Emerging markets May 2013

In 2012 emerging markets returned close to 19%, after a torrid 2011. Within emerging markets, however, most consumer businesses returned far in excess of the benchmark, particularly those with very dominant positions in their home markets. In the six years that Coronation has been researching and valuing emerging market companies, we have compiled a shortlist of what we believe to be the highest-quality stocks within the investment universe. These are the stocks that we would like to own in our portfolios at the right price, namely:

• Ambev – the largest brewer in Brazil with close to 70% market share, world-class management and a compelling long-term opportunity to grow volumes in a country where beer consumption is still low, compared to developed markets. They also have ample room to expand sales of premium brands, which typically contribute much more to profitability than the mass market brands that currently dominate the country’s beer-drinking landscape. 
  
  

• Femsa – a 20% shareholder in Heineken and majority owner of Latin America’s largest Coca-Cola bottler with operations predominantly in Mexico, Brazil and Argentina. They also have full ownership of Mexico’s largest convenience store chain (Oxxo), which is rapidly rolling out stores in a country still dominated by small mom-and-pop operators.
  
  

• Wal-Mart de Mexico y Centroamerica, Wal-Mart’s Mexican-listed subsidiary, operates several retail formats in Mexico and other Central American countries. Already the number one operator in formal retail, the long-term prospects for store growth in the region should allow for many years of continued store rollout and market share gains.
  
  

• Hindustan Unilever, the Indian subsidiary of the Anglo-Dutch multinational, is by far the leader in detergents and personal care in India and has sizeable beverage and packaged food businesses. India is one of the most exciting countries in the world for companies operating in all these areas; a young population that is becoming progressively wealthier will consume ever larger amounts of all Hindustan Unilever’s products. Consumption today, on a per capita basis, is a fraction of other emerging market peers and miniscule in comparison to developed countries.
  
  

• ITC, British American Tobacco’s Indian affiliate, which also operates hotels and a foods business. The incidence of smoking in India is low by international standards, and most of those who do smoke use low-end informally produced mini cigarettes known as ‘bidis’. Over time there is enormous potential for additional consumers who will take up the habit, in addition to the ongoing migration from bidis to proper cigarettes as wealth levels rise.
  
  

• BIM, the leading retailer in Turkey, operates ‘hard discount’ formats that are familiar in Western Europe (Aldi, Lidl). The bulk of the food retail market in Turkey is informal and highly fragmented. BIM has expanded its store base exponentially, yet still has potential to roll out multiple times its current store number over the next 10 years. The company generates all the cash it requires to fund this growth and reinvests in price (to consumer) to maintain its competitive advantage over other formal retailers.
  
  

• Shoprite is the largest food retailer in South Africa. Its expansion over the last two decades has seen it displace previously ‘untouchable’ Pick n Pay as the no. 1 operator in the country. Led by an entrepreneurial management team, the company has successfully tapped into the emerging consumer class in South Africa. It leveraged off this success by expanding into the rest of Africa, a region with decades of formal retail growth ahead of it.

All the companies listed above would be core holdings in our portfolios at the right price. We have assessed their competitive advantages and modelled well into the future to capture what we believe are reasonable estimates of their future revenue and profit growth. Yet none of them offer a sufficient margin of safety to our estimate of fair value. We therefore cannot justify holding any of them.

Given this ‘void’ in our funds, together with our stated preference for investing in above-average businesses, you may well wonder what we in fact hold in our portfolios. The examples below will illustrate where we see long-term value and the mix of businesses that we prefer. Valuation supersedes everything in our investment process.

High-quality businesses that are hated by the market due to a poor short-term outlook

All businesses will experience growing pains, even those previously regarded by the market as impregnable. We hold two such businesses, the first of which is the X5 retail group. The company is currently Russia’s largest food retailer by revenue, but is experiencing poor short-term traffic, integration problems with a rival chain acquired in 2010, and as a result is suffering high turnover in senior management. Our second holding in this category is Arcos Dorados, the exclusive franchise holder for the McDonald’s brand in Latin America. This popular ‘aspirational’ brand has historically done very well in the region. Currently, however, it is experiencing input cost pressures, volatile currencies and a high level of competition from other global quick-service chains, all looking to expand their footprint in a region still predominantly made up of small-scale informal eateries.

Less obvious quality businesses that give one cheaper exposure to the emerging market consumer

We hold two Chinese car companies that we believe provide direct exposure to that country’s consumer class, and at far more compelling multiples than many more obvious candidates. For example, China’s largest listed food retailer, Sun Art, trades at 31 times this year’s earnings with only a two-year history as a listed company. Contrast this with Great Wall Motors (GWM), a home grown Chinese brand that is the leader amongst local pickup and SUV producers. GWM has a long history as a listed company and has delivered earnings growth of above 20% per year for most of its life as a public company. At 11 times this year’s earnings it provides far more reasonable access to the domestic consumer. Furthermore, it is worlds apart from the Detroit majors that have given vehicle manufacturing a reputation for destroying shareholder value. Our second holding is Brilliance China Automotive, the joint venture with BMW, which is more of a luxury brand than a car company (in our view) and can be bought at 13 times earnings.

Companies where short-term earnings look high but profits are well below normal

The fund’s largest holding is SA-listed Naspers, which appears expensive at 24 times earnings, yet we believe that profits are very depressed in most of its main 
businesses. For example, in the pay-TV business the company continues to invest heavily in subsidies for decoders to draw consumers onto their platform. This upfront investment depresses margins in the short term. However, over the long term, it leads to a loyal user base that will migrate upwards into more expensive packages and will rarely cancel their viewership as it remains one of the cheapest forms of entertainment available to consumers. Naspers’s various internet businesses in China, Russia, Eastern Europe and Brazil are still early on in their development lifecycle. On aggregate, they will experience very high revenue growth over the medium term, and have substantial room to improve margins as development spend normalises at more sustainable lower levels. When the expected increase in profits for Naspers is taken into account, the high short-term multiple comes down quite rapidly.

Underresearched mid-cap companies

Daphne Holdings is China’s second largest ladies’ shoe retailer, which operates in the affordable segment of the market. Despite great management, a decent track record, a strong private equity shareholder and a clearly defined path to increase its store footprint, the company trades at 15 times this year’s earnings. We believe this is due to a poor understanding of the intrinsic strengths of the brand and business, which will become more apparent as coverage by the sell-side analysts increases. Indonesian free-to-air and pay-TV operator, Global Mediacom, is another company that we believe trades well below what it is worth due to poor coverage by brokers.

Developed market companies with high emerging market exposure

We often highlight that investors looking for exposure to emerging markets should consider holding developed market stocks that earn a material proportion of their revenue or profits in emerging markets. Many of the largest emerging market names are essentially developed market businesses, like Samsung Electronics or the Taiwan Semiconductor Company. 

To this end, we can hold up to 25% of our portfolio in developed market names that meet our criteria of 40% of revenue, profit or cash flows from emerging markets. In our view, companies like global brewer AB Inbev, at 18 times earnings, are a far better way to access growing beer consumption in Brazil and Asia than, say, holding their listed subsidiary, Ambev, at 30 times earnings. Another example of the disconnect in valuation is our holding in Coca-Cola Hellenic, which earns two-thirds of its profits in Eastern Europe, Russia and Nigeria, but trades at 20 times earnings that are quite depressed due to the Western European part of the business. This compares very favourably to Coca-Cola Femsa (a subsidiary of Femsa mentioned earlier) that trades at 27 times earnings.

We hope that this has provided you with a fairly reasonable overview of the types of business that we own and the strict valuation discipline that has been behind the excellent returns generated by the fund since inception. It is likely that one of the ‘magnificent 7’ in our wish list of stocks will stumble and the market, as it often does, will overreact and ratchet down expectations. Such situations will provide us with an opportunity to own them. In the meantime, however, we will continue to be disciplined and diligent in our search for alternative investment opportunities.

If you require any further information, please contact:

Louise Pelser 

T: +27 21 680 2216
M: +27 76 282 3995
E: lpelser@coronation.co.za

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Notes to the editor:

Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 29% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange. As at the March 2013 quarter-end, assets under management total R409 billion.