higher imports of machinery due to the China Pakistan Economic Corridor (CPEC) as well as higher volumes of oil related imports in addition to higher oil prices, have inflated the import bill, while weak exports and lower remittances have not provided any cushion to either the current account or foreign exchange reserves. Though these are valid concerns, the machinery imports are primarily related to CPEC projects which are being used to put up new power capacity which will help GDP growth rates in the future given the power deficit in the country. The increase of petroleum related imports is occurring not only due to higher prices but also higher volumes led by increased economic activity as is reflected in the higher passenger car and commercial vehicle sales over the past year. Furthermore, if oil prices stay where they are now, the impact of higher prices on imports should reduce in the second half of 2017 as oil prices have ranged between USD 45-55 over the past year.
Given that the current account deficit as a % of GDP is expected to be around 3% this year, the Pakistani Rupee is expected to weaken and this could cause short term cost pressures for most companies but to argue that the above issues diminish the case for investing or under weighting Pakistan is a bit exaggerated. The Pakistani Rupee depreciated by 8.0% in 2012 and 2013 respectively but the KSE100 Index gained 49% in both of these years.
The current political and macro issues are clouding out the more positive longer-term trends in Pakistan backed by the China Pakistan Economic Corridor (CPEC) projects (some of which have already been executed), an improving security situation and a large underpenetrated consumer market. Further, economic indicators such as private sector credit growth, automobile sales and cement sales continue to be positive while estimated GDP growth over the next five years is expected to average 5.5%. The last time such growth rates were achieved was between 2004-2007 when average GDP growth was 6.9%. So, to us it seems the economic cycle has only recently turned in Pakistan over the last 12-18 months and we would use any near term weakness to buy companies we like as further weakness in the market would only make valuations more attractive.
On 26th June Mongolia held its Presidential election where no candidate won more than the required 50% of the votes. Therefore, on 7th July Mongolia held its first ever Presidential run-off where Kh. Battulga of the Democratic Party faced off against the Mongolian People’s Party’s M. Enkhbold (the Mongolian People’s Party currently maintains a Supermajority in Parliament). During the runoff, Kh. Battulga won with 50.7% of the votes, while M. Enkhbold trailed with 41% and the balance of the votes being blank ballots. With Kh. Battulga’s win Mongolia now hosts a Nationalistic President and it remains to be seen how much of what he promised in his campaign will be implemented. Not an ideal candidate to reassure foreign investment, it is worth noting that the President’s powers are limited by the Mongolian People’s Party’s control of Parliament.
The best performing indexes in the AAFF universe in June were Vietnam (+5.2%), Bangladesh (+4.7%), and Sri Lanka (+1.1%). The poorest performing markets were Pakistan (-8.0%) and Iraq (-3.5%). The top-performing portfolio stocks this month were a Mongolian iron ore processing company (+33.3%), a Vietnamese construction company (+26.4%), a Sri Lankan conglomerate (+25.0%), and a Vietnamese real estate developer (+19.3%).
In June, we added to existing positions in Laos, Mongolia, Myanmar, Pakistan, and Vietnam and reduced our exposure in one Pakistani company and completely exited a Vietnamese battery producer. We newly added a Bangladeshi consumer finance company, a Vietnamese industrial park provider and a Vietnamese steel producer.
As of 30th June 2017, the portfolio was invested in 120 companies, 1 fund and held 5.0% in cash. The two biggest stock positions were a pharmaceutical company in Bangladesh (7.6%) and an investment company in Myanmar (2.8%). The countries with the largest asset allocation include Vietnam (27.6%), Pakistan (22.4%), and Bangladesh (16.4%). The sectors with the largest allocations of assets are consumer goods (30.6%) and healthcare (14.5%). The estimated weighted average trailing portfolio P/E ratio (only companies with profit) was 15.93x, the estimated weighted average P/B ratio was 2.87x, and the estimated portfolio dividend yield was 3.81%.