As we have stated before, we will soft close LO Funds—EM Consumer at USD1bn to ensure we retain the capacity to liquidate 30% of the portfolio in one day and 60% in one week, if required.
LO Funds—EM Consumer is now one of the largest funds in the consumer and retail subdivision of emerging markets. I sincerely want to thank all our investors, inside and outside Lombard Odier, for their immense support and trust over the last 24 months. In that time, our team has steadily grown with first, Lajla Aganovic (covering the Middle East, Africa and Latin American consumer and retail), then Thuy-Mai Hoang (risk management and south east Asian consumer and retail) and, more recently, Yeeman Chin. Yeeman, as well as speaking English and French, speaks Mandarin and Cantonese and understands Tagalog (the language of the Philippines). This is a great addition to our team as a quarter of the portfolio is invested in China and more and more Chinese companies are less willing to use English in their discussions with investors. Yeeman is based in Hong Kong.
It is true that our benchmark, the MSCI World index (hedged), has gone up by 38.82% since inception and we have started to lag over the last few months, as the spread between emerging and developed markets has started to widen substantially. Over the last two years, the MSCI Emerging Markets index has gone up by only 10%. Regarding the consumer and retail sectors, two distinct periods are evident. From the end of 2011 to the beginning of the second quarter 2013, the consumer sector was reasonably strong in all markets. However, the combination of currency weakness and a slowdown in all emerging economies has meant performance has been poorer for consumer and retail stocks, in these markets, over the last six months.
Over the last two years, we have had two periods of heavy sell offs in emerging markets: May 2012 and May-June 2013. The latter was also accompanied by serious currency weakness, with the Indian rupee down quasi 30% between March and September 2013. In general, despite equity markets doing well, it has not been an easy period for LOF Emerging Consumer as we have had to deal with high volatility, strong foreign exchange movements and lately, underperformance in the consumer/retail sector. Despite this, we have managed to keep the maximum monthly drawdown to 4% (May 2012 and June 2013compared to between 10% and 14% for the emerging market index).
We have also held volatility below 10% while it reached more than 20% for the emerging markets index. The beta of the Fund has rarely exceeded 0.65x. The Sharpe ratio of the Fund is around 2x.
The way we manage LO Funds—EM consumer is unchanged since its inception. We still very strongly believe in a model combining a bottom-up approach to stocks with macroeconomics and risk management.
Our investment universe is pretty stable at around 300 companies and they share similar characteristics of: 1) top corporate governance, 2) excess return on capital invested relative to the cost of capital, 3) a number one or two ranking in the consumer segment with very strong brands and 4) no leverage in the retail discretionary sector.
Our portfolio of 80 stocks is extracted from this narrow universe and changes are made according to the macro environment or correlation risks (unless idiosyncratic). For instance, in the second quarter of this year, we decided to rebalance our portfolio with much less exposure to south east Asia (Thailand, Malaysia and Indonesia but not the Philippines, which we believe has strong macro metrics) and much more to continental China. Flows and valuation of, the consumer and retail sectors, were becoming abnormal and moving in different directions.
Having been only modestly invested in Latin America, especially Brazil (weak macro environment and currency), we are of the view that the next six months look more positive (despite the difficult environment, low comparables and the World Cup) and recently strengthened our investment in Arcos Dorados and Lojas Renner. We also decided to build a position in Dufry (listed in Switzerland, but with 25% of earnings coming from Brazilian airports).
In terms of countries, around 25% of the portfolio is in China (directly or indirectly), 13% in India, 15% in Latin America and 7% in Russia. The rest is spread between the Middle East, Africa and some international corporations.
Our risk (cash, FX, options) has been well managed this year and our FX strategy has so far been very positive. It has added around 3% of net performance to the Fund this year. We were around 100% hedged in May 2013 and then reduced it to 50% in August. We are now rebuilding our FX hedging as the cost has come down significantly in the last two months; the Indian rupee was trading at 69 against the US dollar in August and is now back to 61.
We are also taking advantage of low equity market volatility to buy protection through SPY and EEM puts (options), which we have not had over the last six weeks. Our options strategy has not produced any revenues so far this year but has considerably reduced the Fund’s volatility. As a reminder, we can use max 2% of NAV premium per year to buy protection. The level of cash is back to 7%, while it was more than 10% in the second quarter.
Regarding October, LO Funds—EM Consumer returned 2.4%, underperforming all major indices whether developed or emerging. As stated above, the consumer and retail sectors are going through a difficult time as investors are now focusing much more on beta names (sectors such as banks and technology) or exports companies in emerging markets, which stand to benefit from recentdevaluations. We are not invested in those areas (and are unlikely to pursue those strategies). We therefore have to accept some months of underperformance.
This month we have done well with Sun Art Retail, Metro and Tingyi while Yum Brands, Carlsberg and Shiseido have been poor. We are adding a few new positions to the portfolio, which we discuss in detail below and are starting to sell some others, which we will discuss in the next letter when they have completely left the Fund. Interestingly, we are now seeing growth stocks with value in our universe. This is quite new. In the food retail space, large positions such as Mexico’s Chedraui or Okey in Russia, are now trading on EVEBIDTA below 10x 2014. These companies are producing sales and earnings growth, over a three-year cycle, of around 15% per year. In the case of Chedraui, or Arcos Dorados, Wumart, Hengdeli and Lojas Renner, it has been a tough 2013 but there could be a rebound in 2014 with easier comparables and a better macroeconomic environment. Our portfolio is now showing that 25% of our stocks stand at or close to two-year lows. We feel this will correct in 2014 unless the macro environment deteriorates further in these countries. However, this is not a scenario we are expecting.
THEMATIC INSIGHT
Indian consumer companies’ quarterly results were very similar to those reported in the past four to five quarters : volume growth is slower than two years ago but fairly stable, ranging between 2%-6% (Nestle, Marico, Hindustan Unilever, Emami, Jubilant LFL (like for like) sales) and 8-10% (Colgate, Dabur, GSK, Bata LFL sales, Future Retail food LFL sales, Hypercity food LFL sales), and even up to 15%+ (Shoppers’ Stop LFL sales). Companies have often taken advantage of favorable raw material prices (increasing gross margin) to increase advertising spend, which in our view is a healthy reaction to slowing macro trends. Competition is not abating but margins remain very comfortable, return on capital employed levels even more so, and long term growth prospects remain significant.
We saw a noticeable decline in Saudi consumption in the third quarter, which was reflected in a sharp revaluation of consumer stocks in our universe (Al Othaim – food retail; Herfy – Fast Food Restaurants). Several factors combined to create such headwinds:
1. The King decided to expel all undocumented foreign residents, which resulted in 1million people leaving the Kingdom (3% of the total Saudi Arabian population). The main impact is expected to be felt in the food and lodging sectors, as well as on telecom operators. Moreover, many construction projects could be delayed as these “ghost workers” will have to somehow be replaced by a legalized workforce. This will most probably slow down expansion projects of retail, fast food chains, shopping malls, etc.
2. Fewer Visas (-20% year-on-year) were given to pilgrims for the Umrah (visit to the holy Mecca all year around) and for the Hajj (seasonal effect, celebrating the end of the month of Ramadan).
Expulsions are continuing in the fourth quarter 2013 and it is still difficult to estimate the loss in the spending level of this population but we believe that it could go up to 1% of the non-oil GDP.
PORTFOLIO ACTIVITY
We began to build a position in Orion in October. Beyond its number (Nb) 2 biscuit / confectionery position in Korea (30% market share, stable earnings stream), Orion’s main attraction is the USD 1bnsnack business it has built up in China over the last few years. This now generates 50% of group EBIT and virtually all of the growth. Strong and regular new launches have secured fair brand recognition and high market shares in chocolate biscuits (Nb.1), potato snacks (Nb.2), and gum (Nb.2). The stock’s valuation is steep, with implied 2014 multiples for the China business of 18.5x EV/EBITDA and 3x EV/Sales. However we feel that the valuation reflects meaningful potential in China over several years, with room for further geographic penetration (presence in only 60,000 points of sales and 200 cities currently), a target to grow the share of traditional retail from c. 20% to 50% of sales (which should have a positive margin impact), and the ability to capture trading-up trends with the brand’s mid/high end positioning. We also note Orion is already number 1 in Vietnam (18% market share in biscuits/confectionery) and looking to enter Indonesia and Thailand in next few years.
We also took advantage of a share placing to start a position in Universal Robina (URC), the leading snack food manufacturer in the Philippines. It has had strong market shares in the Philippines for a while (Nb.1 in snacks, candy and chocolate, Nb. 3 in biscuits, Nb. 2 in instant noodles), but in the last three years has pushed forward successfully in several new segments / geographic markets : it has become Nb.2 in coffee in the Philippines with a 24% share, Nb.1 in ready-to-drink tea in both the Philippines and Vietnam, and Nb.1 in biscuits in Thailand. Valuation is hefty (EV/EBITDA 2014 of 16.5x), but we like the Philippines’ macro outlook and think that the ASEAN market for URC’s mid-end snack products is a large one (still comparatively low income per capita in most of these countries) in which URC can become one of the top players thanks to its existing local production facilities and already sizeable presence (almost 30% of FMCG sales generated in Asia ex-Philippines).
X5 is a Russian retail restructuring opportunity that we have been watching for several quarters. We decided to jump in after the company presented a credible restructuring plan, though time will be required to fully implement it. The company, which three years back was the leading Russian retailer, has seen slowing / negative same-store-sales-growth, deceleration in expansion, margins dipping versus competitors , management outflow and massive share price underperformance. On the positive side, the company owns 45% of its real estate (largely located in the Moscow and St Petersburg regions), new management has been appointed, X5’s current Chairman is the former CEO of Groupe Casino, and on EV/EBITDA 2014 of 6x and EV/Sales 2014 of 0.4x, the market is not really giving the company the benefit of the doubt. Additionally, we like the Russian consumer sector (solid real wage growth, likely acceleration of macro trends in 2014).
We participated in the IPO of Grupo Lala S.A. de C.V., a leading producer of milk in Mexico. The Company is primarily engaged in selling milk, value added flavored health drinks and other dairy products such as yogurt and cheese. It has a leading market share in all of the categories in which it operates (35% to 55% market share) except yoghurts, where it is number 2 with 23% market share (Danone is number 1).
The Group should be able to improve its operating margin with improved logistics and distribution facilities; +130bps to 150bps could be expected over the next two to three years, on a published 2012 EBIT margin of 9.5%. That should trigger mid-teens EPS growth over the next couple of years.
The Group is valued at an EV/EBITDA 2014 of 11.7x and an EV/Sales 2014 of 1.4x, which we find quite attractive for such a leading position in a country where high quality, liquid food manufacturing listed names are quite rare and trading on an expensive valuation.
We are starting to build a position in Dufry, joint number 1 in global travel retail. Its attractive share of revenue from emerging markets (close to 70% of group sales in 2012) derives from its strategy of focusing mainly on Tier 2-3-4 airports. This not only allows the Group to best capture the growth coming from rising tourism amongst the middle classes in emerging markets but also, at the same time, limits the impact on profitability of rental fees (23% of group sales vs 33% industry average). On top of this, as 30% of the EBITDA is coming from Brazil, the company will strongly benefit from the upcoming sports events (2014 World Cup and 2016 Summer Olympics) and from the improving consumer environment. The stock currently trades at an attractive 9.5x EBITDA 2014. Finally, since Autogrill split its retail travel business, World Duty Free, possibility of a merger with Dufry provides good share price potential.
